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Credit Rating Agencies Are Here to Stay

NEW YORK ( TheStreet) -- Is there an " existential threat" to credit rating agencies?

Despite the Justice Department's $5 billion lawsuit against Standard & Poor's (a unit of McGraw-Hill (MHP)) and reports that New York Attorney General Eric Schneiderman is considering similar lawsuits against Moody's Corp. (MCO - Get Report) and Fitch Ratings, it would appear that other federal agencies, along with Congress, are doing everything they can to keep the "big three" with us.

The Big Problems

The U.S. continues to work through the big mess left over from the boom-and-bust in home prices, including stubbornly high unemployment, a lingering weakness in home prices, the uncertain status of Fannie Mae (FNMA) and Freddie Mac (FMCC) (which were taken under government conservatorship in 2008), with banks continuing to address mortgage repurchase requests from mortgage-backed securities investors. Bank of America (BAC - Get Report) faces the most pain from mortgage-putback demands, although the company appears to have rounded the corner with its recent settlement with Fannie Mae and with sufficient reserves and capital to ride out the storm.

The easiest thing to do at this time is bash the three biggest bond-rating agencies, which placed high investor-grade ratings on what we now know was some very dicey mortgage-backed securities, often made up of loans that didn't meet the already suspect underwriting guidelines of the lenders who sold them. Many of these MBS issues received the highest investment-grade ratings because they were backed by bond insurance.

As we have all learned from the mortgage credit crisis, investors need to question the value of bond insurance, because in an asset bubble, everything goes down at the same time. A bond insurer may not have sufficient resources to meet that type of tumult, which is why Ambac saw part of its insurance operations taken over by Wisconsin insurance regulators in 2010. Other bond insurers continue to battle mortgage lenders, whom they claim violated their own underwriting policies for loans that were securitized.

MBIA (MBI - Get Report) has a high-profile lawsuit against Bank of America, which some analysts think the bank will be able to settle for between $2 billion and $3 billion. The insurer's stock shot up 18% last Wednesday, after rival bond insurer Assured Guaranty (AGO - Get Report) was awarded $90.1 million plus interest and expenses, as a result of its mortgage-putback lawsuit against Flagstar Bancorp (FBC).

One of the biggest problems with the ratings agencies has been the built-in conflict of interest in the "issuer pays" compensation model. The bond issuer pays to have the issue rated, with the ratings agency providing feedback during the ratings process on what "credit enhancements," including insurance, may be needed for an investment-grade rating. A ratings agency obviously could lose business if it develops a reputation for being too conservative.

Since ratings agencies compete with one another and are in business to make money, issuers can engage in "ratings shopping," by submitting proposals for structured financial products to several ratings agencies at once, and selecting the one that will "provide it with the preliminary credit enhancement level it desires," according to a report to Congress presented by the staff of the Securities and Exchange Commission's Division of Trading and Markets in December.

The three major ratings agencies and roughly a dozen more competitors are known to regulators as nationally recognized statistical rating organizations (NRSROs). This designation and a host of regulations that incorporate the ratings have long cemented the ratings agencies with implied government stamps of approval.

Before the credit crisis and the ensuing Great Recession, the ratings agencies' status led some corporate risk managers to rely almost exclusively on the ratings when gauging the credit risk of their securities portfolios.

The Solutions

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 attempted to address many of the problems mentioned above. Section 939 of Dodd-Frank is titled "Removal of Statutory References to Credit Ratings," and requires the SEC and other federal agencies to do just that.

Over 10 years ago, when I was working as a credit analyst at the Federal Home Loan Bank of New York, I was surprised to learn that new rules from the Federal Housing Finance Board required the 12 FHLBs to set aside risk-based capital for their swap portfolios, using formulas that incorporated the ratings. A spokesperson for the Federal Housing Finance Agency, which now regulates the FHLBs as well as Fannie Mae and Freddie Mac, said in an email that "the project to remove credit ratings from regulations is an agency-wide and government-wide endeavor. The references for the FHLBanks are part of our agency-wide efforts and they have not yet been finalized."
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