Ratings Agencies Get Their Comeuppance – They’ve Been Downgraded! Part Two

Part One of my blog post “Ratings Agencies Get Their Comeuppance – They’ve Been Downgraded!” dealt with the favored status of the large ratings agencies in our country over the last several years.  The premise in that post was that responsibility for the financial crisis in this country beginning in 2007, and the resulting collapse of credit availability, housing prices and employment, was a direct result of the rampant and largely unregulated securitization of mortgage backed securities that Wall Street engaged in circa 2005-2007.  But while Wall Street may have been the “Evil Genius” that came up with the scheme, it would have never been possible but for the complicity of the big ratings agencies, who were the Shills in the Crowd

Without the investment grade ratings of Moody’s and S&P, in particular, the large pension and retirement funds could never have purchased the toxic tranches sold by the Wall Street investment banks.  You see, although investors sought the higher returns of the Private Label secondary mortgage market – there was a big problem.  Unlike Fannie and Freddie’s securitizations, which had the “implicit guarantee” of the federal government, the Private Label market had no such financial backstop.  So it seized on the next best thing – the imprimatur of the big rating agencies.  The agencies [for a fee] dutifully complied and rated Wall Street’s Private Label mortgage-backed securities as “investment grade” – meaning that they were suitable to purchase by the large funds. 

After being sued from pillar to post by the investment funds that purchased Wall Street’s toxic tranches, it has turned out that the ratings agencies were able to avoid all civil liability.  In May, 2011, the U.S. Court of Appeals for the Second Circuit issued a unanimous 3-judge ruling[1] holding the rating agencies were only issuing an “opinion” under their Commercial Free Speech rights, and could do so without liability.  This ruling, along with several others in the Federal District Courts, has tended to affirm the “Commercial Free Speech” holding.  But have they really escaped the hangman?  Next, the comeuppance. ~ PCQ

BackgroundOn June 26, 2012, the Office of the Comptroller of the Currency (OCC) published the final rules that were mandated under Section 939A of the Dodd Frank Act.  While most folks have no idea what Section 939A refers to, there is no question that the Big Three agencies know full well, since it may mark the beginning of the end of their industry – at least as they have known it for the past 100 years.

This section of Dodd-Frank, which goes into effect on July 21, 2012[2] provides as follows:

(a) AGENCY REVIEW.—Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review—
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.

(b) MODIFICATIONS REQUIRED.—Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.

(c) REPORT.—Upon conclusion of the review required under subsection (a), each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection (b).

In more prosaic terms, the new law can be explained as follows: The main product that ratings agencies sell…are, well, RATINGS.  Under Section 939A of Dodd-Frank, henceforth, all federal financial regulatory agencies are to delete the “R-word” from their vocabulary.  Metaphorically, it appears as if Moody’s and S&P are being Photo-shopped out of the regulatory landscape!  How will they survive?  What will they call their main product?  Now I know how Prince must have felt without his name….

The RulesThe regulatory rules that were implemented pursuant to Section 939A can be found at 12 CFR Parts 1 and 160 [Guidance on Due Diligence Requirements in Determining Whether Securities Are Eligible for Investment] and 12 CFR Parts 1, 5, 16, 28, and 160 [Alternatives to the Use of External Credit Ratings in the Regulations of the OCC].

The “Guidance” Rules.  Essentially, these rules have are designed to assist agencies in developing their own “in-house” tools to establish creditworthiness and risk.  Interestingly, the term “investment grade” is also being banished from the regulatory landscape.  After searching Google for a good definition of the term, I’ve settled on the following:

A credit rating given to a government or corporate bond that indicates that the agency giving the rating (for example, Standard & Poors, Moody’s or Fitch) thinks the issuer has strong creditworthiness and is unlikely to default. The grades used by two of the leading agencies are as follows: Moody’s AAA / S&P AAA for the highest quality, lowest risk bonds, down to Moody’s Baa / S&P BBB for quality bonds with an adequate capacity to pay interest and principal but which are more vulnerable to adverse economic conditions. All those at Baa/BBB or above are adjudged investment grade.” [See, http://www.finance-glossary.com/define/investment-grade/12452/0/I]

 In order to fully appreciate the potential impact of this law, it is necessary to appreciate the level of validation that has historically been given to the issuance of credit ratings. Here is a good explanation of the impact “ratings” have in finance and investing.

“Ratings from the major agencies, are important to some extent because investors look to them as high-quality assessments of credit risk.   But they are important for two other related reasons.   First, the financial regulatory system incorporates ratings issued by agencies that  enjoy  the  government-recognized  status  of  a  “nationally  recognized  statistical  rating organization” (NRSRO).  At least 44 SEC rules and forms rely on ratings, including rules that require money-market funds to invest in instruments with high credit ratings and that exempt highly rated structured-product vehicles from the (fatal) designation as investment companies. State laws require state funds and employee pension funds to meet credit-rating requirements. Banking regulations determine regulatory capital requirements based on the credit ratings of the securities the bank  owns.  Judicial decisions  protect fiduciaries that  rely  on  credit  ratings.  Second, agency ratings — with the agencies often identified by name – are hardwired into the financial infrastructure through private arrangements:  Investment guidelines and covenants for all manner of fixed-income instruments are keyed to agency ratings.  Indeed, many structured products[3] are set up so that they default if they fail to meet ratings criteria, even if investors are receiving all scheduled payments.” [“Credit Rating Agencies and the ‘Worldwide Credit Crisis’: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement” – John P. Hunt, September 5, 2008. Berkley Law.]

 Keeping in mind the above significance of ratings, here is what the OCC’s Guidance rules say about the term “investment grade”:

“…the OCC proposed to amend the definition of ‘‘investment grade’’ in 12 CFR part 1 to no longer reference credit ratings. Instead, ‘‘investment grade’’ securities would be those where the issuer has an adequate capacity to meet the financial commitments under the security for the projected life of the investment. An issuer has an adequate capacity to meet financial commitments if the risk of default by the obligor is low and the full and timely repayment of principal and interest is expected.”

Translation:  (a) The term formerly known as “investment grade,” will now mean that the issuer of the security has financial staying power if the obligor [e.g. the borrower under the mortgage backed security] has a low risk of default; and (b) You can’t say you heard it from a rating agency.

Riddle Me This Batman:  Isn’t the ultimate question still whether the stream of income is and will remain reliable?  And isn’t that the essence of what the rating agencies were opining?  So if the issuer, or the issuer’s agent, renders this opinion – rather than a rating agency, won’t it come with the same warnings and disclaimers as all securities offerings?  And won’t it still be protected Commercial Free Speech?  So, what’s changed to protect the investor? [This is what I dislike about increasing government interference regulation. The rules may change, but the effect remains the same. – PCQ] But I digress; perhaps the “Alternatives” discussion below will help clarify….

2. The Alternatives Rules.  The full title of the rules is “Alternatives to the Use of External Credit Ratings.” They address possible resources for the finance and investment industry to use, rather than the agencies that use the R-word.  After reading the rule – admittedly only once – this is the best I could glean: First, banks don’t have to use external companies such as Moody’s and S&P.  But, secondly…

“…if a national bank chooses to use credit ratings as part of its “investment grade” determination and due diligence, the bank should, consistent with existing rules and guidance, supplement the external ratings with a degree of due diligence processes and additional analyses that are appropriate for the bank’s risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by an NRSRO is not automatically deemed to satisfy the revised “investment grade” standard.”  [Emphasis added.]

Translation:  So not only are the ratings agencies being air-brushed out of the financial landscape, but issuance of their  priceless R-words will not qualify as sufficient due diligence for the issuer to call the security “investment grade.”  Talk about being marginalized…. This may really make the agencies Poor and Moody.

Next: Part Three: The Private Sector Snubs the Ratings Agencies

[1] In Re Lehman Brothers Mortgage-Backed Securities Litigation.

[2] You need a score card to figure out the effective dates of many of the sections.  A wonderful such scorecard is found here, compliments of the fine lawyers at Sullivan & Cromwell LLP.

[3] A “structured product” or “structured investment product” is merely an investment mix that has been customized to fit an investor’s risk tolerance and other parameters. – PCQ