Did the SEC Open an Escape Hatch for Ratings Agencies?
Despite almost universal recognition that the failures of the credit ratings agencies to perceive and disclose the risk in asset-backed securities played a pivotal role in setting the stage for the financial crisis, they’re still an integral—and legally mandatory—part of our financial system.
They’re so influential, in fact, that they can effectively veto efforts to regulate them.
Recently the ratings agencies exercised their veto power over attempts to subject them to liability for faulty ratings.
The ratings agencies have long escaped liability for bad ratings by arguing that their ratings are merely opinions and therefore protected by the first amendment. Dodd-Frank sought to change that by subjecting ratings agencies to the same kind of “expert liability” that pertains to lawyers and accountants who certify statements in securities prospectuses.
The agencies responded by immediately refusing to allow their ratings of asset-backed securities to be disclosed. On July 22, 2010, the market froze because the rules of the Securities and Exchange Commission required bond issuers to include the ratings when registering new asset-backed securities for sale.
With the agencies refusing to allow disclosure of their ratings, bond issuers found themselves unable to offer new securities.
The SEC quickly acted to unfreeze the market by saying it would waive the requirement for ratings disclosure—for six months. Then, this January, the SEC extended this waiver indefinitely.
Because the ratings are no longer disclosed to outside investors, the agencies do not have to worry about being sued under the “expert liability” provisions of Dodd-Frank. The agencies effectively vetoed expert liability.
This looks like dirty pool to some critics. Gretchen Morgenson of the New York Times describes it as an “escape hatch” through which the ratings agencies escaped.
“That the S.E.C.’s move strengthens the ratings agencies’ protection from investor lawsuits, which runs counter to the intention of Dodd-Frank, is also disturbing,” she wrote in Sunday’s New York Times.
I’ve also heard critics describe the ratings agencies as “holding the market hostage” until their demands were met.
There is something disturbing that a few privately held companies—basically, Moody’s , Standard and Poor’s—can cause the market for asset-backed securities to come to a screeching halt. But the source of this power is not the market—it’s the government rules that make the ratings agencies central to debt markets.
From this perspective, removing the requirement for ratings disclosure is a step in the right direction. It took away a huge source of business for the agencies—even as it took away liability that Congress sought to create.
It is difficult to imagine another solution. Congress probably cannot constitutionally compel the agencies to permit disclosure of the ratings while also increasing their liability for doing so. It would be like Congress making your local coffee shop liable for people who spill hot coffee on themselves—and then requiring the coffee be served at ultra-hot temperatures.
Usually, when the government imposes additional costs—such as taxes or novel legal liabilities—on an activity, it allows private individuals or businesses to avoid the costs by not performing the activity.
Barney Frank hits close to the mark when he describes the SEC’s response as part of its long term strategy of eliminating investor reliance on ratings. It would be better to say that the government is seeking to eliminate regulations that mandate the reliance on ratings agencies. If investors still want to rely on ratings, let them do so at their peril.
Perhaps ironically, removing the regulatory reliance might make ratings agencies more worthy of investor trust. Government rules prevented competition for the agencies and guaranteed that businesses would pay for ratings because they were mandatory. This not only took away any incentives to asses securities properly—it took away the ability for ratings agencies to detect flaws in their models.
The ordinary market processes that would have conveyed this information—business drying up or fleeing to competitors—couldn’t operate. From the agencies perspective, customers were scrambling to pay for ratings—making it appear as if the market was telling them they were on the right track.
Eliminating the ties between the government and the ratings agencies would go a long way to restore the error-detection and information-provision functions of markets. If the agencies are inept, issuers and investors will avoid them. If some are better than others, issuers and investors will assess the price to value ratio of the ratings and flock to those that provide the best mix. In other words, they’d operate just like every other business in a free market.
We’ve got a long way to go to eliminate the reliance on ratings agencies in government statutes and rules. It’s not just the requirements on the supply side, such as the one that applied to sales of new securities that the SEC has now put aside.
There are also plenty of demand side requirements—allowing firms to set aside less capital for highly-rated securities or requiring that insurance companies and pension funds only purchase securities with a minimum rating. All of these will need to go.
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