A Question of Agency
Sam Chandan Sept. 29, 2009, 6:41 p.m.
As the immediacy of the financial crisis has dissipated and a semblance of stability has been restored to the sector, policymakers’ attention has turned to long-term structural impediments to the market’s renewed functioning and the myriad failures that contributed to the mis-measurement of risk at the market’s peak. As part of this refocusing of attention, the drumhead calls for rating-agency reform have been growing louder. Scrutiny of the most recognizable of the rating agencies’ practices has intensified over just the past week, following allegations that at least one agency has persisted in inflating its ratings.
The Treasury Department announced in late July that the administration had sent proposed legislation on credit-rating-agency reform to Capitol Hill. Among its many objectives, the legislation sets out to minimize conflicts of interest, increase transparency and disclosure and improve oversight of the agencies. As a more generic goal, the proposal also seeks to reduce the market’s reliance on the rating agencies. However, no alternative risk-measurement regime is proposed to fill any resulting void. Although independent assessments of risk by investors themselves preclude incentive conflicts, such a system also raises the cost of investing and narrows the field of potential investors.
The current initiatives—by the Obama administration and, more recently, by the Securities and Exchange Commission (S.E.C.)—are hardly the first efforts to reform the ratings process. Just three years ago, in September 2006, President Bush signed the Credit Rating Agency Reform Act into law. The provisions of the act took power over the nationally recognized statistical rating organizations (NRSROs) a year after its passage, in September 2007. The stated intent of the legislation was to foster “accountability, transparency, and competition in the credit rating agency industry.” Famously, the agencies were cited at that time for assigning investment-grade ratings to Enron up until four days before its demise.
In many respects, current initiatives echo the broad goals of the earlier legislation. In the aftermath of the credit market’s collapse, it is generally agreed that the changes sought in 2006 failed to address the conflicts of interest and information asymmetries that bedevil the securitization process. Just last week, Securities and Exchange Commission Chairman Mary Schapiro stated that “in the recent financial crisis, reliance on credit ratings did not serve investors well.” In separate comments, she added, “It is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust.”
Regulating over the complex process of risk measurement, where the quality of the valued service is difficult to verify, will remain a vexing challenge. If the compensation of the agencies by the issuers they rate is the basis for many of the system’s failures, the proposals offered up thus far may prove ineffectual. Instead of addressing the system of issuer pay directly, the S.E.C. has sought to encourage competition by requiring that issuers provide the same information to all rating agencies, whether they are compensated by the issuer for the their ratings or not.
In doing so, the S.E.C. hopes to break a stranglehold on information by the agencies that have dominated the market up to now. If they succeed, it will be because investors can contract with ratings agencies that are beholden only to them.
Systematic differences in ratings quality that depend on who pays whom will indicate a bias in the process that will be difficult to maintain if the requirements for transparency are sufficiently strong. In this context, the market entry of firms such as Realpoint, with its singular focus on commercial real estate, also holds the potential to raise the level of analytical rigor across the spectrum of rating agencies.
Whether the current reforms will succeed in restoring investor confidence in the ratings process is of critical importance for the commercial real estate investment market. At the heart of the securitization process, the rating agencies fulfill a specialist role in carefully measuring risk and then disseminating their assessments to a broader class of investors. Absent a renewal of confidence in their capacity to fulfill their role, or an alternative institutional framework for measuring and communicating risk, a fully functioning CMBS market will remain beyond our grasp.
Sam Chandan, Ph.D., is president and chief economist of Real Estate Econometrics and an adjunct professor of real estate at Wharton.