Update 547 — Bond Rating Agency Reform:
Hearing on “Unfinished Title” of Dodd-Frank
Long-regarded as the unfinished business of Dodd-Frank, reform of the credit rating agencies central to the financial crisis of 2008 was the subject of Wednesday’s House Financial Services Subcommittee hearing. Chair Waters condemned bond rating agencies for giving AAA ratings to worthless mortgage-backed securities and countless credit products. Those who relied on their ratings around the world suffered. Homes and life savings were lost, not to mention the trillions of dollars it cost the economy.
Eleven years later, companies tapping the bond market continue to shop around for preferred ratings (shopping in an oligopoly affords few choices and no bargains). A booming market, relaxed underwriting standards, and a thinly regulated industry combine to raise systemic risk concerns and re-argue for reforms.
Below, we review how we can improve this critical piece of our capital markets.
Good weekends all,
Credit Rating Agencies’ Role in the Market
CRAs, referred to officially as Nationally Recognized Statistical Rating Organizations (NRSROs), play an outsized role in financial markets. CRAs assign ratings to institutions and debt instruments based on their creditworthiness, with ratings ranging from investment grade to “junk” bonds. Ratings provide a key source of information to investors, significantly affecting the allocation of capital in the market. For example, many large institutional investors such as pension funds and 401(k)s may only purchase investment-grade bonds.
Two main problematic features define the CRA industry:
- Incentive Structure: Bond issuers pay CRAs for their ratings — as opposed to the investors purchasing the bond. This “issuer-pays” model amounts to a significant conflict of interest. Since CRAs’ main source of revenue is bond issuers, they prefer to produce favorable ratings. And bond issuers can engage in “ratings shopping” by choosing the CRA that will yield the best rating possible, leading to inflated ratings.
- Market Concentration: Three large CRAs dominate the market: Moody’s, S&P, and Fitch. There are nine CRAs registered with the SEC, but these three issues over 95 percent of all credit ratings, accounting for 93.3 percent of total industry revenue in 2019. These large CRAs operate as an oligopoly, allowing them to dominate the market and have significant power over the price of ratings.
These two features of the CRA industry led to disastrous consequences in 2008. In the years leading up to the financial crisis, the CRAs significantly understated the risk associated with complex asset-backed securities, in some cases giving investment-grade ratings to products consisting mostly of subprime mortgages. The final report of the Financial Crisis Inquiry Commission described the Big Three CRAs as “key enablers of the financial meltdown.”
Dodd-Frank CRA Reform, a Stillbirth
The 2010 Dodd-Frank Act included several provisions attempting to address the CRAs’ role in the financial crisis. Many were slow-walked and not implemented by the SEC. Consequently, key problems Dodd-Frank intended to address remain in need of further reform.
In an attempt to reform the CRA industry, Dodd-Frank:
- created an Office of Credit Ratings (OCR) within the SEC with power to oversee and regulate the CRAs and produce an annual report on the state of CRAs
- directed the federal government to cease mentioning credit ratings in regulations
- established liability for CRAs by creating a private right to action
- required the SEC to endorse an alternative business model to the issuer-pays model
Many of these reforms have not been implemented in a manner reflecting Congress’ intent. The OCR has been a largely ineffective regulator. Its annual reports on CRAs do not specifically identify institutions tagged with regulatory violations or other problems, severely limiting the reports’ informational value. As an office housed within the SEC, the OCR has been a toothless regulator, issuing few significant enforcement actions or penalties against the CRAs.
Despite Dodd-Frank prohibiting the federal government from mentioning credit ratings in rules and statutes, the practice remains. In a 2017 analysis of the state of CRAs, law professor Frank Partnoy found that the federal government’s reliance on credit ratings remains “pervasive” and that regulated institutions continue to “rely mechanistically on ratings.”
Notably, the SEC has failed to enforce the provision in Dodd-Frank increasing the legal liability of CRAs for inaccurate ratings of structured finance products. This provision effectively struck down SEC Rule 436(g), which excluded CRAs from legal liability established under Section 11 of the 1933 Securities Act. In response to this, the CRAs in 2010 threatened to essentially go on strike, prompting the SEC to immediately reverse course by promising not to enforce this policy.
A similar fate befell Dodd-Frank’s requirement that the SEC endorse a new business model. The SEC neglected to endorse an alternative model to issuer-pays after completing a study and has not taken any significant action on this front since 2013.
Proposed Legislative, Regulatory Reforms
With regulatory oversight weak and implementation of Dodd-Frank incomplete, it is no surprise that, according to Partnoy, “The fundamental problems that led to the financial crisis … remain as significant as they were before the financial crisis.” Both Congress and the SEC have the opportunity to improve CRA operations and accountability. The following reform options, listed in order of viability, received consideration in Wednesday’s subcommittee hearing:
- SEC to Name CRAs in Reports: The SEC does not name the specific CRAs that have compliance failures in its annual examination reports, instead describing them as a “large NRSRO” or “small NRSRO.” The SEC could disclose the identity of these NRSROs to improve public transparency and accountability.
- Restoring Section 11 Liability: In 2010, the SEC issued a no-action letter saying it would not enforce Dodd-Frank’s provision establishing Section 11 liability for CRAs. The SEC can reverse course and begin enforcing a law on the books designed to prevent negligence.
- Uniform Treatment of NRSROs Act (Rep. Dean): This bill would ensure that credit ratings from any SEC-registered NRSRO will receive equal treatment by the Federal Reserve for businesses seeking loans from emergency credit facilities. When the Fed last year stood up lending facilities with funding from the CARES Act, it only accepted ratings from the three largest CRAs, locking out many small businesses that could not afford to purchase them. This legislation passed the House with bipartisan support last year and stands a chance of becoming law this Congress, though its effect would not be felt until the next time the Fed creates emergency facilities.
- Commercial Credit Rating Reform Act (Rep. Sherman): This bill would establish a credit rating agency assignment board responsible for randomly allocating CRAs to provide ratings for corporate issuers and issuers of new asset-backed securities. The legislation seeks to mitigate the conflicts of interest inherent in the issuer-pays model. Its chances of passage in this Congress are doubtful, as Republicans believe reforming the CRA business model is not necessary.
- Requiring Ratings to be Insured: During Wednesday’s hearing, Reps. Foster and Cleaver brought up the prospect of requiring CRAs to carry “insurance” against the possibility that their ratings are incorrect — with financial payouts going to investors who have been harmed by bad ratings. The industry would likely oppose this strongly.
Fixing a Flawed System
Establishing uniform treatment of CRAs and a random assignment model are well-intentioned legislative reforms to a flawed system. Another option could be to require a review of performance before all-in payment, deferring compensation until the rating can be reassessed — a rating of the rating — at regular intervals. This would alleviate the conflict of interest in the issuer-pays model by aligning payments with a performance of the rating without a need for mandating assignments.
The SEC, meanwhile, has the power to implement significant reforms established by Dodd-Frank. Under a Democratic administration, the SEC can take concrete actions to strengthen its oversight of CRAs. A good first step for President Biden and Chair Gensler would be to name an OCR Director willing to take a more active approach to reform.