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TheStreet Open House

Credit Rating Agencies Are Here to Stay

Following the Justice Department's announcement of the lawsuit against Standard & Poor's, an editorial in the Wall Street Journal highlighted the irony of one government agency taking a ratings agency to task while "another agency continues to endorse it." The Journal went on to say that "the SEC, which had been investigating the credit raters, is not part of this week's lawsuit," and also that "more than two years after the Dodd-Frank law ordered their repeal, SEC rules still force institutions to follow the advice of these government-anointed credit raters."

That last statement is actually unfair to the SEC, because the agency has taken many steps to address the problems with the credit ratings agencies, and is preparing to make other moves to address the potential for conflicts of interest in the "issuer pays" compensation model. The Justice Department's lawsuit also centers on events that took place before the credit crisis.

The SEC in 2010 created a separate Office of Credit Ratings, which has supervisory authority over the credit agencies, and is required under Dodd-Frank to examine each NRSRO annually. An SEC spokesperson said in an email that "the Office is also responsible for developing rules to strengthen transparency of the credit rating process as well as managing conflicts of interest, strengthening internal controls and regulatory governance."

The SEC has also removed 18 references to the ratings agencies from regulations, "and another 13 removals have been proposed and are pending final approval."

Kevin Petrasic, a partner in the Global Banking and Payments Systems practice of Paul Hastings in Washington, says a major challenge for the SEC and other agencies in meeting Dodd-Frank's requirements to remove references to the ratings in regulations is that "these provisions have been in place for decades."

"The challenge is that there is no substitute. What the credit agencies provide is a relative degree of uniform expertise that allows for a relative degree of consistency," he says. When asked whether the answer might be to have a government-run agency handle the ratings process for mortgage-backed securities, Petrasic says "it would be extremely difficult for a federal regulatory agency to do what the private ratings agencies do. There would be a tendency to be overly conservative at times like this and lax during the good times."

"A private-sector solution with incentives to get it right will be the most flexible to take the steps at the appropriate times to make adjustments and have the expertise to build up over time to make the judgment calls on nuanced issues."

Based on the SEC staff report to Congress -- which the SEC carefully said was the opinion of the staff and not necessarily the SEC commissioners -- it would appear that the "issuer pays" model is here to stay.

While the report doesn't say as much, it's pretty clear that the current payment model will continue because that's where the money is.

The SEC staff detailed a proposal to address the potential conflict of interest of having bond issuers pay for ratings, by implementing an "assignment system for credit ratings." Under this system, the SEC would establish a "CRA Board" to dole out assignments for "initial ratings" for specific bond issues. Issuers would still be allowed to have bonds issued by other agencies. According to Frank Mayer, a partner in the Financial Services Practice Group of Pepper Hamilton in Philadelphia, this type of system is likely to be put in place.

"The SEC will interact with the industry and it will have to be done in an equitable and transparent way," Mayer says, adding that "the ratings agencies will now have a higher level of liability and responsibility."

"There will also be standardized reporting," he says, adding that "through the training overseen by the SEC you are pushing conflicts of interest out of the system, so there is nothing wrong with the issuers paying for it."

Another major issue that needs to be addressed when reducing statutory reliance on the ratings is the Basel III capital requirements. Credit ratings are still built in to risk-weighting of securities held by banks and bank holding companies in the U.S. Mayer says there are also "a lot of discussions at the international level," because of new capital requirements for foreign banks with operations in the U.S., "even though they have robust capital requirements at home."

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