Everyone hates the big credit rating agencies—Standard & Poor's, Moody's, and Fitch. Europeans resent the clout that they wield. Democrats hate them for their complicity in expanding the subprime mortgage market that brought down the economy and left us with a 9 percent unemployment rate. Republicans, though they're generally opposed to the Dodd-Frank financial reform legislation, have no love for the credit rating agencies, either. The conservative Wall Street Journal columnist Holman Jenkins, in a July 27 column headlined "Who Elected The Rating Agencies?," called section 939A of Dodd-Frank, which requires federal regulations to be stripped of all references to credit ratings, a "rare useful provision." Citing section 939A, David Zervos, the head of global fixed-income strategy at Jefferies, calls the noise the credit raters are currently making about downgrading U.S. Treasuries a "last gasp of hot air."
Yet the stock performance of the rating agencies doesn't suggest that they're losing their relevance. Moody's stock is one of the best-performing for any big U.S. company this year. There may be a good reason. Last week, the House financial services committee held a hearing about the rating agencies. Much of it was devoted to the possibility that the agencies would downgrade the United States, but the various witnesses brought prepared statements about the progress of section 939A. After reading these, I'm not convinced that this important reform is going to happen.
The ratings agencies would like you to believe that the source of their power is the accuracy of their opinions. But in fact, its true source is the extent to which their ratings have been embedded in various rules and regulations across the financial world. It all started back in 1975, when the Securities and Exchange Commission began to use such ratings to calculate how much capital broker-dealers should be required to hold. To prevent the proliferation of fly-by-night raters, the SEC designated a handful of firms as "nationally recognized statistical rating organizations," or NRSROs. By the time the financial crisis hit, NRSRO ratings were embedded in thousands of regulations and private contracts, if not more, determining what securities money-market funds would be permitted to own, how much collateral counterparties would have to put up in trades, and countless other arcane matters. At the hearing, Mark Van Der Weide of the Federal Reserve testified that Fed regulations contained no fewer than 46 references or requirements regarding credit ratings. In theory, section 939A will bring an end to the NRSROs' regulatory power. Every federal agency is required "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."
"With the elimination of regulatory reliance on ratings, the entire NRSRO superstructure should be dismantled," testified Larry White, a professor at New York University and a longtime critic of the agencies. Moody's and S&P themselves say they want to be taken out. The agencies say their ratings should speak for themselves and not carry the force of law. Why they should favor a law that weakens them is a bit of a mystery, but perhaps the answer is that so many others are willing to argue their case for them. Several witnesses at last week's hearing voiced resistance to section 939A taking effect:
"Just as it is not feasible or practical for us or other institutional investors to simply stop using credit ratings altogether, it may not be feasible or practical for federal agencies to strike, in one fell swoop, ratings from all of their rules and regulations," said Gregory Smith, the chief operating officer and general counsel of the Colorado Public Employees' Retirement Association. "We encourage regulators to take a careful, deliberate approach to eliminating references to ratings over time. "
- "Credit ratings … will likely remain a widely accepted, standardized evaluation tool that banks and other market participants will use as part of their efforts to assess the risks of their exposures," said the Federal Deposit Insurance Corporation in its statement for the record.
- "OCC believes the absolute prohibition against any references to ratings under section 939A goes further than is reasonably necessary," said David Wilson, senior deputy and chief national bank examiner for the Office of the Comptroller of the Currency.
- "There is no silver bullet to change this industry," said James Gellert, the CEO of a startup called Rapid Ratings, which is attempting to compete with the established NSRSOs.
Consider the issue of removing ratings from the process of determining how much capital banks must hold against various exposures. The banks say that there isn't a ready alternative. Smaller banks argue that they don't have the resources to use anything other than credit ratings, which are relatively cheap and easy, and that if forced to find alternatives they'll have a harder time competing against large banks. The large banks argue that if they can't use credit ratings, they'll have a harder time competing against foreign banks, which still use ratings. Indeed, the Federal Reserve reported that replacing credit ratings could "lead to competitive distortions across the global banking system and the domestic banking landscape."
That reference to the "global banking system" gets to another problem: Despite European dislike of the American rating agencies, ratings are ingrained in the global capital standards--even those implemented after the 2008 sub-prime crisis, which exposed the ratings agencies' unreliability. As the OCC's David Wilson pointed out, the latest global regulatory framework ("Basel III") continues to use ratings to judge creditworthiness. "U.S. regulators cannot conform our capital standards to those agreed to internationally if section 939A precludes any reference to or reliance on credit ratings," wrote Wilson in his statement.
One year ago, as U.S. regulators began soliciting comments from the banking industry about what they should use instead of credit ratings, the gist of what they heard back was this: Don't mess with our ratings. "Generally, comments received did not concretely identify or suggest alternative standards of credit-worthiness," the FDIC said in its hearing statement. "Most commenters … argued that credit ratings are valuable tools in evaluating credit risk." The OCC's Wilson reported that "a majority of the commenters said that the OCC should continue to use credit ratings in its regulations."
This lingering attachment to the ratings agencies isn't limited to banks and regulators. Investors—yes, the very same people who got burned relying on the rating agencies three years ago—don't want to see them go. As Gellert, the CEO of Rapid Ratings, put it, "There are many market players who benefit from, and support, the status quo." If investors no longer have ratings to rely on, then they'll have to do the credit analysis themselves. If they're wrong, they won't be able to blame those accursed rating agencies! And as Gellert explained, the allure of ratings goes beyond the avoidance of responsibility. Ratings actually help investors game the system. In what's known on the Street as "ratings arbitrage," funds that are statutorily prohibited from buying non-investment-grade bonds buy the highest yielding bonds with the lowest investment grade rating that they can find, thereby juicing their returns. That creates an artificial demand for securities that don't merit the rating they received, at least by the market's judgment. Ratings arbitrage is what put the most dangerous mortgage-backed securities in greatest demand at the peak of the subprime madness.
Investors don't just want to keep credit ratings around—they want to keep credit ratings from the current big three. After the crisis, in 2010, Jules Kroll, a well-known investigator, formed Kroll Bond Ratings in order to provide investors with an alternative. But Kroll noted in his testimony that investors often require before they'll buy a security that it have not just a rating, but a rating from Moody's, Standard & Poor's, and/or Fitch. Kroll Bond Ratings took an informal survey of the top 100 pension funds, and found that of the 67 that published their guidelines, almost two-thirds required a rating from at least one of the top three firms. "It is self-evident that this practice further entrenches the incumbent rating agencies," wrote Kroll in his prepared remarks.
In fairness, the regulators, or at least the SEC, do still seem to be plodding gamely ahead. In March, the SEC proposed to remove credit ratings from the rules that govern which securities a money market fund may purchase. Gellert says that his business is doing very well, because although investors may still be using ratings from the big three, they're also eager for another opinion. That can only help. And he says that at the hearing he saw bipartisan support for removing ratings from regulations.
Then again, on July 21, in a little-noticed vote, the House financial services committee approved (over the objections of Massachusetts Rep. Barney Frank, ranking Democrat on the committee and one of the named authors of Dodd-Frank) a repeal of the part of Dodd-Frank that (quite reasonably) subjects the credit rating agencies to "expert liability," meaning that if the ratings agencies screw up they'll face the same legal risk as accountants and other third party advisers in bond sales. The July 29 Wall Street Journal reported that various business groups, including the Chamber of Commerce, are suing the government to overturn various parts of Dodd Frank that they don't like. The Journal piece didn't mention section 939A, but it would seem a likely target. According to the OCC's testimony, some in the industry are already recommending a "legislative change" to the section. Loathe them though everyone does, reliance on the credit rating agencies turns out to be a terrible habit that almost no one is willing to break.