Reining in the Ratings Agencies

The Securities and Exchange Commission passed new rules to rein in the credit rating agencies, amidst a growing chorus of Congressional and market critics who demanded a crackdown.

But the new rules are still shot through with holes, putting investors at risk, market analysts say.

The SEC's proposed changes come about a month and a half after Congress held hearings overseen by Rep. Henry Waxman (D-Calif.) that showed--via internal memos, email exchanges and  instant messages--how insiders at these companies knew they were botching the job and did little to stop the worst credit crisis in US history from happening.

The credit rating agencies have already been heavily criticized for being painfully slow to warn investors about the problems at Bear Stearns, Enron and WorldCom, just to name a few calamities.

Some of the rule "changes are substantive," says James H. Gellert, chief executive officer of Rapid Ratings International, an independent ratings and research firm in New York City that sells financial health ratings of companies.

But "some are 'rules for rules sake' and will accomplish little," a "significant wrist-slapping and nothing more," Gellert adds. For example, the SEC did not stop an inherent conflict of interest, where credit rating agencies get paid by Wall Street firms to rate their bonds, which in effect lets companies buy their ratings, Gellert says.

As ratings fees for subprime bonds soared to the ionosphere during the credit bubble, the credit agencies handed out Triple-A ratings for shoddy subprime bonds like Kleenex, making subprime bonds the "major culprit of the sub-prime crises," Gellert notes, with the agencies complicit in the ensuing meltdown.

More reform may be coming, beyond the SEC's new rules. "None of the rules adopted..are a substitute for the larger regulatory reform that is coming next year," New York Sen. Charles Schumer, a senior Democrat on the Senate Banking Committee, told FOX Business's sister publication, the Wall Street Journal.

Still waiting to see whether Congress assesses, say, a new, annual risk management fee on Wall Street credit rating agencies. Maybe then the agencies will stop their drive-by appraisals of nonsensical real estate securities, where they happily gilded the silly by rubberstamping this rubbish as Triple A, lining their pockets all the while (see "The Credit Rating Agencies Moment of Shame").

The Credit Agencies' Cash Cow

The agencies profited royally from the subprime crisis. Total residential mortgages in the United States grew from $639 bn in 1995 to $3.3 tn in 2005. Over that period, the dollar amount of subprime loans alone exploded to $807 bn from $35 bn over the same time frame. Alt-A loan volume, (Alt-A loans sit between risky subprime and less risky prime loans) was $676 bn in 2005.

Wall Street then took those loans, gathered them into pools, sliced and diced them, and then built bonds off of their cash flow streams. Depending on the type of mortgage product underlying a given security, the pool could consist of 1,000 to 25,000 loans.  

In a case of mass dereliction of duty, Wall Streeters then paid the credit rating agencies to assign these bonds Triple-A ratings in order to sell them to investors as "safe," bonds that now sit as landfill in investment portfolios around the world.  

Total revenues for the three credit rating agencies doubled from $3 bn in 2002 to over $6 bn in 2007, according to Congressional testimony. At Moody's, profits quadrupled between 2000 and 2007. Moody's had the highest profit margin of any company in the S&P 500 for five years in a row.

Revealing Water Cooler Talk

Here are excerpts of what office insiders at the companies were saying behind the scenes, revealed at the hearing.

"What happened in ‘04 and ‘05...is that our competition, Fitch and S&P, went nuts. Everything was investment grade. It didn't really matter. ...We tried to alert the market. We said we're not rating it. This stuff isn't investment grade. No one cared because the machine just kept going. "-Moody's chief executive Raymond McDaniel, a "Managing Director's Town Hall," September 2007.

"Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue."- Unidentified member of Moody's management team, September 2007.

"Rating agencies continue to create [an] even bigger monster - the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."-Email from an unidentified S&P employee in its structured finance division.

"It could be structured by cows and we would rate it."-Email from an unidentified S&P employee in its structured finance division.

An instant message between two Standard & Poors employees, Shannon Mooney and Ralul Dilip Shah in the structured finance division at S&P:

Shah: btw - that deal is ridiculous.

Mooney: I know right...model def does not capture half of the risk.

Shah: We should not be rating it.

Mooney: We rate every deal. It could be structured by cows and we would rate it.

Shah: but there's a lot of risk associated with it--I personally don't feel comfy signing off as a committee member.

The rating agencies "allow issuers [Wall Street firms] to get away with murder." -Vanguard, the large mutual fund company, in a letter to Moody's.

"If you can't figure out the loss ahead of the fact, what's the use of your ratings? ... [I]f the ratings are b.s., the only use in ratings is comparing b.s. to more b.s."-Unidentified senior official at Fortis Investments.

The New Rules

The rules would force the ratings agencies to give the SEC an annual report of credit actions, such as downgrades or upgrades, plus disclose histories for all current credit ratings paid for by issuers such as banks. The rules also would prohibit an agency from issuing a rating for a structured finance product unless the information in the rating is made available to other rating firms.

The SEC hasn't distinguished whether the slate of new rules (including disclosures of historical ratings) will apply to corporate ratings too, says Gellert.

Problems with the New Rules

Conflicts of Interest: Under the new rules, credit rating agencies can no longer give recommendations to a Wall Street firm about the structure or nature of a bond, plus they can't participate in any fee discussions, negotiations, or arrangements, nor can they receive gifts of more than $25. "Superficial" and "pure window dressing," says Gellert, because any credit rating "analyst, whether present at a fee discussion meeting or not, knows that the issuers [Wall Street firms] pay their salaries," adding they are still "paid by the companies they rate, and have to compete for that payment with other" credit rating agencies.

No Stopping Opinion Shopping: The rules do not stop the rampant abuse on Wall Street, whereby firms can go to another credit rating agency to get a better rating on their bonds. Worth noting is that Congressional testimony disclosed an internal, industry presentation by Moody's McDaniel, in which he said Moody's "analysts and MDs [managing directors] are continually ‘pitched' by bankers, issuers, investors" and sometimes "we ‘drink the kool-aid.'"

Annual Report Card: The agencies now must give the SEC an annual report card on the number of rating actions per year. However, Gellert says a "major criticism of the big agencies is that their ratings flat-line or don't change often enough to be true guides to the market about an issuer's changing financial health." His company, which doesn't get paid by bond sellers to rate bonds, sells ‘Financial Health Ratings,' calculated quarterly, which can provide "immediate indicators of changing financial health."

Performance Statistics: The rating agencies now must give the SEC "performance statistics," broken out over one-, three-, and 10-year periods. The companies must also disclose ratings changes (for example, shifts of bonds from one rating level to another, up or down) as well as default statistics compared to their initial rating. They must also disclose any defaults that arise after a Wall Street firm demands the credit rating agencies withdraw their rating on, say, a bond.

The problem, says Gellert, is that the ratings agencies can cook up their own definition of "performance statistics," leaving them to their own devices to massage their yearly performance. They are still not forced to submit, say, bond ratings correlated to defaults, or correlated to share prices, credit default swaps or bond prices/spreads, Gellert notes.

More Disclosure on How They Rate Bonds: Gellert notes that the SEC proposals would force the agencies to disclose more information in three areas affecting their ratings: (1) actual verification performed on the underlying assets backing a subprime bond or structured finance bond; (2) assessments of the quality of the company, such as a mortgage lender, who is issuing the structured finance bond; and (3) types of models and criteria used to rate the bonds.

Is all of this window dressing? It's an open secret on Wall Street that credit rating agency analysts do not scrutinize the quality of loans in each and every pool backing a bond. Remember, depending on the type of mortgage product underlying a given security, the pool could consist of 1,000 to 25,000 loans. And forget it when it comes to expecting the ratings agencies to keep tabs on the pool of loans over time.  

The first two points "are important and get to the heart of one of the issues in the public's mind--did S&P, Moody's and Fitch have any standard for knowing what they were rating and how the collateral was originated  for structured products," Gellert says.

However, expecting the ratings agencies to keep tabs on the underlying pools of loans backing bonds "often elicits chuckles because the big agencies are perceived to actually do little of it.  A crackdown on this lax area of ratings standards is warranted," he says.

Meaningful reform is a long way off. That's because the SEC "has no mandate to opine on the efficacy of ratings or methodologies, so no amount of regulation or scrutiny can overcome the inherent conflicts that exist here," Gellert adds