Analysing the pre-Hearing Statements before the US House Committee on Financial Services’ Examination of NRSROs

Ahead of the US House Committee on Financial Services’ Subcommittee’s hearing on ‘Examining the “Nationally Recognised” Statistical Rating Organisations (“NRSROs”)’, the President of Fitch Ratings – Ian Linnell – has released his prepared statement that he will read to the subcommittee as one of the witnesses called. There are a number of issues raised in his statement, and they are worth reviewing before the Hearing today (which can be accessed here from 2pm EST [7pm UK]). There are also a number of interesting points raised by the other witnesses called, but we shall start with Mr Linnell.

 

After some preamble regarding the theorised position of the credit rating agencies within the financial marketplace – and it is important that we keep this concept of the theorised position of the agencies, and their actual position, in the forefront of our minds – Linnell makes the point that whilst Fitch supports the concept of Congress looking to expand the regulatory framework in certain sectors, the proposals being heard in the Hearing ‘are concerning, and could, in our view, have negative consequences for securities markets, NRSROs and investors who rely on our ratings for an independent assessment of risk’. The Hearing is to focus on a number of proposals that are believed to be, potentially, of use with regards to correcting some of the central issues affecting the impact that credit rating agencies have upon the marketplace.

 

Linnell cites the proposals as (i) creating a new quasi-government board that will be responsible for assigning NRSROs to providing ratings for each security issuance, rather than the issuers hiring NRSROs for a rating, (ii) overriding a 2010 ‘no action’ letter than allowed ABS issuers to issue prospectuses without the attached rating from an NRSRO, as NRSROs would have had to provide their consent for doing so (which they are not willing to do), (iii) standardising rating methodologies, and (iv) compel equal treatment of NSRSO ratings.

 

In response to (i), Linnell argues that a new approach of assigning rating agencies to the rating of issuances ‘could introduce new conflicts of interests in how NRSROs are selected’ although there is no follow-up to what they may be (presumably this will be asked of Mr Linnell in the Hearing). Similarly, the next sentence of the new system of governmental selection is that it ‘may create market confusion as to who is accountable for the rating’. This, again, is not followed-up. There are two arguments here, perhaps. One is that the new conflicts of interest that could be passed to the new system could range from either governmental officials being pressured by issuers – which would be surely less pronounced than with the CRA conflict we have witnessed – or governmental officials being lobbied by credit rating agencies for preference. The second argument could be that the conflicts of interest within the CRA dynamic are both known and substantial, but the potential conflicts signalled by Mr Linnell with a government-based model are not known, and could be much less than that which we have all become accustomed to. This moves into the second response from Mr Linnell, which is that the issue of accountability could be brought into question should the new model take shape. This is, perhaps, one of the most striking instances of a rating agency not addressing the obvious (and arguably laughable) divergences in what they say and what really happens. Accountability is a massive issue in the credit rating world, and the leading rating agencies focus so much energy in not being held accountable. The argument of their ratings being ‘opinions’, and the concerted and conscious effort to never be exposed to ‘expert liability’ means that, in reality, the rating agencies are rarely accountable for their actions. The incredible and significant legal process that resulted in Moody’s and S&P settling with the DoJ and CalPERS a few years ago provides further evidence for this (and that the two agencies managed to make clear, as part of the settlement, that they still accepted no responsibility for the losses incurred).

 

What follows is standard from credit rating agencies, but is a clear example of the divergence I mentioned earlier. Lindell says that what needs to happen instead is that investors become more educated as to the mechanics of credit rating agencies and their ratings. This is because ‘the value the investment community places in nay rating will turn on the reputation of the NRSRO that offers it. That reputation, in turn, relies on a record of delivering credible and predictive assessments of risk, with transparency in explaining how the assessments are reached and what they mean’. There is no evidence to suggest that there is a negative causal link between reputational capital losses and a loss of business in the rating industry. The market share of the Big Two in particular, after their many transgressions in the past 15 (and more) years has not translated into a loss of market share. This is why I have consistently argued that the ‘value’ of the rating agencies is the ability to signal to others, and that the signal is easy-to-understand and well known within the circles financial market participants need to signal to (issuers to investors, investment managers to principals, investors/issuers to regulators, and regulators to the marketplace [though they are not technically supposed to do this anymore since Dodd-Frank/EU III]). The insistence to continue with the defence of reputational capital being an efficient constraint on transgressive behaviour needs to stop (but it is very much the ‘industry line’).

 

Mr Lindell then turns his attention to a so-called ‘no action’ letter that was issued by the SEC in 2010. You can read much more technical detail on this, and also the proposal to remove it, from Bill Harrington (of the Croatan Institute) and his LinkedIn profile which compiles the years of work he has put into this issue. However, essentially the no-action letter was developed by the SEC for the Ford Motor Credit Company (who offer asset-backed securities [ABS]) because the Dodd-Frank Act declared that, where an ABS issuer was to issue an ABS, then they needed to disclose the rating attached to it in its registration statement. To do that, they needed the consent of the rating agency. In fear of being exposed to liability on account of the rating agency being classified as an ‘expert’ (as opposed to merely offering an ‘opinion’, the rating agencies indicated that they would refuse to consent. This impasse threatened to grind the ABS market to a halt, and therefore the SEC declared in its ‘no-action’ letter that it would not take action against ABS issuers if they did not disclose the rating attached to their securities. Lindell confirms, categorically, that if the same requirement is re-imposed, then Fitch Ratings will not be giving its consent for its ratings to be attached. He argues that the ratings and commentaries are available freely online, but they will not give their consent to the attachment within the registration statement. With seemingly no actual appetite to apportion expert liability onto credit rating agencies (although Dodd-Frank did call for this), the stalemate is heavily favouring the rating agencies and this is why Harrington describes this concept as NRSRO ‘blackmail’. Rhee asks whether a. the threat of strike can be maintained across the nine NRSROs (which is a valid question, because there then exists an opportunity for smaller NRSROs to gain market share by exposing themselves to expert liability in return for business), but also b. whether expert liability can really be applied to NRSROs as their products are much more subjective than, say, an auditor’s report. The potential eventualities from applying expert liability are many.

 

Lindell finishes by discussing one of the proposals that the methodologies of the rating agencies be set against a standard (what is being called ‘Equal Treatment’). He again argues that users of rating agencies derive benefit from the ‘choice and competition’ that is within the rating industry. Again, this is easily disputable. Rating methodologies have been found to be particularly similar anyway, and if the ‘choice’ at the top of the rating industry is between three similar companies, then we need to question the understanding of the word ‘choice’. However, and again, the reality here needs to be considered. Users are not generally interested in ‘choice’ here, and the enforced standardisation, despite the reality being that they are all generally similar anyway, means that users will be negatively impacted in their need to signal. If methodologies are standardised, there are two issuers. Users will no longer need more than one rating (which could negatively impact the credit rating market) but, much more importantly, to whose standard should be it attached to? Is there enough convergence with regards to what elements rating agencies should focus on, and how? The answer is no, and the state does not really have the authority (and I argue appetite) to set those parameters. If the rating agencies are mandated to work on common standards, the natural competition between the big players will come to the fore and convergence will not be witnessed.

 

Before we look at the other submissions, there is something to state here. It is acknowledged that the Hearing is to discuss certain proposals, which is more than fine. However, in the proposals, the underlying dynamics of the rating dynamic are, for the most part, not accounted for. The Big Two are not represented, which is perhaps short-sighted. The power dynamics underlying what Harrington calls the NRSRO Blackmail are not really considered (Mr Harrington really ought to have been included in the line of witnesses). The ability of rating agencies to defend their position via their willingness to participate in these proposals is not really considered either. We also should recognise that the credit rating agencies are a considerable political presence and it is very unlikely such proposals would be allowed to elevate through the US political system without resistance. Regulating the actual rating agency dynamic rather than some theorised or imagined one is the only way reform will hold in this sector.

 

In other submissions, there are some really interesting points. Professor Robert J. Rhee notes that with regards to restoring accountability (amongst other things related to the agenda of the Hearing), the practice of the SEC examining different credit rating agencies and then developing reports where the credit rating agencies are anonymised is particularly problematic and should be stopped. Amy Copeland McGarrity, the Chief Investment Officer for the Colorado Public Employees’ Retirement Association, spoke clearly about her time chairing the Credit Ratings Subcommittee of the Fixed Income Market Structure Advisory Committee (FIMSAC) and the distinct pushback they received when proposing elements such as the outsourced selection of rating agencies for issuers (like that being proposed in the Hearing). This is a helpful insight into what is likely to happen if the plans in the Hearing are elevated. Interestingly, Jim Nadler – the President and CEO of Kroll Bond Rating Agency – also weighs in on a number of important issues. Unsurprisingly, his main concern is increasing competition in the rating space, which given his firm’s small market share makes sense. Yet, he does provide his views on the concept of applying expert liability. He states that not only is the current range of liability avenues appropriate, potentially holding rating agencies liable against Section 11 of the Securities Act of 1933 is ‘in direct conflict with how the market already functions as a result of changes provided by the Dodd-Frank Act’. Essentially, his understanding is that because NRSROs are at the mercy of information provided to them by issuers (paraphrasing his words), ‘NRSROs are in the same position as the investors receiving the information from the transaction parties and should be treated as such’. In a nutshell, the rating agencies are not tasked with assuring the information given to them, so they cannot be held liable. There are arguments for and against this, but the underlying rating dynamic is revealed here. Technically, they are not tasked with fully assuring the information given to them (although there are low standards of scrutiny in existence). Nadler cites Rule 17g-5 (c)(5). This rule prohibits an NRSRO from making recommendations based upon the corporate or legal structure, assets, liabilities, or activities of the issuers.

 

The hearings later today should be of great interest. However, we should likely view the proceedings through a particular lens. If we want to predict how impactful the proposals may be, let us listen for the tone of the conversation coming from proponents of the proposals. The proposals have a lot of validity, but if they focus on the rating dynamic as it is theorised, the proposals (if even enacted) will only really impact that theorised understanding. The impact ‘on the ground’ will likely be nominal at best. It may not be regulatory ‘sexy’ (for a want of a better word) but regulatory reform must focus on the realities and sometimes that may result in there being compromises made. We have seen, in the implementation of Congress’ mandate in 2010, that the regulators will take a pragmatic approach anyway, so why not start that approach at the top. The regulators are majoritively concerned with keeping order within the system they are tasked with supervising, and that is their mandated role. Fundamental changes can happen within markets, but they are rare. Also, they only usually occur after a massive crisis that affects that marketplace, and we have had that in the credit rating world. That time has passed (regrettably). We are now very much in the refining phase and I predict that this will be realised and played out within this proposed suite of proposals – the ‘nudges’ will be considered more, and the ‘radical’ will be dismissed. Whether or not this is a good or bad thing is for another conversation, but the reality is that regulatory dynamics will be respected within the credit rating space.

 

Keywords – credit rating agencies, House of Representatives, Hearing, reform, @C_R_R_I