April 28, 2008
Gerald Baldwin

 

On Tuesday, April 22, 2008, Congress took the latest step in its examination of the mortgage markets. According to Committee Chairman Dodd, this was the 48th hearing conducted on subprime mortgages. This time the subject was the role of credit rating agencies in the securitization process. The U.S. Senate Committee on Banking, Housing, and Urban Affairs heard testimony from the Chairman of the SEC, two experts on the role of credit rating agencies in the credit markets and representatives of the three largest rating agencies. Neither Chairman Dodd nor Senator Shelby was “pleased” that Standard & Poors and Moody’s chose to send witnesses other than their respective CEOs. Fitch Ratings’ President and CEO did appear and testify. Undoubtedly, there will be more hearings to come.

So far, Congress has heard from witnesses who variously blame the upheaval in the mortgage industry on borrowers who over-extended themselves or who overstated their finances, speculators who were riding the rapid rise in housing prices, developers who wouldn’t stop building even though home ownership was at an all time high, unscrupulous loan originators whose only interest was in closing deals and passing the risk on to investors and Wall Street for creating the financing vehicles that made it possible for sub-prime borrowers to finance a home. Last week it was the rating agencies who took the spotlight. The players have all had their turns.

The mood of the Committee seemed to support new legislation to change the way credit rating agencies are regulated.

Christopher Cox, Chairman of the SEC, testified about the present state of the law and what the SEC is doing currently. Until September of 2006, rating agencies were basically unregulated. The Credit Rating Agency Reform Act gave the SEC the responsibility to regulate the industry. However, according to Chairman Cox, that regulatory power is extremely limited: registration with the SEC; auditing to determine if the agencies have followed their own disclosed policies for rating securities (but not determining whether those policies produce accurate results); and generally trying to make sure that the public knows what standards the agencies purport to apply when making their rating decisions. In other words, the present role of the SEC in the rating process is in verifying that there is full disclosure of the process, not the accuracy of the rating. Whether one agrees with the scope of the SEC’s power in this area, any attempt to blame the SEC for today’s market problems is misplaced – the SEC’s rules were not even adopted until June of 2007. However, the comments of some of the Committee Members implied a desire to give the SEC greater responsibility and power in regulating the agencies.

The testimony of the two “independent” witnesses, Professor John C. Coffee, Jr. of Columbia University Law School, and Dr. Arturo Cifuentes, an investment banker, was extremely critical of the rating system. Professor Coffee warned the Senators that the lack of competition in the industry, inherent conflicts preventing objective ratings and the industry’s apparent immunity from liability, all conspired to make the ratings industry ineffective. He even suggested that the agencies did not understand that their traditional approach to rating corporate or municipal bonds would not produce a reliable rating for collateralized debt obligations. Dr. Cifuentes suggested specific overhauls for the rating system. First, he recommended protection of the rating analysts from profit/compensation pressures. He said that the industry had to separate the analysts’ compensation/advancement from the amount of income generated by their ratings while rewarding analysts on the basis of the accuracy of their ratings. He also recommended the public, including competitors, be given greater access to the data used by the agency as well as the methodology utilized to analyze it. In other words, he wants the agencies to reveal exactly what data they looked at and how that inquiry resulted in their particular rating decision. Today, rating agencies reveal little more than the “grade” they award to a particular issue.

Judging from the apparent reaction of several of the Committee Members to each of these witnesses, as well as their displeasure with the failure of the agencies to be represented by their CEOs, the rating business may be forced to change in some systemic ways. It is still much too early to predict exactly what form those changes will finally take but it seems likely that at least two issues will receive serious discussion by Congress: eliminating conflicts of interest and imposing legal liability for losses.