ANALYSIS-Franken bill unlikely to make credit ratings more reliable

May 14, 2010

By Karen Brettell

NEW YORK, May 14 (Reuters) – Legislation designed to create more independent credit ratings for risky assets may not result in more reliable indicators of an asset’s future performance and details on how the process would work are still unclear.

The U.S. Senate on Thursday voted in favor of a proposal by Democratic Senator Al Franken to create a clearinghouse that will be comprised in majority by investors including pension and other fund managers, who will be responsible for assigning a rating agency to rate complex products at their inception.

By removing the decision on who allocates the first rating on these assets from the issuers, the legislation aims to remove ratings shopping wherein issuers of risky debt could seek out agencies that gave more favorable ratings to assets.

Some industry professionals are skeptical, however, that selecting an agency via a committee would lead to more accurate ratings.

“You cannot have someone decide who is the best rating agency for any deal,” said Sylvain Raynes, founding principal at R&R Consulting in New York, and former analyst in structured securities at Moody’s Investors Service.

“I cannot imagine this responsibility will not be corrupted immediately,” he added.

The legislation is part of a push to strengthen the ratings process after Moody’s Investors Service, Standard & Poor’s and Fitch Ratings created a false confidence in risky mortgage-backed assets that in many cases defaulted, causing a global flight out of credit securities and economic slowdown.

All three of the dominant ratings agencies competed to rate the securities, and were paid by the issuers of the deals.

The Franken bill will allow securities to be rated by other rating agencies, with any differences between their ratings and those of the initially selected agency to be made public.

The bill also intends to reward agencies with the best track record over time with a greater share of business.

“The question will be how the committee chooses a qualified rating agency for a particular structured sub-sector. Then they will need to develop a criteria that would lead them to select someone for a particular transaction,” said Jerome Fons, principal at Fons Risk Solutions, and former managing director of credit policy at Moody’s.

Its also unsure if the process applies only to assets that will be registered with the Securities and Exchange Commission or would also apply to those sold in the private placement market.

“If it only covers SEC registered transactions people may choose not to register their securities,” said Fons.

Ratings accuracy will also be difficult to measure as it may take years before the ultimate performance of an asset relative to its rating is clear.

The bill also intends to create more opportunities for smaller firms to compete against the Big Three who currently dominate the market.

Opening the market to more players would likely have multiple benefits, but also risks opening the process to less reliable raters.

Senator Christopher Dodd, who is overseeing the financial-reform effort in the Senate, voted against the Franken amendment, citing concerns that it could have unintended consequences.

“I don’t know what the implications are. Not all the rating agencies are equal,” he said.

More ratings agencies in the pool to provide the benchmark rating on assets, would also increase the chance of potentially less reliable agencies gaining more influence.

“Even bad rating agencies would be screaming for their allocation,” said R&Rs Raynes.

For text of the amendment, please click here

((karen.brettell@thomsonreuters.com; +1 646 223 6274; Reuters Messaging: karen.brettell.reuters.com@reuters.net ))

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