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Dec 23

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Credit Agency Reform should be a Congressional Priority

My post yesterday summarized a recent SEC inspection report that showed dramatic continuing failures by the credit reporting agencies.  The post also indicated that the SEC is unable to address the needed changes on its own.

In mid-December, the SEC issued a separate report required under section 939F of Title IX, Subtitle C. The SEC described its reporting requirements as follows:

 … a report containing: (1) the findings of a study on matters related to assigning credit ratings for structured finance products; and (2) any recommendations for regulatory or statutory changes that the Commission determines should be made to implement the findings of the study. In particular, section 939F provides that the Commission shall carry out a study of the following:

(1) The credit rating process for structured finance products and the conflicts of interest associated with the issuer-pay and the subscriber-pay models;

(2) The feasibility of establishing a system in which a public or private utility or a self regulatory organization (“SRO”) assigns NRSROs to determine the credit ratings for structured finance products, including:

(a) An assessment of potential mechanisms for determining fees for NRSROs for rating structured finance products;

(b) Appropriate methods for paying fees to NRSROs to rate structured finance products;

(c) The extent to which the creation of such a system would be viewed as the creation of moral hazard by the Federal Government; and

(d) Any constitutional or other issues concerning the establishment of such a system;

(3) The range of metrics that could be used to determine the accuracy of credit ratings for structured finance products; and

(4) Alternative means for compensating NRSROs that would create incentives for accurate credit ratings for structured finance products.”

The current system under which the credit rating agencies operate cannot help but deliver poor results. The SEC describes the current “issuer-Pay Model” as follows:

Under the issuer-pay model, the NRSRO is paid by the arranger to rate a proposed structured finance product. …This payment model presents an inherent conflict of interest because the arranger has an economic interest in obtaining credit ratings that are demanded by investors and that lower the issuer’s financing costs and the NRSRO has an economic interest in having the arranger hire it in the future. This creates the potential that the NRSRO will be influenced to issue the credit ratings desired by the arranger.

There are several aspects of the credit rating process for structured finance products that may heighten the effects of the conflicts of interest inherent in the issuer-pay model. For example, an arranger may have multiple NRSROs analyze a proposed structured finance product and select the one or two NRSROs that provide the desired credit ratings (i.e., engage in “rating shopping”). When this occurs, the arranger provides information about a proposed structured finance product (e.g., a CMBS) to multiple NRSROs that rate the type of product being offered. The NRSROs will provide preliminary estimations of the credit enhancement levels necessary to support a credit rating in the highest credit rating category. The arranger then selects the NRSRO or NRSROs that provide it with the preliminary credit enhancement level it desires. This creates an incentive for the NRSRO or NRSROs to provide preliminary estimations desired by the arranger in order to be hired to produce a final credit rating for the transaction.

In addition to the “rating shopping” dynamic, the issuer-pay conflict may be more acute for structured finance products (as compared to other types of debt instruments) because certain arrangers of these products bring substantial ratings business to the NRSROs. As sources of repeat business, arrangers of structured finance products may exert greater undue influence on an NRSRO than personnel involved in obtaining credit ratings for other types of issuers. Furthermore, in the case of certain structured finance products, there are only a few major investment banks that assemble and sell these products. Losing the business of one of these banks could have a substantial impact on an NRSRO’s revenues. Conversely, an arranger potentially could bring repeat rating business to a credit rating agency because the arranger’s own credit rating was determined by the credit rating agency and, therefore, wants to curry favor with that credit rating agency.”

The solution involves and independent board that would assign ratings work. The amount of work assigned would increase or decrease based on the quality of the rating. The SEC critiques the challenges that exist with such a system, but these challenges represent a significant improvement over the status quo. However, this significant change likely requires Congressional authority. Congress now has significant study of this issue through the SEC reports, combined with the numerous prior failures of the existing system.

About the author

David Nolte

I am a founding principal of Fulcrum Inquiry, an accounting and economic consulting firm that performs damage analysis for commercial litigation, forensic accountings, financial investigations, and business valuations. I am a Certified Public Accountant (CPA) and an Accredited Senior Appraiser (ASA), as well as having other professional credentials. I regularly serve as an expert witness involving damages measurement. My litigation-oriented resume is on Fulcrum's website.

Permanent link to this article: http://betweenthenumbers.net/2012/12/credit-agency-reform-should-be-a-congressional-priority/

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