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."