Should asset backed securities be outlawed?
On Tuesday the SEC is holding a roundtable on credit ratings to address the ongoing question of ratings shopping. Rating shopping is when a bond issuer shops its deal to various credit rating agencies to see who will assign the highest rating. The rating agencies that will assign the best ratings are given the business and the rating fee. Here is how the SEC describes its event:
As previously announced, the roundtable will consist of three panels. The first panel will discuss the potential creation of a credit rating assignment system for asset-backed securities. The second panel will discuss the effectiveness of the SEC’s current system to encourage unsolicited ratings of asset-backed securities. The third panel will discuss other alternatives to the current issuer-pay business model in which the issuer selects and pays the firm it wants to provide credit ratings for its securities.
The possibility of a credit rating assignment system comes from legislation that Minnesota’s senator Al Franken inserted in Dodd-Frank. Franken’s law requires that the SEC study the feasibility of a bureau or panel that would assign a rating agency to rate an offering. Currently issuers choose which firms will rate their offering although for structured finance or asset-backed deals issuers must share the particulars of the new deal with all raters recognized by the SEC in that category. This is equivalent disclosure and something that I have advocated with the SEC since 2007 and Congress since 2008. It has slightly increased competition in rating structured finance securities as seen in the chart above although the size of the market has declined since 2007.
In theory the idea of a bureau that assigns rating agencies has much in it’s favor, but it goes against all the rest of the law related to credit ratings. Current law (Credit Rating Agency Reform Act of 2006) enshrines the principles of increasing transparency and competition for ratings. The Franken proposal moves in the opposite direction by narrowing the number of opinions on specific bond issue.
But maybe all of this is shooting in the wrong direction away from the real problems of rating asset-backed securities. Here is a comment from former Moody’s senior vice president William J Harrington made on a Financial Times story about the SEC Roundtable:
Few securities are backed only by mortgages or only by credit card debt or only by auto loans. Rather, securities are backed by derivatives and by mortgages together, or by derivatives and credit card debt together or by derivatives and auto loans together.
Derivative-asset-backed securities are misrated by all firms – none should be rated higher than A/BBB. Instead, large and small rating firms alike assign zero probability to derivative event risk so as to rate new issues AAA and AA.
Bank bail-outs kept upright the domino of derivative event risk last go-round. Subsequently, derivative event risk has grown more pronounced with the extreme concentration of too-big-to-fail derivative providers.
Why do issuers allow derivative event risk to fester? Because securitization issuers don’t exist except as Cayman Island post office boxes.
With respect to securitizations, the rating conflict of interest is “bank-underwriter-plays-with-issuer monies” and not “issuer pay.” No entity has fiduciary responsibilities with respect to rated debt.
If Harrington’s comment is right then nothing the SEC or Congress can do will fix the ratings problem for asset backed securities. Although the market has been shrinking and broadening some (see chart above) maybe it’s best the whole thing be made illegal. The American economy could not withstand another credit market implosion like we suffered in 2007 and 2008 and that lead to Bear Stearns and Lehman collapsing. Tweaking around the edges leaves a potential time bomb embedded in the economy.