Should Free Markets Govern the Bond Rating Agencies?

Should Free Markets Govern the Bond Rating Agencies?


This is an obvious conflict of interest. But rather than changing the pay model, regulators responded to the crisis by heightening their scrutiny of the ratings agencies that are registered with the Securities and Exchange Commission. The agencies must disclose certain information, for example, about their performance measurement statistics and the procedures they use to determine debt grades. Ratings agencies must also establish an “effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings” according to the S.E.C.

The Choice Act fails in two ways related to the credit rating agencies. First, it proposes rolling back Dodd-Frank’s accountability measures over these companies, no longer requiring that the chief executive of a ratings agency attest to the company’s internal controls over the processes it uses to determine credit grades. The bill would also rescind the Dodd-Frank requirement that a ratings agency confirm in its disclosures that a rating was not influenced by its business activities.

There’s more. What’s especially odd about the Choice Act, given that it was written by lawmakers with a deregulatory and free-market bent, is that it would keep the existing agencies entrenched and protected from competition. It achieves this by maintaining the government imprimatur for ratings agencies known as a nationally recognized statistical rating organization — an N.R.S.R.O., in industry parlance. Aspiring ratings agencies must apply to the S.E.C. to receive this imprimatur, which is very difficult to get.

Bill Harrington is a former senior credit officer at Moody’s and an expert in ratings on asset-backed securities and derivatives. In an open letter on LinkedIn, he called the bill a gift to the ratings agencies and said it would eliminate any accountability that exists among these companies.

In an interview, Mr. Harrington was especially critical of the way the bill lets chief executives at the agencies off the hook in attesting to the integrity of the ratings process. He characterized the Choice Act as “a complete disaster.”

Jeff Emerson, a spokesman for the House Financial Services Committee — from which the Choice Act emerged — contended that because raters can already offer services without applying for the government’s seal of approval, the free market is working.

“We do not believe there is a government accreditation or imprimatur by maintaining the regulatory regime over credit ratings agencies that elect to register with the S.E.C.,” he said in an email. “This is why the Choice Act repeals the Dodd-Frank section that allows the S.E.C. to establish a board to assign ratings of structured financial products. We do not need to put the government back into the ratings approval business.”

Mr. Harrington said he thought the comment from the committee spokesman was evidence of a deep misunderstanding of how the ratings agency business works, especially of how beneficial the government’s designation is to the companies who have it. He is disturbed that the Choice Act would keep ratings agencies entrenched and the S.E.C. as a gatekeeper that inhibits competition in the arena.

There is a better idea, said Lawrence J. White, a professor at New York University’s Stern School of Business: Eliminate the government’s ratings agency certification once and for all. Let anyone publish opinions on the creditworthiness of a debt obligation, and allow the market for these services to reward excellence and punish failure.

He took this position in a paper on the topic back in 2013.

“It is important to remember when we talk about investors in the bond market, we’re not talking about Mom and Pop sitting around the dining room table figuring out what to do with their 401(k),” Professor White said in an interview. “The overwhelming bulk of bond holdings are by institutions that you’d expect would have enough expertise to figure out who’s a good advisory firm.”

Given that institutional investors are the bond market, he added, “The argument for government certification of who these advisory firms are going to be becomes much weaker.”

Mr. Harrington and five former ratings agency executives agree entirely with Mr. White. And they published a letter on LinkedIn on May 1 recommending the idea.

The requirement to license ratings agencies, they wrote, puts “the government’s imprimatur on credit assessments that are too often the result of sloppy procedures and/or commercial bias.” Stripping credit ratings of the government’s stamp of approval would allow the market to work by opening up the business to competition.

Eliminating the lock that the big agencies have on ratings might also avoid another financial mess, the group contended. “A return to something resembling the pre-2008 status quo, in which a government-sanctioned oligopoly of conflicted companies assess credit quality risks a repeat of the financial crisis,” they wrote.

Over the years, lawmakers have tried to open the world of ratings agencies to encourage more participants and, possibly, better performance. Legislation in 2006 encouraged the S.E.C. to let new companies into the ratings club. The commission set up the Office of Credit Ratings to register new entrants. But the number of credit ratings agencies — now 10 — has not grown. It has been almost five years since a new entrant has been allowed into the club.

“Why do we need to have credit ratings agencies receiving some federal license that indicates the S.E.C. approves of what they’re doing?” asked Marc Joffe, a former Moody’s executive who is one of the six former executives calling for an end to the licensing requirements. “Take that away, and anyone who is providing credit assessment can compete on a level playing field with the ratings agencies.”

The six people who signed the letter have been discussing regulatory policy on ratings agencies for the past several years, Mr. Joffe said. One of them is Ann Rutledge, a founder of R & R Consulting in New York and CreditSpectrum, a provider of credit analytics.

“The will to make our capital markets more efficient isn’t there,” Ms. Rutledge said in an email to me. “The only people who will suffer as a result are ordinary Americans dealing with a dysfunctional economy, dysfunctional because capital markets are rigged to pay themselves for paying themselves.”

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