The SEC’s Bipolar Approach to Credit Rating Agencies

JohnJay resized 600Guest Contributor: John Jay, Senior Analyst, Aite Group

The Securities and Exchange Commission (SEC) is coming to the rescue of the investment community; it is considering leveling civil fraud charges against credit rating agencies (CRAs) — in particular Standard & Poor’s (S&P) and Moody’s — in relation to their roles in facilitating the 2008 and 2009 financial collapse via mortgage securities’ ratings.

This is reminiscent of an old Honeymooner’s episode in which Ed Norton tries to convince his buddy (Ralph Kramden) that he has his best interest at heart: “Who took you to the hospital and took care of you when you got hit in the head with a bat? It was me.” After a momentary pause, his friend responds, “You’re the one who hit me in the head with the bat!” And so it is with the way the SEC is managing CRAs.

It is the SEC who created the Nationally Recognized Statistical Rating Organizations (NRSROs) — 10 in all — to help investors determine the creditworthiness of fixed income investments. The marketplace took the NRSRO designation as a virtual governmental “seal of approval.” The Big Three of CRAs (Moody’s, S&P, and Fitch) issued their lettered credit-rating scales and rated the overwhelming majority of U.S. mortgage and mortgage-related securities during the 2004 to 2008 period. Taking into consideration the amount of debt outstanding, debt to be issued, and market pricing of the gradations of credit risk, NRSROs command much market impact; the U.S. mortgage market is US$11 trillion in size.

A closer look at prospectuses will show that many of these securities required that at least two NRSROs for issuance. Without NRSRO ratings, the marketability of the securities would have been greatly hamstrung. This is not to say that mortgage and mortgage-related securities could not have been sold, but non-rated securities would have undoubtedly been much more expensive to issue.

Asset managers, too, rely on NRSRO ratings. Terms such as “investment grade,” “high yield,” or “high grade” refer directly to NRSRO ratings. A case could be made that without NRSRO ratings, the buy-side fixed income business would not be nearly as significant as it is today. The Pacific Investment Management Company (PIMCO) — primarily a fixed income shop — alone manages over $1 trillion in assets, for instance.

Now CRAs are being taken to the mat for a system that was first established by the SEC. Fraudulent behavior by CRAs will be difficult to prove. An even greater challenge — and perhaps a fixed income process endgame — will be for the financial system to wean itself from an NRSRO setup that so many have relied on.

About Maureen Lowe

President and Founder of Financial Technologies Forum, LLC. Editor-In-Chief of FTF News. Entrepreneur, Jersey Girl that recently returned to Jersey, Loves to Bake, Married to a Kiwi, First Time Mom
This entry was posted in Guest Blog, Operational Risk, Regulation and tagged , , . Bookmark the permalink.

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