How will Mary Schapiro fix the ratings-agency mess?

By Felix Salmon
July 22, 2010
seems to be closed, with Ford pulling a deal which was going to be more than $1 billion.

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The biggest unintended consequences of Dodd-Frank to date is the fact that the market in asset-backed securities seems to be closed, with Ford pulling a deal which was going to be more than $1 billion.

There are two related issues here. The first is the repeal of SEC Rule 436(g), which had prevented investors from being able to sue ratings agencies if the ratings turned out to be wrong. There has been lots of talk of the ratings agencies “going on strike” — but technically the ratings agencies have never given their permission for their ratings to be used in bond prospectuses. Instead, the banks got the ratings in there anyway by dint of Rule 436(g), which basically allowed the ratings to be included even without permission from the ratings agencies themselves. Now that the rule has effectively been repealed, they can’t do that any more.

The second issue is a different SEC rule: Regulation AB Item 1120. That’s what people are talking about when they say that credit ratings are required to be included in bond prospectuses for asset-backed securities.

But Dodd-Frank gives the SEC the power to effectively rescind AB1120. If that happened, then credit ratings wouldn’t be included in bond prospectuses, but the bonds could still be sold.

Repealing AB1120, if only temporarily while the SEC works out some kind of sensible permanent solution, seems to be the obvious way to go, especially since it’s a move in the direction of removing credit ratings from official rules and regulations.

At the same time, however, it’s something of an end-run around the whole point of repealing 436(g), which is to make ratings agencies accountable for their actions. No one actually reads bond prospectuses in any case; all the buyers of structured notes are going to know what the ratings are even if they’re not in the prospectus. So repealing AB1120, while it might solve the gridlock problem, would be a bit of a stick in the eye of the legislators who repealed 436(g).

There’s one other possibility here, which would have a similar effect: the SEC could decree that credit ratings count as forward-looking statements, and therefore can’t be subject to “expert liability.”

But for the time being, we’re at an impasse which only the SEC can really do anything about: so long as the ratings agencies are liable for their ratings, they won’t allow them to be used, and yet at the same time the SEC is insisting that credit ratings are included in bond prospectuses. Clearly Congress hoped that the ratings agencies would reluctantly accept their increased liability, but equally clearly that ain’t gonna happen any time soon.

So this is a big test for Mary Schapiro: whether and how she fixes this problem will be a good indication of her philosophy as head of the SEC. What’s certain is that the ball’s now in her court.


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Even if they accept their increased liability, won’t they need to understand the limitations of that liability before they can figure out how to price it? No one was expecting that they would accept that liability without charging more for their services, were they?

Posted by MattJ | Report as abusive

The language of AB 1120 is remarkably clear for legalese (which probably means I don’t understand it…). It doesn’t say that the ratings must be disclosed. It says that if the sale of a tranche is CONTINGENT on achieving some rating level, that fact must be disclosed, as well as what that minimum rating is and what company provided the rating. It sounds like a weak attempt at forcing disclosure of when deals have been contrived to get, say, AAA for the senior tranche – as happened with so many subprime deals, with the rating agencies disclosing their methodology to the dealers so that the dealers could cook the deals to order (by finding the holes in the rating models).

Here’s the full text:

§ 229.1120 (Item 1120) Ratings.
Disclose whether the issuance or sale of any class of offered securities is conditioned on the assignment of a rating by one or more rating agencies, whether or not NRSROs. If so, identify each rating agency and the minimum rating that must be assigned. Describe any arrangements to have such rating monitored while the asset-backed securities are outstanding.

Posted by FosterBoondog | Report as abusive

I have trouble understanding why a credit rating agency has anymore sway than an analyst that does his homework, unless the rators have some secret formula that determines what a rating should be that others would not be a party to. I’m not sure how we fix the problem, because any fix seems to bring about a whole mess of it’s own problems. Perhaps threat of litigation is the only way to keep ratings people in check…

Posted by CDNrebel | Report as abusive

the theory behind the rating agencies was that they were a supposedly disinterested third party. because the sellers have an interest in selling useless rocks if given the opportunity. and some buyers (banks, pensions, stock funds, 401k firms, and others) aren’t really all that interested in just how good what they buy is on occasion. the rating agencies were suppose to keep them honest. but some where along the line this formula for private protection broke down

Posted by willid3 | Report as abusive

Felix, I don’t think your suggestion on forward-looking statements is feasible any more. Dodd-Frank specifies that statements made by credit rating agencies are not forward-looking statements for purposes of the Exchange Act’s Section 21E safe-harbor. So this is no longer within the purview of the SEC.

Posted by Gennitydo | Report as abusive


I’m not sure I follow you on your reading of 436(g). The rule did much more than just allow issuers to use ratings in their prospectuses, because the reason “permission” was not needed was because 436(g) exempted ratings agencies from being held to a standard of negligence for their work in a court of law.

Many, many, many lawsuits against the agencies are immediately thrown out of court without being heard because the suits allege negligence, and the courts cite 436(g) as the reason that the case cannot even be heard.

So in a narrow way, you are correct. But the way you phrase it kind of misses the point. The regulation was specifically designed so that ratings agencies couldn’t rate garbage SF transactions without doing what would pass as due diligence in a court of law.

I’m not surprised at the agencies’ reaction; however, given that a huge amount of their revenue stream comes from rating SF products, I think this is more of a game to see who blinks first. There’s no way that agencies will risk losing the SF market in the long term. Instead, they’ll just have to deal with the legal uncertainties.

And if garbage SF transactions don’t get rated, well, good. That’s the whole point.

Posted by shrivti1 | Report as abusive