The Securities and Exchange Commission spends a lot of time and money trying to discover insider trading in stocks. But when it comes to structured financial products — the funny securities that were at the heart of the financial crisis — it has just adopted a proposal that will facilitate such trading.
It did that in the name of reforming the credit rating agency system. The new rule shows the dangers of trying to solve one problem without thinking about others.
At the heart of the problem is that it is legal for companies and other issuers of securities to give confidential information to rating agencies.
Back before the crisis, the fact the agencies had access to such information served to enhance the respect given to their opinions.
Now we know that the major rating agencies — Standard & Poor’s, Moody’s and Fitch — disgraced themselves in rating structured finance products. They relied on bad assumptions, and in some cases may have been lied to by issuers. Their models turned out to be spectacularly wrong.
A lot of people think a root cause of the problem was the conflict of interest created by the fact the agencies were paid by the creators of those products, and therefore were dependent on their good will for additional business.
But regulators are unwilling to outlaw the old system, in part because that would leave investors without access to ratings unless they paid for them. So the solution chosen by the S.E.C. is to encourage other rating agencies to rate the products.
The rule adopted last week says that whatever information is given to the agency hired by the issuer to rate the structured finance security must be given to other rating agencies, including those that provide analyses only to investors who pay for them.
The result will be that analysts for the other rating agencies, like Egan-Jones Ratings, will have access to information not available to the general public, and their analyses will go only to clients. Those clients will have the benefit of nonpublic information, or at least of their agent’s analysis of what it means.
The answer is obvious: Cut off the inside information. The rating agencies now have an exemption from the S.E.C.’s Regulation FD, for fair disclosure. If that exemption were removed, the level playing field would be restored. And the respect that ratings now get from people who assume the raters know more than they do would fade away.
There could be temporary exceptions, to allow companies to tell the raters of plans not yet announced — like a takeover — so that the rating agencies could issue their opinions as soon as the announcement is made. But when they did issue the ratings, whatever information the agencies were given would also have to be made public.
Instead of ending the exemption for rating agencies, the S.E.C. broadened it to include agencies that are newly able to demand the information.
“The commission believes it is important to foster competition among rating agencies to improve the quality of ratings services, particularly among those providing ratings of structured finance products, and the recently approved rule change is designed to advance that goal,” said Meredith B. Cross, director of the commission’s division of corporation finance. “We are also mindful of concerns about potential misuse of confidential information, and the new rule includes important safeguards to address those concerns.”
The safeguards include getting the analysts to promise not to disclose the inside information. But the commission did not, and could not, demand that the analysts not use the information in assessing the security. That is the whole point of the new rule.
One argument against making some of that information public is one of confidentiality. The owner of an office building whose mortgage was included in a mortgage-backed security would not like competitors to see his rent roll. But summary data could be developed, and, in any case, public companies have been able to live — and compete aggressively — while making the considerable disclosures required by securities laws.
Who should get privileged information?
Sean Egan, managing director of Egan-Jones Ratings, is likely to benefit from the new rule. Not only would he be able to get the information to rate whatever he wanted to rate, but he would have an advantage over other securities analysis firms because he would have access to information they did not have.
It is, he told me this week, an advantage he does not want. “My argument is that there should be no carve-out for ratings firms,” he said. “Why should they be given privileged information?”
He speculated on what would happen if, say, Goldman Sachs asked that its analysts be allowed to get inside information from companies that was not made available to analysts from Merrill Lynch or Morgan Stanley. The S.E.C. would laugh at such a request.
The new rule letting other rating agencies get the information does not apply to corporate and municipal securities, only to structured finance. While it is certainly true that the biggest ratings disasters came in structured finance, there have been some ratings failures elsewhere. It would make more sense to open all the markets, and let everyone have access to the same information.
Rating agencies came to enjoy privileged status for a variety of reasons. They seemed to be almost like utilities, and regulators came to rely on ratings to provide easy comparability in a complex world. Bank regulators allowed banks to carry less capital against AAA-rated securities. The S.E.C. specified that most assets in money market funds had to be held in highly rated securities.
The S.E.C. has repealed some of those rules, and is considering whether to part with others. Bank regulators are working on capital rules. But there remains great demand for that simplicity.
So long as ratings were more or less freely disseminated to all, letting the agencies have access to information not available to others seemed to do no harm. In fact, it may have done harm by providing added credibility to ratings issued by agencies that, no matter how good their intentions, suffered from a fundamental conflict of interest in that they could get the information only if the company being rated chose to hire them.
But there is, in reality, little difference between what a credit rating analyst should do and what a securities analyst should do, particularly for debt securities. There are thousands of securities analysts, many of them seeking to sell their services to institutional investors. It makes no sense to give Egan-Jones, or any other analysis firm, a competitive advantage simply because it chooses to register as a credit rating agency.
There would be another advantage to a rule that said rating agencies got the same information as other analysts. Money managers who lost a lot of their clients’ money in collateralized debt obligations and other funny pieces of paper have been able to blame the rating agencies for misleading them, and thus try to escape responsibility.
In fact, those managers had the obligation to understand what they were buying. The management fees they were collecting should have covered more work than checking out what Moody’s had to say.
In a world where it was clear that Standard & Poor’s had the same information as everyone else, it would be a lot easier for the rest of us to weigh the wisdom of a given rating. The prestige of a Fitch rating would depend on its reputation for superior insight and analysis, not on its access to confidential information.
Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.