The government can try to make the credit-rating merchants less conflicted. It can’t make the raters more competent.
That’s a lesson lawmakers should bear in mind, now that the U.S. Senate’s financial-overhaul legislation calls for creating a new ratings board overseen by the Securities and Exchange Commission. Whenever an issuer of asset-backed securities wants an initial credit rating, it would have to request one from the new panel, under the proposal. The board then would assign one of the government-recognized rating companies to the task, and serve as an arbiter for the fees the rater could charge.
The idea is to make the raters more independent. “There is a staggering conflict of interest affecting the credit-rating industry,” said Senator Al Franken, the Minnesota Democrat who offered the amendment approved last week. “Issuers of securities are paying for the credit ratings. They shop around for their ratings.”
There’s a more difficult problem with the rating companies, though, that no law could ever fix. Even if their motives were pure, that wouldn’t necessarily mean their grades would be any more reliable.
Consider the wide divergence in ratings for a mortgage bond issued five years ago called Park Place Securities Inc. Series 2005-WHQ2. The eighth-highest tranche in that offering, dubbed the M-2 class, is rated AA+ by Standard & Poor’s, one rung below its highest level. Moody’s Investors Service rates the same bond B1, or four notches below investment grade. Fitch Ratings calls it CCC, signaling a high risk of default.
And what do investors think of this bond? One company that owns it is a unit of Hartford Financial Services Group Inc., a tidbit I learned with help from the research firm SNL Financial, which tracks statutory insurance filings. Hartford pegged the bond’s fair market value at a measly 25 cents on the dollar as of Dec. 31, according to its latest annual report.
So, if you had only one credit rater to go by, you might be led to believe this security was either utter trash or suitable for your grandma -- or somewhere in between. That doesn’t necessarily mean S&P is corrupt. It’s probably just clueless. Even if the original rating were the product of some undue influence, the most rational explanation for keeping it at AA+ now, when S&P gains nothing by doing so, is ineptitude.
Fitch had a AAA rating on the third-highest tranche of a mortgage-bond deal called Argent Securities Inc. 2006-W4, until April 16. That’s when it dropped its rating to C, signaling imminent default. Moody’s cut the same bond to Ca, its second-lowest mark, from Aa1 on April 12. S&P has rated it CCC since August 2009. All three started at AAA back in 2006.
Similarly, Moody’s has an A3 investment-grade rating on the sixth-highest tranche of NovaStar Mortgage Funding Trust Series 2005-4. S&P and Fitch rate it CCC and CC, respectively.
Other times, the three major raters act like blind mice. Fitch and S&P still have AAA ratings on the fifth-highest tranche of HSBC Home Equity Loan Trust (USA) 2007-3, while Moody’s calls it Aa2, its third-highest rating. The bond now trades for 61 cents on the dollar, according to Bloomberg data, which tells you the market regards it as junk.
Give Franken credit for trying. His heart seems to be in the right place. Attempting to repair the credit raters legislatively, however, is like trying to fix a rotten tomato by sprinkling it with salt. Some problems just aren’t solvable through third-party intervention.
Rather, the most responsible thing the government can do now is distance itself from the industry, which happens to be what a separate amendment approved by the Senate would do. That proposal, by Florida Republican George LeMieux, would delete references to credit raters from certain securities and banking statutes, removing their federal endorsement.
Historically, one of the best reasons for requiring ratings was they could act as a check on money managers that advertise themselves as risk-averse buyers of investment-grade holdings. Without some independent benchmarks to keep them honest, this argument goes, some fund managers inevitably would try to juice their returns and management fees by loading up on speculative, high-yield paper, creating hidden risks for their investors.
When ratings aren’t credible, though, they are worse than useless. They are dangerous. Sure, it would be nice to live in a world where a AAA credit rating meant something, namely that the risk of default is minimal. Such a place doesn’t exist anymore, though, if it ever did.
The Franken amendment has other obvious flaws. The issuers still would be paying the raters. Once they bought their initial letter grades, issuers of asset-backed securities could buy additional ratings directly from other companies without having to route their orders through the supposedly neutral board. And because the amendment addresses only asset-backed securities, other debt issuers such as municipalities and corporations wouldn’t have to go through an intermediary for any of their ratings, which makes no sense.
Better to tell investors they’re on their own and let Moody’s, S&P and Fitch try to hawk their opinions like any other promoter, without the government’s help. To put a new twist on an old line from Franken’s “Saturday Night Live” character, Stuart Smalley, proving they’re good enough and smart enough is the only way they’ll ever get investors to trust them again.
(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)
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