November 22, 2009

A significant but largely overlooked piece of the financial reform bills being debated in Congress could have a direct impact on bank capital, commercial real estate lending, investments and even correspondent relationships: Reform of the credit ratings agencies.

"Banks care about the quality of ratings because they don't like to get stuck with toxic sludge," says attorney David Brown Jr., a partner at Alston & Bird in Washington, D.C. The involvement of credit ratings agencies (CRAs) "quickens the diligence process," but tardy downgrades and revelations that undermine the confidence in ratings "can throw sand in the gears. There are regulatory capital issues that flow from these ratings."

There are 54 regulations that require use of credit ratings, including 12 pertaining to banks, notes the TARP IG's report to Congress last month. These mostly have to do with risk-based capital standards but also touch on permissible investments and correspondent relationships. Even the New York Fed relies on "NRSROs" to evaluate asset-backed securities for TALF. CRAs whose ratings are accepted by the SEC are known as Nationally Recognized Statistical Rating Organizations or NRSROs.

While other proposals in the broader financial reform bills are likely to see hefty debate and compromise, consensus has emerged on the need for strict rules on CRAs regarding conflicts of interest, transparency of methodology, ratings accountability and legal liability. Three CRAs - Moody's, Standard & Poor's and Fitch - dominate the market.

"The government intends to radically change the way credit ratings are issued, paid for and litigated," `says attorney Dan Crowley, a financial services lobbyist with K&L Gates in Washington, D.C. "The government is trying to address what it sees as an oligopoly among the major rating agencies on the theory that a lack of competition led to laxity in their practices, and to address the potential conflict of interest" from having issuers pay for their own ratings. "But some of these proposals are pretty draconian."

Similar proposals for CRA regulation have been introduced by Senate Banking Committee Chairman Chris Dodd (D-Conn.) and Rep. Paul Kanjorski (D-Pa.), who chairs the capital markets subcommittee of the House Financial Services Committee, which already has approved his proposal and referred it to a vote of the full House.
The most controversial piece of each bill would place legal liability on CRAs for their ratings. Both bills also would introduce conflict of interest rules to prevent CRAs from inflating ratings of mortgage-backed securities to win business. Kanjorski's bill would require CRAs to have a third of their boards be independent directors to oversee CRA methodology. Dodd's bill would place oversight of methodology with the SEC, require annual exams and allow the SEC to remove the NRSRO designation if a CRA performs poorly.

"This is going to happen," Crowley says. "The question is in what form. The temptation is to take all the ideas and aggregate them. I've never seen such a fluid process."

How CRA Reform Would Impact Banks

Ending the practice of ratings inflation is the most important element of the legislation for banks, since inflation can affect their capital, lending and investment decisions. OCC, FDIC and OTS each require use of NRSRO ratings in their risk-based capital rules. This flows from Basel, which recently was amended to require that banks supplement, but not replace, CRA ratings with internal credit risk analytics.

"The regulators and Congress have pretty much realized that it was a mistake to rely on credit ratings in deciding how to regulate the largest banks," says attorney David Scranton, a senior banking partner at Stradley Ronon of Philadelphia. "That really will be the key change banks will have their eye on."

"Think of consequences of a lack of trust in CRAs by investors as it relates to banks," agrees Jim Allen, head of capital markets policy at the CFA Institute, an association of investment professionals based in Charlottesville, Va. "If you don't trust the ratings from CRAs, and you see that a bank has based its capital on the ratings from the CRAs, it has an effect upon your confidence in the capitalization of that institution."

Halting ratings inflation also could help construction lending related to municipal projects that require letters of credit, says Scranton, formerly an in-house counsel for regional banks. The letter is provided by the bank to the trustee as a guarantee that municipal bond holders will be paid in case of default. This bolsters the bond's rating issued by the CRAs, he says.

CRA reform also would help iron-out valuation issues by bringing price stability to the securitized debt that remains on bank balance sheets, Crowley says. "The ratings agencies are widely viewed as having missed the boat on the way up in rating these securities as AAA when they clearly had risk, and they are seen as overcompensating on the way down," he says. "Banks still hold the same assets, but now the ratings are having an adverse impact on their capital."
CRA reform "should be a stabilizing force across the board: both for banks and investors," Crowley adds. "The structure is designed to stay ahead of developments, so for the next credit default swap product there is a mechanism to make sure the analysis is appropriate. Banks will have a better understanding of the inherent risks" before they invest.

Many of the Congressional proposals - on transparency, accountability and SEC oversight - have been promoted for months by the SEC, as outlined by Chairman Mary Schapiro's testimony in July before the House Financial Services Committee. But even the SEC has lagged on CRA reform. In August, the SEC Inspector General criticized it for slow adoption of rules to implement the Credit Rating Agency Reform Act of 2006, and lax CRA exams. The IG also recommended stricter conflict of interest rules.

Meantime, several states have pursued legal action against the big three CRAs. In September, California Attorney General Jerry Brown launched an investigation into their role in fueling the financial crisis by giving "stellar ratings to shaky [securitized] assets" purchased by banks and others. He issued subpoenas regarding due diligence, methodologies, marketing and conflicts of interest to S&P, Moody's and Fitch.

Why Congress' Plan Won't Work & an Alternative Proposal

Some worry that Congress is moving in the wrong direction. Though ratings inflation and low-quality ratings are "legitimate targets of reform," the Congressional proposals would only "tinker" with the rating process in "ways that have little hope of fixing either," warns Charles Calomiris, a professor of financial institutions at Columbia Business School in New York.

Under the current rules, "The business is going to come their way regardless of the quality of their work," Allen agrees, noting that CFA has pushed to eliminate use of CRAs by regulators. The House bill originally included a provision to strip statutory references to credit ratings, but it was eliminated. The SEC has initiated steps to do so with money market funds. "Frankly, if investment funds, banks, insurance companies, have to rely upon the NRSROs by law or regulation, then there's not much incentive to increase the quality of the work," Allen says. "They are an oligopoly."
That's why Calomiris advocates a pay for performance (P4P) system that links CRA payment to the actual performance in predicting defaults, a solution he shared with FinCri Advisor in a paper he prepared prior to testifying before Congress last week on the issue.

P4P would remove the incentives to inflate ratings and increase the focus on accurate methodologies, Calomiris contends, noting that it mainly was buyers of securitized debt, not sellers as Congress assumes, that pushed for ratings inflation. This was done to avoid capital charges, he says, adding that rate shopping by sellers was done at the behest of buyers who wanted them to engineer structures of securitization that would reach the maximum allowable debt against a given pool.

"If a rating agency gives too conservative an answer relative to its competitors, the sponsor just uses another rating agency," Calomiris notes. "Rating agencies had no incentive to construct realistic models or to respond realistically to bad news relating to subprime instruments for a simple reason: Their buy-side clients did not want them to do so."
That's why Congressional proposals that require buy-side investors to pay for ratings would be useless, he says. It would give them even more control over ratings. That's also why tinkering with CRA boards won't help: Independent directors would be advocates for these same buyers. Even holding CRAs legally liable is "misguided," Calomiris says, because there is no objective standard for CRA performance.

P4P, he insists, is the answer. "If ratings agencies' fees are linked to the quality of their objectified ratings, then ratings agencies would find it unprofitable to cater to buy-side preferences for inflated, low-quality ratings," Calomiris notes. He would link the letter ratings to numerical estimates of the probability of default and expected loss - data that CRAs already collect. Regulators could set a cap on ratings inflation over a specified time that could result in a clawback of fees or a temporary loss of license.

Crowley says it is unlikely new proposals, such as P4P, will be added, given that the House has passed its version and the Senate takes up debate after Thanksgiving. "Out of 500 potential issues, where does this type of idea fall in terms of individual Senators' priorities? It seems remote to me," he says.

"I am skeptical," Allen agrees. "Once again, if a bank or investment fund still is required to look to the CRA for ratings, you will end up in more or less the same situation. How bad would it have to be to get to a situation where there is a clawback or a license removed? On all of these proposals, it depends on how you implement the rules."