Credit ratings beyond the S&P case
The long awaited prosecution against a U.S. credit rating has finally arrived. The Department of Justice filed a civil suit this week alleging that Standard & Poor’s committed mail and wire fraud and defrauded investors with ratings of residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs). These securities are known in regulatory and market parlance as “asset backed securities” because loans or bonds are bundled into larger, more complex securities. Until this market collapsed in the 2008 financial crisis, it was the source of great profits for banks, investors and credit rating agencies. It also accelerated the collapse of the financial system as the securities were sold around the world to increasingly less sophisticated investors.
At the core of the allegations against S&P is that the ratings agency loosened its methodology to get more market share from Moody’s and Fitch, the other dominant raters. Bloomberg writes:
In 2004, S&P discussed changing its rating criteria as executives internally raised concerns about losing deals to competitors.
One analyst in May 2004 wrote that the company was losing a ‘huge’ deal to a competitor because S&P was more conservative than others, the government said.
‘This is so significant that it could have an impact on future deals,’ the analyst wrote, according to the complaint. ‘There’s no way we can get back on this one, but we need to address this now in preparation for future deals.’
The question really is whether the practice of loose rating standards has stopped. That is somewhat hard to determine because raters are allowed to modify their methodologies if they disclose these changes to the public and users of their ratings. There is also always an element of subjective or qualitative judgement when ratings are assigned.
The other, more insidious, market practice that led Standard & Poor’s to loosen its methodologies is “rating shopping.” Rating shopping occurs when the investment bank or arranger for an asset-backed security “shops” the deal around to various rating agencies to determine who will assign the highest rating. By achieving the highest rating it lowers the cost of borrowing to fund the deal, raising profits.
These efforts by investment banks and arrangers created competition between raters to lower the subordination levels (the amount of a deal that would stand ready to accept the first loss if bonds or loans within the structure were to default). Andrew Cohen, in a study of commercial mortgage back securities for The Board of Governors of the Federal Reserve, concluded that rating shopping did cheapen the standards (subordination) that raters used to evaluate the creditworthiness of securities. Cohen writes:
Taken together, the evidence supports the claim that rating shopping contributed to the downward trend in credit support levels over the sample period.
Raters lowering subordination levels was a well known practice when it was happening, and the Federal Reserve study only verifies what many market participants were saying.
What about now? Does rating shopping continue in the asset-backed securities market? Actually, it is much harder now for investment banks or arrangers to shop a deal for the best ratings due to a new SEC rule – Rule 17g-5 – that requires an issuer to make the financial details of the new offering available on a password-protected website to all qualified credit rating agencies. This disclosure is required whether a rating agency is paid to rate a deal or not. The rule is summarized by Sidley Austin:
Rules adopted in November 2009 by the Securities and Exchange Commission (the SEC) under the Credit Rating Agency Reform Act of 2006 will require issuers, sponsors or underwriters (referred to as “arrangers”) of structured finance securities to post on a password-protected internet website, the information provided by arrangers to credit rating agencies hired by an arranger to rate or monitor the credit ratings of the securities. The new rules will require the arranger to provide access to the website to other credit rating agencies that provide the arranger with a required certification. The deadline for compliance with these new rules is June 2, 2010.
So the ABS deal can no longer be shopped to the easiest raters who would assign the highest rating. The ABS market has contracted, and the number of total ABS ratings has declined from 366,331 in 2007 to 286,587 in 2011. The distribution of ratings has also broadened to include other raters, including DBRS and Morningstar. Other rating agencies like A.M. Best, Egan-Jones and Kroll Bond Ratings have also rated a small number of deals (less than a 100 each in 2011).
Standard & Poor’s was not the only bad actor in the debacle of asset-backed securities ratings. The ratings business was not transparent for decades, and it allowed many bad incentives and practices to develop. Hopefully the new rules in place from the 2006 Credit Rating Agency Reform Act and Dodd Frank Wall Street Reform Act are improving ratings oversight. Additional transparency will flush out bad incentives and practices.
Fitch Form NRSRO
Moodys Form NRSRO
S&P Form NRSRO