This blog article summarizes a recent article published in Capital Markets Law Journal. Reference: Norbert J. Gaillard and William J. Harrington, “Efficient, commonsense actions to foster accurate credit ratings”, Capital Markets Law Journal, 11(1), January 2016.
Three factors have made investors, debt issuers, and regulators highly dependent on credit rating agencies (CRAs) and thus vulnerable to rating failures: the oligopolistic structure of the credit rating market; the use of ratings in regulatory rules; and the CRA business model. In the 1990s, the advent of structured finance (SF) products and the proliferation of derivative contracts deepened dependence on CRAs, which, in turn, incentivized them to inflate SF ratings and to underestimate credit losses from derivative contracts in all sectors.
The Dodd-Frank Act of 2010 passed rulemaking requirements to address the sources of flawed nationally recognized statistical rating organization (NRSRO) ratings;[i] the US Securities and Exchange Commission (SEC) belatedly implemented some of the requirements and omitted other key ones. To redress the SEC omissions, this article makes two series of proposals that will foster rating accuracy.
A/ Here is a sample of the numerous decisions the SEC should make right now.
1/ Let Section 939G of the Dodd-Frank Act take effect and subject NRSROs to meaningful liability
To encourage NRSROs to assign accurate SF ratings, the SEC should withdraw the 23 November 2010 letter issued to Ford Motor Credit Company LLC. This letter preserves the operation of Rule 436(g) with respect to SF issuers and thereby contravenes the clear intent of Congress as expressed in the plain language of Section 939G of the Dodd-Frank Act. It is worth noting that Rule 436(g), which exempted NRSRO ratings from being considered part of a registration statement prepared or certified by an expert, was nullified by the Dodd-Frank Act. The continued operation of Rule 436(g) supports NRSROs in assigning inflated ratings to SF debt and perpetuates the NRSRO oligopoly by disadvantaging other CRAs that are not similarly exempted from expert liability.
2/ Empower analysts to preserve rating accuracy at each stage of the rating process
The SEC has implemented measures that give NRSRO management great leeway in developing internal control structures; now the SEC should use its statutory discretion in oversight and rulemaking to direct NRSROs to establish quality assurance structures that evaluate rating committees and ratings. Quality assurance structures will assess an analyst’s contributions to all rating committees in which she has participated either as a voting member or a non-voting observer. These assessments, which will form the core of an analyst’s performance reviews, will probe how an analyst weighs quantitative and qualitative information presented in committees, as well as how she discounts human concerns such as supporting a peer, preserving career goals, staying in management’s good graces, or being distracted by putatively systemic concerns. Equally important, analyst assessment will incorporate evaluations by fellow committee members regarding an analyst’s preparation, contributions to debate, and openness to diverging views. To promote rating accuracy, the quality assurance function must report directly to an independent board member of an NRSRO, i.e., bypass management entirely so that an analyst will not be penalized for voting to assign an accurate rating when an inaccurate rating better serves management’s goals.
3/ Focus on management conflict of interest and dispose of canard of “rogue” analysts
The clear intent of the US Congress, as expressed in the plain language of the Dodd-Frank Act, to mitigate a widely presumed, but unfounded conflict of interest with respect to an NRSRO analyst and her prospects for post-NRSRO employment harms rating accuracy. As a corrective, the SEC should immediately post a no-action letter addressed to all NRSROs informing them that they no longer need to: 1) perform a “look-back” review when an analyst joins an entity that is either rated by the NRSRO or sponsored by a rated entity; or 2) track the employment progression of a former employee who has left the NRSRO in the previous five years. As a result, an NRSRO will conduct look-back reviews and report on employment transitions only with respect to former managers of rating processes who have left the NRSRO.
4/ Monitor CRA investment in analytical staff
The increase in Fitch, Moody’s, and S&P staffs between December 2008 and December 2014 was dwarfed by the surge in their respective operating income. As a result, the CRAs’ willingness to employ adequate resources must continue to be questioned. Recognizing the difficulties in assessing the optimal number of analysts needed, the SEC could implement and track a workload indicator for each asset class; observations of blatant or persistent understaffing would provide grounds for the SEC to suspend or revoke the registration of the delinquent NRSRO with respect to the affected class of securities, as suggested by Section 932 of the Dodd-Frank Act. In the meantime, regulators can also check, through ad hoc interviews, that a portion of a CRA’s analysts has sufficient time to conduct research or, at least, keep abreast of recent research in their respective fields.
B/ CRAs must also overhaul their methodologies.
1/ Twenty-five years overdue: connect the derivative dots across all sectors
NRSRO methodologies must assess how the obligations of each of the two parties to a derivative contract can reduce their respective net assets and available cash over the life of the contract. In one common instance, when a derivative contract contains a flip clause or other walkaway provision that enables one party to repudiate amounts owed the second party when it is credit-impaired, methodologies must allocate credit losses to the two parties that are equal to full contract value. Methodologies must also track the derivative counterparties for all issuers in a sector and assign credit losses that reflect outsized exposure of the sector to an individual counterparty. For most derivative contracts worldwide, the two parties are one of the world’s largest financial institutions on one side, and a common issuer – municipal, corporate, sovereign, supra-national, SF, or smaller financial entity – on the other side.
To date, NRSROs have preserved methodologies that treat entry into a derivative contract as mutually beneficial to both parties; an issuer benefits from having smoothed out otherwise volatile cash flows and a large bank benefits from having booked a new source of stable earnings in its enormous, and prudently managed, portfolio of derivative contracts. These methodologies extend the win-win assessments of derivative contracts further by also assuming that all derivative contracts will be protected by proactive regulators and, if necessary, propped up by taxpayer bailouts.
2/ Big lesson of the bailouts: interconnectedness of key sectors reduces systemic diversity
Cross-sector holdings of bonds, loans, and other receivables, whether as an outright investment, collateral held against repayment of borrowed money, or margin received against the market valuation of a derivative contract, increase the correlation of credit risk across all sectors.
NRSRO methodologies must calibrate key inputs that are common to all ratings of all issuers in all sectors, such as the recovery rate of a defaulted instrument and the market volatility of issuer assets and liabilities, using 2007-2009 data adjusted to reflect outcomes as if the bailouts had never occurred; that is, methodologies must assess the baseline condition of issuers that makes the aggregate system susceptible to failures in the first place. Recovery rates will be lower, market volatility will be higher, ratings will be more accurate, and the likelihood that inflated ratings will make more bailouts a self-fulfilling prophecy will be reduced.
3/ Stop bailouts at their source: fix SF methodologies
The ratings of the approximately $1 trillion of outstanding SF debt that has been issued in the US since 2009 indicate that a new cycle of rating inflation is well underway in all SF sectors and by all NRSROs. A compilation of NRSRO ratings as of June 30, 2015 projects that, for the ten-year period from 2016 to 2025, this $1 trillion in debt will experience total credit losses of $13 billion, i.e., just 1.3%. Moreover, most of these credit losses – $12 billion of the total $13 billion – affect only the $130 billion subset of SF debt that is rated BBB or lower. The remaining $870 billion of SF debt that is rated A or higher is projected to incur credit losses of just $1 billion, i.e., to be 99.9% immune from credit loss.
This optimism means that SF rating inflation cannot be fixed by simply fine-tuning existing methodologies. Instead, SF methodologies must start from the commonsense premise that, but for the bailouts of both the SF sector under the Troubled Asset Relief Program (TARP) and the financial sector under a series of government measures, all SF sectors would have incurred larger credit losses and experienced more pronounced rating implosions than was the case in 2007-2009. NRSROs have adopted this insight for a few headline sectors – namely, US RMBS and some CDOs.
Next, SF methodologies focus disproportionately on asset pools, even though an SF rating ostensibly incorporates credit risk to SF debt from all aspects of its structure, not simply from the credit risk of assets if held to maturity. These other aspects of an SF structure include: reliance on a third-party trustee for enforcement of contractual protections for investors; the validity of legal underpinnings of the structure; market losses from selling assets at discounts; and counterparty exposure under a derivative contract. By evaluating only an asset pool rather than all contributions to the credit risk of SF debt, an NRSRO makes itself dependent on asset-specific information provided by an issuer. As a result, SF methodologies remain lenient enough to support AAA ratings in most sectors.
Lastly, SF methodologies must distinguish between types and tenors of derivative contracts, as well as between credit profiles of derivative counterparties and whether or not they have grounds to challenge a flip clause, so that ratings reflect forward-looking estimates of credit losses attributable to the insolvency of a derivative counterparty. The bankruptcy of Lehman Brothers has shown that industry-standard swap contracts with flip clauses do not insulate SF debt from credit losses and also that cross-currency derivative contracts expose SF debt to outsized credit losses compared to other derivative contracts.
[i] The concept of ‘NRSRO’ was introduced in 1975 for the purpose of categorizing debt as investment grade or non-investment grade in calculating broker-dealer capital. The initial NRSROs – Fitch, Moody’s, and S&P – preserved their oligopoly as more CRAs became NRSROs by subsequently acquiring several of them.