SEC Trying to Gauge Risk Without Credit Raters: One Year Later

To authors of the Dodd-Frank Act, the credit-rating industry was a chief villain of the 2008 financial crisis. As a result, the law instructed U.S. regulators to strip use of credit ratings from their rules.

What Dodd-Frank didn’t decide was what should take the place of previously accepted risk ratings from companies including Moody’s Investors Service (MCO), McGraw-Hill Cos. (MHP)’ Standard & Poor’s and Fitch Ratings.

A year after the law passed, U.S. agencies are still struggling to write and enforce regulations -- particularly banking and securities rules -- without using credit ratings.

“Our staff has been given an impossible challenge: finding an appropriate substitute for an objective evaluation of credit risk when it may not exist,” Securities and Exchange Commission member Luis Aguilar said in April.

A report from the Financial Crisis Inquiry Commission concluded that the major credit raters were “key enablers of the financial meltdown,” justifying the exploding sales of mortgage-related securities before turning around and issuing rating downgrades that “wreaked havoc across markets.”

The financial system became overly dependent on credit ratings as the unquestioned measure of investment risk, the commission and other critics said.

Fidelity Investments said the SEC’s idea about who should evaluate credit risk would add a “significant degree of subjectivity” to figuring risk. Photo: Rich Clement/Bloomberg Close

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Fidelity Investments said the SEC’s idea about who should evaluate credit risk would add a “significant degree of subjectivity” to figuring risk. Photo: Rich Clement/Bloomberg

“For better or worse, ratings have come to be a shorthand way of describing a level of credit risk that is generally understood by all market participants,” Jim Nadler, president and chief operating officer of Kroll Bond Ratings Inc., said in an interview.

No Substitute

In the absence of a good substitute, the Securities and Exchange Commission has handed the problem back to the market: in two rules issued last spring, the agency has suggested that money-market funds, which invest in top-quality bonds and other securities, evaluate credit risk themselves and that broker-dealers figure out their own measures for creditworthiness when tallying their required reserves.

“The alternative standards that they’ve come up with need to be strengthened,” said Steve Hall, a securities policy expert at Washington-based Better Markets Inc., a non-profit research group promoting Dodd-Frank regulation. “They need to be more specific.”

Boston-based Fidelity Investments, which said its $450 billion in money-market assets makes it the largest money funds manager, said the SEC’s idea would add a “significant degree of subjectivity” to figuring risk.

Changing Standards

A manager’s standard “could change from month to month, or even week to week,” Scott C. Goebel, Fidelity’s senior vice president and general counsel, said in a letter to the SEC.

Removing third-party ratings “could have the opposite of the intended effect, as it could permit a money fund to purchase a security that today would not meet the minimum threshold,” Simon Mendelson and Richard Hoerner, BlackRock Inc. managing directors and co-heads of global cash management and securities lending, said in a letter.

The New York-based firm, which manages $208 billion in U.S.-registered money market funds, also pointed out that many institutional investors have guidelines limiting their holdings to rated securities.

Another regulator removing credit ratings from regulations, the Federal Deposit Insurance Corp., also ran into “significant challenges involved with developing creditworthiness standards for the broad range of exposures and complex securities structures,” according to Sept. 30 Senate testimony from then-Chairman Sheila Bair.

Real-Life Impact

Stephen H. Cohen, a New York partner at Loeb & Loeb LLP who works with broker-dealers, said the proposal for counting dealers’ reserves has “real-life” impact that will affect small brokers differently from big operations like Bank of America Corp.’s Merrill Lynch unit.

“Merrill Lynch, using its research staff, may make a determination not as favorably as a three-person shop,” said Cohen, who predicted a possible “Wild West environment.”

While crafting ratings replacements, the SEC also proposed a wider, Dodd-Frank-mandated overhaul of practices within the ratings firms. The companies would have to ensure the quality of ratings, prevent conflicts of interest and release more information on how they assess debt securities.

To prevent potential conflicts of interest, marketing and sales employees would be barred from ratings work, and the SEC could de-register firms that violate conflict-of-interest rules.

More Review

Ratings companies would also have to review activities of employees who leave to join firms whose products they rated. Outside contractors hired to assess asset-backed securities would have to provide public information on their conclusions.

The adoption of that and other rules won’t make Dodd-Frank’s July 21 deadline, according to the agency’s calendar. When they do pass, the rules’ toughness may not be their final measure of effectiveness.

“Even if strong, new internal control standards are put in place by the SEC, it won’t clean up the credit-rating system unless the SEC has the funds and willpower to actively enforce those standards,” said Senator Carl Levin, a Michigan Democrat and chairman of the Senate’s Permanent Subcommittee on Investigations, in a statement.

The industry, its critics routinely point out, is still paid by the clients whose products they rate.

‘Fundamental Problem’

Senator Al Franken, a Minnesota Democrat, said this year’s regulatory progress won’t fix that conflict. “They still haven’t tackled the fundamental problem,” he said in a statement.

The SEC isn’t dealing with it because Congress didn’t address it in Dodd-Frank. Even some of the things Congress did require -- such as the formation of an Office of Credit Ratings to coordinate additional new oversight of the firms -- are being held up by lawmakers. SEC Chairman Mary Schapiro said her agency awaits approval to spend money on opening the office.

“We’re still waiting for permission,” Schapiro said in an interview, adding that the SEC has organized rating company inspections within its existing structure while it waits. “We have examiners who are dedicated now to the credit-rating agencies and have to examine them all every year,” she said. “They’re well through that process for this year. So, it’s moving ahead.”

The rating firms say they support many of the regulators’ changes. Daniel J. Noonan, a Fitch spokesman, said the firm has made several changes since the 2008 credit crisis, and the proposed regulations “largely reflect constructive changes already in place at Fitch.”

Investor Value

“We believe the market -- not government mandates --should decide the value of our work,” David Wargin, an S&P spokesman, said in an e-mail. “Regardless of any regulatory mandate, we believe investors continue to find value in the ratings.”

Kroll’s Nadler, whose company started issuing ratings in June and declares it aims “to restore trust” in ratings, said he thinks investors should be using ratings as only one piece of an analysis.

“Investors need to do a bit more of their own work,” he said, so they can “make their own determination separate from the ratings.”

To contact the reporter on this story: Jesse Hamilton in Washington at jhamilton33@bloomberg.net.

To contact the editor responsible for this story: Lawrence Roberts at lroberts13@bloomberg.net.

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