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) 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) 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) 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) 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."

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."

So there is plenty of work for various government agencies to do in order to address the problems with the credit ratings agencies that helped inflate the housing bubble. But the SEC has taken big steps to directly supervise the ratings firms, and is likely to take even greater control to mitigate the conflict of interest in the "issuer pays" model.

In the meantime, corporate investors and money market funds have to do their own due diligence when selecting investments. "The buck stops with the board of directors," Mayer said. "There's no longer going to be robotic reliance on the ratings."

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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