This is the year in which we are likely to see some of the proposed changes in regulation of the financial industry become law. In a recent white paper I wrote about the principles of reform that I hoped to see guide the changes as they apply to rating agencies. They include changing the business model by having investors rather than issuers pay for ratings, reduce the barriers to entry to encourage more competition in the industry, and enhance accountability so that those wronged by woefully inaccurate ratings would have recourse for compensation. Judging by the current bills (Senate Bill Title IX Investor Protection Act of 2009, and the House Bill, HR 4173 Accountability and Transparency in Ratings Agency Act) this is not going to happen.
Both bills share the basic operating principle that the business model in the ratings agency business is to remain unchanged. The primary reason that the rating agencies failed so miserably in their primary task was because they served the wrong master, issuers and not investors. Both bills substitute an internal compliance agent, additional reporting and further disclosure as means to restoring confidence in the work of the rating agencies. No question these proposed reforms will make kowtowing to issuers more difficult, but will they end the practices we have recently seen? The financial motivation to bias ratings to what issuers want will not change. What will change is that SEC examiners will be collecting data, reviewing codes of ethics and conflict of interest policies, meeting with compliance officers, and reviewing the methods used for assigning ratings. I believe you could fairly characterize the potential situation as greed as represented by highly motivated and clever individuals working for rating agencies versus examiners who have very recently demonstrated an inability to properly supervise and enforce longstanding straightforward regulations. I am not optimistic.
Moreover, both bills do nothing to encourage more companies to enter this industry. The barriers to entry that currently exist will be raised a bit higher with additional and potentially costly reporting requirements. The bills also propose that the agencies make public the procedures they use to generate their ratings. Fundamental to the ratings process when done correctly are models that predict the financial performance of the company being rated or the underlying collateral in the case of securitized debt. These models presumably represent an important component of the intellectual capital of a firm. What potential new entrant would want to risk their IP becoming public because of a reporting requirement? Finally what particular need would a new agency serve? I could see investors creating a demand for agencies with particular expertise or unique sophisticated methods in assigning ratings. However with issuers paying for the ratings I do not see a source for innovation in the credit rating business.
The bills provide for penalties as a deterrent against violating the proposed reforms. The SEC is given rulemaking authority in the establishment of penalties. Presumably they will be made sufficiently onerous to encourage voluntary compliance with the provisions of the bills. But that leaves unanswered the question of restitution for those victimized by inaccurate ratings. To be fair that is a legal issue that should be addressed by the courts and not the legislatures. Therefore my evaluation of these bills is based on two of my three previously stated principles, correcting the business model and encouraging greater competition among agencies. As for the first principle I certainly hope that greater disclosure and transparency are sufficient to overcome the bias in the business model, but I remain skeptical. On the second principle I have no doubt. Not only do the bills not encourage additional competition, they discourage it by increasing the barriers to entry, financial and otherwise.
Ben Wolkowitz Headstrong
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