Editor’s note: This article was adapted from an Oct. 11, 2010, presentation by Todd Seaver, a partner at Berman DeValerio, and Kevin Lindahl, general counsel of the Fire and Police Pension Association of Colorado, at this year’s National Conference on Public Employee Retirement Systems’ Public Safety Employees Pension & Benefits Conference.
For decades, rating agencies ran wild on Wall Street, using their privileged position in the financial game to post some of the highest profit margins on the S&P 500. But the agencies’ transformation from passive assessors of corporate risk to financial engineers exacted a catastrophic toll on the world economy.
While the rating agencies didn’t single-handedly cause the 2008 financial collapse, they could have single-handedly prevented it. Now, with the economy still in tatters, Congress, federal regulators and activist investors are working on two fronts: to hold the rating agencies liable for their part in the crisis and keep them accountable in the future.
Working Toward Accountability
The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law by President Obama on July 21, 2010, aims to increase accountability and transparency among rating firms in a number of ways. Among other things, the law requires the agencies to disclose more information about rating methodologies and tighten internal controls designed to avoid conflicts of interest. Under Dodd-Frank, the Securities and Exchange Commission will establish an Office of Credit Ratings to oversee the agencies, while the SEC and other federal agencies will eliminate their reliance on ratings.
One critical component of reform is the creation of a new system by which the rating agencies will be compensated for their ratings. The Dodd-Frank bill contemplates rulemaking by the SEC on this front, and several proposals are under consideration which aim to neutralize the pernicious effects of the present system, where the issuer of the security pays the rating agency for rating its security.
On the accountability front, Dodd-Frank eliminates rating agencies’ long-standing exemption from legal liability for any misleading statements in ratings that are later used in registration statements.
Even before Congress acted, however, the rating agencies were feeling some legal heat. The California Public Employees’ Retirement System’s seminal lawsuit, CalPERS v. Moody’s et al., filed by Berman DeValerio in July 2009, is one of several private actions pending against the agencies. The Connecticut attorney general’s office is litigating a case against Standard & Poor’s and Moody’s Corp., while the California attorney general’s office is conducting its own far-reaching investigation.
Historical Perspective
To understand how rating agencies got out of control, it is helpful to look at their history.
In their earliest days, rating agencies performed a simple yet valuable service to the investor community by rating creditworthiness and analyzing the value of corporate bonds and government debt. In the early 1900s, John Moody published a newsletter for investors focused on railroads that eventually branched out to become a widely used evaluation tool for corporate debt and creditworthiness. Other rating companies followed in Moody’s footsteps, including Fitch Publishers and Standard Statistics (the precursor to Standard & Poor’s). But for decades the industry changed little fundamentally.
In the 1970s, however, two key transformations took place. Rating agencies transitioned from a subscription-based revenue stream to an “issuer pays” model in which the rating agencies were paid by the debt-issuers. Additionally, the SEC granted certain credit rating agencies status as Nationally Recognized Statistical Rating Organizations, effectively creating a government-sanctioned oligopoly with little regulation.
The rating agencies operated in an environment in which they could more or less do as they pleased. And real trouble arrived with the advent of structured finance in the late 1980s.
Due to the inherent complexity and opaqueness of structured finance products, such as mortgage-backed securities and collateralized debt obligations, rating agencies assumed a more pivotal role in the financial industry. They not only assisted in engineering the construction of structured investment products, they also became a gatekeeper to the structured finance market. Put another way: none of these products could successfully come to market without a rating agency’s blessing.
Throughout the late 1990s and into the early 2000s, the rating agencies established and operated inadequate and incompetent review processes that were an important cause of the eventual financial collapse. Simultaneously, they were reaping huge profits.
By rating a structured investment product, Moody’s or Fitch typically received between $100,000 and $1 million in revenue, as opposed to $50,000 for rating a municipal bond of similar size. The more complex the product, the more the rating agencies could charge – and the more essential the rating agencies became to the debt issuer.
Competition spurred a “race to the bottom” in rating quality. Banks would shop for the best rating available, creating a dangerous conflict of interest for rating agencies. This market dynamic was evident to the players involved, including Moody’s CEO Raymond McDaniel.
In an October 2007 report to the company’s Board of Directors, McDaniel clearly pointed to the dangers of the present-day ratings game. “The real problem is not that the market does underweights (sic) ratings quality but rather that … it actually penalizes quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating,” he wrote. “Unchecked, competition on this basis can place the entire financial system at risk.”
Less than a year later, Moody’s CEO proved prescient: the toxic combination of a boom in complex, opaque structured investments and government-sanctioned, profit-driven ratings helped trigger the worst economic collapse since the Great Depression.
What’s in Store
Looking forward, the SEC and other regulators must work to strike a balance between curbing the rating agencies’ excess and allowing them to fulfill an important market function. Without healthy rating agencies, large investors would be forced to dedicate tremendous resources to conducting their own due diligence from the ground up. This would drive up transaction costs, while yielding inconsistent analyses. Lacking alternatives, smaller funds could be forced to limit the scope of their investment mix, raising volatility and reducing risk-adjusted rates of return.
Dodd-Frank provides a structure for effective regulation: the house has been framed, but the walls still need to be filled in. The SEC has a lot of work ahead in making rules to keep the rating firms in check.
Now is the time for institutional investors to provide input to the rule-making process. The result, we all hope, is a set of regulations that allows rating agencies to flourish while increasing confidence that their ratings are accurate, thorough and the product of transparent procedures that minimize conflicts of interest.
*In August 2017, our firm name changed to Berman Tabacco. Case references and content published before that date may refer to the firm under our prior name, Berman DeValerio.