Ratings Agencies in the Crosshairs

Dechert LLP

Dechert LLP

Back in the febrile, hyperventilated times that birthed the Dodd-Frank Wall Street Reform and Consumer Protection Act (blessedly known simply as Dodd-Frank), one of the issues that energized the activists’ intent on “fixing” what was wrong was the notion that the ratings agencies were complicit in the overpricing of financial assets.  In a “want for a nail, a shoe was lost” sort of way, overpricing of financial assets caused asset bubbles which led to or exacerbated the apocalypse.  The culprit?  The issuer pay model by which the issuers which retained the ratings agencies to rate their securities paid the ratings agencies’ fees from the proceeds of the related securitization.  From a certain perspective, this was having the prisoners hire the guards.

Under Dodd-Frank, the SEC promulgated a rule under which all the information delivered to a retained ratings agency must also be delivered to all the other ratings agencies based on a conviction that this would encourage the publication of unsolicited ratings by the non-hired agencies.  This was supposed to keep everyone honest.  A classic example of the regulatory embrace of a good theory in the face of inconvenient facts.  It was doomed to fail from the beginning, and anyone who understood how markets worked knew that from the get-go.  Under this new Rule 17g5, issuers were required to create a data site (known as a 17g5 site) to include all relevant deal data given to the agencies rating the deal to which all ratings agencies would have access for the purpose of creating unsolicited ratings.  However, in a “no good deed goes unpunished” sort of way, if a ratings agency elected to look at this data, it had to tell the SEC and, if it accessed information for over ten deals, it became committed to publishing ratings for at least 10% of them.  That was not going to work.  It costs a lot money of to publish a rating, particularly a rating in the commercial real estate space where the agencies need to actually see a significant percentage of the properties (it’s customary in CMBS securitizations for the ratings agencies to visit up to 65% of the OPB of the deal).  If it’s an unsolicited rating, who’s going to pay them?  It’s a classic problem of the commons.  No one investor is going to pay for a rating when every other investor will enjoy the benefit of that rating for free!  (Well, hold on now.  Thinking outside the box, maybe I should propose, a Facebook-like solution here.  Could they sell advertisements for cars, furniture, liquor, political calumny and Viagra on their ratings site?  The money will flow in!)

To my certain knowledge, no unsolicited rating has been issued since the Great Recession.  While in a few scant instances, Moody’s (at least) issued commentary on other deals (generally critical – how shocking is that?), they shied away from actually providing a rating and did not trigger the Dodd-Frank process for the unsolicited rating.

The SEC was also directed to continue to assess the issuer pay model and develop alternatives.  That investigation has proceeded in a desultory sort of way for over a decade.  There has been little movement.  Other than some roundtables and a newly established Credit Ratings Subcommittee, progress has been slow (when in doubt, create a committee and study it.  At least you have something to do and probably get doughnuts).  Back in December of 2012, the SEC published a white paper on its progress toward developing an alternate model which, at great length and some erudition, ultimately amounted to an admission that the SEC couldn’t figure out what to do.  They quietly put it back on the shelf.

As throwing up one’s hand, which is where the SEC had been, after a lot of hard and disciplined analytic work, is simply not an acceptable conclusion, the process of coming up with a better way to manage the ratings process has ground on.  The SEC’s Fixed Income Market Structure Advisory Committee held a meeting on the credit rating industry on November 4, 2019 and the talk provoked more questions than answers.  Though panelists argued that the SEC should curtail the issuer pay model, the chair of the new Credit Ratings Subcommittee conceded that the group has yet to decide whether to recommend any new model for implementation.

Nonetheless, some members in good standing of our political class, unburdened by training and inclination to delve into substance, have concluded that they are deeply troubled by a dangerous degrading of ratings engineered by greedy bankers seeking higher valuations and hence bigger fees.  These politicians are outraged (outrage is, of course, the default setting for our vote seeking class thoroughly marinated in today’s politics of populism).

Not surprisingly, this state of affairs has caught the eye of some presidential wannabes (spoiler alert… Senator Elizabeth Warren).  She recently demanded to know why the SEC has not successfully come up with a new pricing model for the ratings agencies!

While it is broadly recognized that the current pricing model is fraught, notwithstanding a great deal of hard thinking by folks both in the industry and out, we have failed to come up with a better solution.  How about converting the agencies into a co-op?  A utility?  How about a random allocation of ratings agencies to upcoming transactions in some sort of a bureaucratically driven lotto?  Maybe make all the agencies do a rating and then average the levels?  None of these makes a compelling case for a better outcome, and all have significant negative costs and externalities that would need to be carefully weighed.  My view:  All would utterly fail.

So no silver bullet.  But beware of politicians who smell an opportunity to champion an ostensibly wrong in need of righting.  Beware of politicians, particularly in this progressive age, who can gin up an argument that the ratings agencies are complicit in a Wall Street versus Main Street sort of way.

I’m very serious!  This is a perfect issue for politicization in this age of simple solutions.  It is horribly complex; no one will actually understand it or will be willing to spend the time to dig in and figure it out.  However, it can be made to sound simple.  Find a problem, translate it impressionistically into something that can be cast as a problem in need of a robust and muscular governmental response, identify a black hat (you have to have a black hat…guess who!), be prepared to blithely ignore nuance, have a high tolerance for the very real possibility of bad outcomes and actual damage to the economy, and voila, we’ve got a winning political hand!

That’s what I’m worried about here.  I’m open to any pricing model that actually works and won’t disrupt the market, but I don’t see an alternative to the issuer pay model yet in honest, intellectual currency.  But as the old saying goes, to a man with a hammer, everything looks like a nail, and if our duly elected representatives, notwithstanding overwhelming and compelling evidence to the contrary, who all seem to think a new law or regulation can fix virtually anything, get the bit in their teeth and decide to actually do something here, it’s likely to be bad.

A government fired up to “do something” with an almost willful disdain for the possibility that they could actually make things worse is something that should frighten us considerably and motivate us to do something.  If the availability of ratings is disrupted, either because a new pricing model makes ongoing rating activity improbable or impossible, or if the availability of ratings is meaningfully interrupted, truly bad things will happen.  Our economy relies heavily on our capital markets for lending (about 70% of all US corporate and CRE borrowing is capital market based whereas 30% is provided by the prudentially regulated banks, which for any number of reasons, that’s actually a good thing).  But as a large portion of the investor marketplace requires a rating (even though they are supposed to come up with their own views of credit quality…Shhh!), even a short disruption of the marketplace due to a collapse of the ratings process could, in these relatively fraught and fragile times, trigger a recession and a deep one at that.

The dominoes, baby.  Some muscular but deeply flawed governmental response gets political traction, catching fire after being dumbed down into an “us versus them” conversation, and then, with only the certainty and conviction that the fervently religious are blessed, or the political class can fabricate, we break the system in a misguided effort to fix it.  We eliminate the current ratings agency models, the alternate fails to work, the ratings process collapses and capital formation is significantly impaired.  What happens next?  When an activist polity finds that its regulatory activities have not solved the intended problem and actually made it worse, the response often is…more governmental action!  (Venezuela anyone?)  This goes on until even the most obdurate ideologue figures out it isn’t working.  But that could be quite late in the game and the damage will be done.  If the capital markets are disrupted, a recession will ensue.  Full stop.

Folks, there are some questions that don’t have answers.  There are some problems which are not, in fact, solvable with simple and costless solutions and the robust application of governmental power, not everything is a win-win.  This is one of them.  The negative externalities of all of these alternate proposals floated to date are large and open ended.  We don’t really know whether they might work (they won’t), nor what price we would pay for implementing them (might be high)!

And on the other hand, while this may not be a classic “if it ain’t broke, don’t fix it” thing, the problems of the current ratings model are not existential.  Our ratings model is not like a terminal disease; it’s more high blood pressure than cancer, a manageable condition, which through sustained attention and treatment can be kept under control such that our markets can continue to thrive.

So what should happen?  Investors should keep the agencies honest.  Prudential regulators should press, through the banking structure, to ensure that ratings discipline is maintained.  Market participants should eschew the siren song of excess easing of criteria.  That’s how adults fix problems.

So, attend to this everyone.  There clearly are flaws in the current system, but the solution is not to blow it up, it’s to fix it.  To get the adults in the room to pay attention to what would happen if ratings discipline is lost and to make sure it doesn’t happen.  That’s a way to keep our duly elected representatives at bay.  We can at least not make it easy for them to barrel into the space by screwing up.

Finally, let’s face it, even if ratings discipline is maintained, there’s no guarantee that an activist polity won’t decide there is a problem in search of a solution here, regardless of the data and the risks.  We can’t allow that to happen.  Back to the barricades everyone!

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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