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Legalized Plunder

July 28, 2009

One of the worse type of regulation are those that give monopoly power to market participants. The current incredible crisis happened in part because the rating agencies were given monopoly power by the Federal Securities Exchange Commission. Here I a few excerpts from a rare article on this topic.

Q. So, which rating agencies must U.S. regulated financial institutions heed?

A. There are a special set of rating agencies—designated as “Nationally Recognized Statistical Rating Organizations” (NRSROs) by the U.S. Securities and Exchange Commission (SEC)—whose ratings must be followed.

Q. How many NRSROs are there?

A. As recently as 2002 there were only three: Moody’s, S&P, and Fitch. Today there are ten. Two are headquartered in Japan and one is headquartered in Canada; one (A.M. Best) specializes in insurance companies’ obligations. That leaves six: the Big Three and three smaller firms (Egan-Jones, Lace Financial, and Realpoint).

Q. What role have the rating agencies played in the current financial crisis?

A. Recall that the crisis started as a problem of widespread defaults on recently issued mortgage-related securities that had subprime mortgages as their underlying collateral. The three large U.S. rating agencies initially were overly optimistic about the creditworthiness of these mortgages. Like too many other participants in the mortgage markets, they seemed to be “drinking the Kool-Aid” that housing prices could only increase—in which case even subprime mortgages wouldn’t be a problem, since the borrower could always refinance the mortgage or sell the house at a profit.

The rating agencies’ overly optimistic ratings allowed the packagers of these securities to sell large “senior” slices as “safe” (low-interest bearing) investments and thus allowed substantial profits to be made on the packaging process, which in turn encouraged more subprime mortgages to be originated, etc.

The rating agencies were also criticized for delays in downgrading these securities after other market participants had already recognized the problems. These criticisms echoed others earlier in the decade, when Moody’s and S&P had maintained “investment grade” ratings on Enron’s debt until only five days before that company’s bankruptcy filing in November 2001.

Although there is plenty of blame to go around with regard to the current debacle—and in the end, the investors who bought the bonds were overly optimistic, too reliant on credit ratings, and ignored risk to a shocking degree—the rating agencies clearly played a major role in exacerbating the problem.


Q. But aren’t the rating agencies regulated?

A. Well, yes—and no—and sort of. Remember the “NRSRO” designation that was mentioned above? The SEC devised it in 1975 so as to prevent broker-dealers from using the ratings of potentially “bogus” rating firms. After creating the category, the SEC immediately “grandfathered” Moody’s, S&P, and Fitch into it, and then designated only four more NRSROs over the next 25 years. But mergers among the entrants and between the entrants and Fitch reduced the number of NRSROs back to the original three by 2001.

In essence, the SEC had become a major barrier to entry into the rating agency business. It would not be surprising to discover that a protected oligopoly had become sluggish and careless—and the potential conflicts of the “issuer pays” model surely didn’t help matters.

However, except for the rare designation of a new NRSRO—and even then, the SEC conducted the designation process in an extremely opaque fashion, never specifying any criteria for designation—the agency didn’t impose any other regulatory controls on the rating agencies.

In 2006, the Congress passed legislation that specifically instructed the SEC to cease being a barrier to entry and to allow all qualified applicants to be designated as NRSROs—and to do so in a more transparent process. (As a consequence of this legislation, and of congressional pressures earlier in the decade, there are now the ten NRSROs mentioned above.) The legislation specified the criteria for designation and did give the SEC some limited regulatory powers to ensure that incumbent NRSROs are adhering to those criteria (such as addressing conflict-of-interest problems). The SEC is currently investigating the NRSROs’ behavior during the debacle.

Q. So, is more regulation needed?

A. That’s one possible direction for SEC action. Since the large U.S. rating agencies made a slew of bad judgments in the past few years, new regulations could try to push them to make better judgments in the future. These efforts could include such measures as mandatory training for bond analysts, required disclosures on potential conflicts, mandatory “Chinese walls” between the analysts and the business/marketing personnel at NRSROs, or even a ban on the “issuer pays” business model. The SEC took a few modest steps in these directions in December.

Q. Are there drawbacks to more regulation?

Yes there are. In its efforts to get the NRSROs to “pull up their socks,” the SEC may well reduce or eliminate flexibility in the industry and squelch creativity and innovation with respect to alternative business models and better ways of assessing the default probabilities of bonds. Further, there is always the risk that the SEC “gets it wrong”—say, mandating the wrong kind of Chinese walls—but in that regulatory sphere, there are no alternatives.

Q. Is there a better way?

A. Yes, and it’s one which would rely less on regulation and more on markets.

Let’s start with the basic goal of financial regulation that led to the required reliance on rating agencies and then led to the SEC’s creation of the NRSRO category and its subsequent protective moat around the category’s incumbents. That goal was to insure the safety of the bond portfolios in banks, insurance companies, pension funds, money market mutual funds, broker-dealers, etc. This was a worthy goal. But in deferring to the NRSROs’ judgments as to safety (such as the determination of “investment grade”), the regulators were in essence delegating their safety judgments to this select group of rating agencies, who turn out not to have done their jobs all that well.

The key, then, is for the financial regulators to pull back that delegation. The goal should still be to have safe bond portfolios in regulated financial institutions. But the burden should be on each institution to defend its choices of bonds to its regulator. This defense could reside in original research. Or it could involve reliance on a trusted advisor, which could be a rating agency or some other advisory service. Regardless of the form of defense, the regulator should insist that the financial institution has a reasoned, sound basis for its choices.

Regulated financial institutions would thus be free to take advice from sources that they consider to be most reliable—based on the track record of the advisor, the business model of the advisor (including the possibilities of conflicts of interest), and anything else that the institution considered relevant. Again, the institution would have to justify its choice of advisor to its regulator. But, subject to that constraint, the bond-advisory information market would be opened to new ideas and new entry in a way that it has not been since the 1930s.

With this burden-on-the-institution regulatory model adopted by financial regulators, the SEC could eliminate the NRSRO designation.


Q. Is there anything else that would help?

A. Yes. In the past few decades, when investors or issuers have sued a rating agency, claiming that they were injured by that agency’s rating, the agencies have usually prevailed by claiming that they are “publishers” (remember that word “opinion” that they like?) and thus are protected by the First Amendment of the U.S. Constitution. Although perfect accuracy is an unrealistic expectation, and thus they should be given some range for making errors, nevertheless opening up the possibility that the rating agencies could be held financially accountable for their wider errors might well provide them with stronger incentives for getting it right.

Lawrence J. White is Professor of Economics at the NYU Stern School of Business. From 1986 to 1989 he was a board member of the Federal Home Loan Bank Board and, in that capacity, also a board member of Freddie Mac.

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