By healthy margins, the Senate last week passed amendments* to the financial reform bill designed to uproot the rating agencies from some federal statutes, to extend whistle-blower protections for the agencies’ employees and to decouple the agencies from issuers during the initial rating process.
The last and most far-reaching of the amendments, championed by Senator Al Franken of Minnesota and co-sponsored by 21 Senate colleagues, targets so-called rating shopping and other incentive misalignments associated with the issuer-pays model. Through the creation of a new Credit Rating Agency Board (CRAB), legislators expect to mediate the initial relationship between issuers of structured products and the rating agencies, sundering the formers’ influence over the ultimate rating assignment.
In describing the need for reform, Senator Franken offered an indictment of the current process, saying that “the credit rating agencies have demonstrated that they’ve blindly followed the perverse incentives of the current market. Congress should not sit idly by and let the credit rating industry continue to expose our economy to great risk just because Wall Street insists the problem doesn’t have an easy solution.”
Behind the rhetoric on both sides, there is substantive policy change in Senator Franken’s amendment. The policy does not address the full extent of structural issues that confound the securitization market; nonetheless, it has definite implications for market structure and the commercial mortgage-backed securities market.
Is the Credit Rating Agency Board
In positioning regulators at a key juncture in the securitization process, the policy change will facilitate even broader oversight than is suggested by the letter of the law. In the short run, however, the update to the regulatory regime will have little impact on commercial real estate securitization activity. Even if the financial reform bill is passed by the Senate and reconciled with the House version over the next few weeks-well before the August recess-the creation of the CRAB and implementation of its key authorities will be staged over the subsequent 18 months.
Once implemented, the CRAB should open the door for a larger number of rating agencies to participate in the CMBS marketplace. It will do this through some as-yet-undetermined process of assignment whereby issuers’ requests will be paired with agencies by the CRAB staff. This is critically important for innovation that is otherwise stifled in the presence of oligopoly in the ratings market and information asymmetries at virtually every stage of the securitization process. Smaller agencies with alternative approaches will find the new structure to be an equalizer.
The success of the new regulatory structure will depend on the soundness of the issuer-rating assignment mechanism. Over the long run, the intercession of the CRAB in the initial relationship between issuers and agencies may have deleterious consequences that partly offset its benefits if the mechanism is not well designed.
Foreshadowing the importance of well-considered design in the assignment mechanism, Bloomberg News quoted Standard & Poor’s as offering the following assessment of the amendment: “Credit-rating firms would have less incentive to compete with one another, pursue innovation and improve their models. This could lead to a more homogenized rating opinion and, ultimately, deprive investors of valuable, differentiated opinions on credit risk.”
If policy makers fail in their implementation, this is one potential outcome. It is not, however, the necessary outcome of reform.
Countering the assessment of the CRAB’s negative impact on incentives to innovate, Senator Franken, in a May 3 statement, described how “… the entire credit rating structure is basically one enormous conflict of interest. Issuers want high ratings, and raters want business. The market offers incentives for inflated ratings, not accurate ratings. And these perverse incentives have driven the behavior of all participants. Any rating agency looking to enter the market with better methods, or any rating agency that refuses to inflate its ratings, will never be able to compete …”
Predicated on the notion that issuers, left to their own devices, are only incentivized to choose the highest ratings, the new regime works because agencies will no longer compete for issuers’ business. As has been pointed out, this may also undermine incentives for the agencies to compete to produce the most analytically sound assessments. Avoiding that possibility will depend upon the board’s ability to substitute an evaluation process that rewards robust, transparent and effective methodologies in the place of the manipulable private mechanisms that it is designed to circumvent.
A regime that encourages more robust and reliable ratings is exactly what Senator Franken and his colleagues in the Senate envision. “The Board will be inclined to make the process one that incentivizes accuracy,” Mr. Franken states. “The Board will be required to monitor the performance of the agencies in the pool. If the Board so chooses, it can reward good performance with more rating assignments. It can recognize poor performance with fewer rating assignments. If the rater is bad enough, that might even be zero assignments.”
Operating under the auspices of the Securities and Exchange Commission, the CRAB will be equipped to evaluate the soundness of rating methodologies in approving an agency’s application for status as a nationally recognized statistical rating organization. And again, the CRAB will accept issuers’ requests for initial credit ratings in lieu of requests being made to the rating agencies themselves. To be sure, Senator Franken’s amendment does not specify exactly how rating requests will be assigned to the agencies. Instead, the CRAB will have to evaluate and select the assignment model.
An Update on the Financial Reform Debate
The amendments relating to the rating agencies will be for naught if the financial reform bill does not pass through the Senate. Following the passage of a number of amendments last week, the Senate now seems increasingly likely to reach a limited consensus on the financial reform legislation.
Earlier this year, that consensus had eluded Senator Chris Dodd and his peers on the Senate Banking Committee. The progress made over the past few days has been unexpected by many given that the Republican minority had, at first, blocked the bill’s introduction for debate on the Senate floor. Key updates from last week include a weak amendment calling for an evaluation of the government-sponsored enterprises’ conservatorship, amendments to the oversight of community banks and state-chartered banks.
Another amendment requires the Federal Deposit Insurance Corporation to investigate alternatives to the current system of credit ratings in determining credit-worthiness.
*The text of the Amendment 3991 “instruct[ing] the Securities and Exchange Commission to establish a self-regulatory organization to assign credit rating agencies to provide initial credit ratings” is available through the Library of Congress, at thomas.loc.gov.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.