Standard & Poor's, Moody's Investors Service (MCO) and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days. Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law.This is absurd. The day bond issuers stop using ratings in their prospectuses is the day raters stop mattering. By the same token, companies pay for ratings explicitly so they can include them in SEC registration statements as a seal of approval for prospective investors. It's a beautiful friendship, like Tango & Cash.
The new law will make ratings firms liable for the quality of their ratings decisions, effective immediately. The companies say that, until they get a better understanding of their legal exposure, they are refusing to let bond issuers use their ratings.
What's really going on here? Lobbying. Although President Obama has signed the financial reform bill into law, the ratings firms still hope to persuade Congress to make a quick fix, or encourage regulators to take up their cause.
The new law repeals an SEC rule known as 436(g), which allows bond issuers to use credit ratings without a rating firm's consent. Sounds innocuous enough, but that effectively protects federally mandated raters from getting sued if they make false or misleading statements in a bond prospectus. For instance, if Moody's were to give an investment-grading rating to, oh, a pool of mortgage-backed securities arranged by Goldman Sachs (GS) that subsequently vaporizes in a cloud of red ink, investors couldn't sue the ratings firm.
The raters have exploited this safe harbor for years. It allows them to pose as experts, like a doctor prescribing medicine (take a "AAA" rating and call me in the morning), without accepting full legal responsibility for their services. Critics have long pressed the SEC to drop 436(g), and -- kudos to Congress and the SEC -- it's finally happened.
Now the ratings firms are flexing their muscles. How? By throwing a wrench in the bond markets. Under securities law, many bonds are required to include ratings in their registration documents. So if S&P, Moody's and Fitch bar issuers from doing that, bond sales could slow, or freeze altogether. And that's exactly what's happening, according to the Journal, which notes that no asset-backed bonds were offered up for sale this week. Nyah!
The fracas highlights an essential -- and hard to reconcile -- fact about the credit agencies: They're at once useless and indispensable.
Obviously, ratings have often proved unreliable, especially in recent years as agencies colluded with bond issuers to cook up ratings on spec. More fundamentally, the idea of accurately representing financial risk with a letter grade has always been dubious, especially with the emergence of increasingly complex structured financial products.
In other words, what does it really mean to assign a "AAA" rating to the top tranche in a CDO composed of residential mortgage-backed securities? Not much, in some ways, since during the financial boom it was common for 90 percent of the underlying loans in these instruments to consist of subprime assets (That's the whole point of such CDOs -- to turn dross into gold.)
Or think about the difference between assessing the danger that a corporate bond could blow up versus rating the risk inherent in a pool of mortgages. The former only requires evaluating a single company; but the latter involves making judgments about thousands and thousands of individual loans. If you really feel like torturing yourself, ponder the eye-glazing complexity of rating so-called "CDO squareds," which are asset-backed securities formed out of asset-backed securities, which are themselves composed of ABS.
Despite these challenges, credit ratings remain an integral part of the financial world. Mortgage, credit card and other markets where loans are securitized can't function without ratings, for instance. Ratings also are baked into all sorts of regulations, including capital requirements for a range of financial institutions. And various financial parties rely on ratings to ensure they are legally protected.
That's a comfy place for the ratings firms to live -- essential, but sheltered from accountability. But it's not so hot for the rest of us.
Yet for all the criticism of the rating agencies, no one has proposed a better alternative (although having the government issue ratings has its merits). We're not going to overhaul the ratings system overnight, or even for the foreseeable future. If so, then the issue is how to ensure that credit ratings are relatively accurate. Making ratings firms more legally accountable is a good start.
Images from Flickr user Bixentro and the White House