Conflicts of interest still in place
While the liability reform was the first part of the law to die, another initiative designed to reduce conflicts of interest withered even before the law was signed.
Several investigations into the causes of the financial crisis concluded that S&P and Moody’s wanted to gain market share and boost profits so badly that they gave AAA ratings to investments — particularly mortgage bonds — that didn’t deserve the high marks.
“It was not in the short term economic self-interest of either Moody’s or S&P to provide accurate credit ratings … because doing so would have hurt their own revenues,” said the report by the Senate Permanent Subcommittee on Investigations.
The investigations, including a Justice Department inquiry that ended in a lawsuit against S&P, found that the companies issuing securities would shop their deal between S&P and Moody’s in particular and see which company would give them the AAA rating on the most favorable terms. Issuers — including huge Wall Street banks such as JPMorgan and Goldman Sachs — paid as much as $150,000 for a rating on a mortgage bond offering, according to the Justice Department. A CDO rating could fetch as much as $750,000.
Sen. Al Franken, D-Minn., tried to eliminate one major conflict by creating an independent agency that would assign the job of rating a new security to the agencies on a rotating basis.
Franken’s amendment would have reduced “ratings shopping” by creating a system for assigning ratings rather than having issuers bid for them. The Senate approved it in May 2010 by a vote of 64-35. Then-Senate Banking Committee Chairman Christopher Dodd, D-Conn., and House Financial Services Chairman Barney Frank, D-Mass., opposed the bill, however, and opposition from the big-three firms was fierce.
Lobbying by S&P, Moody’s and Fitch peaked in 2010, with the three companies spending a combined $3.6 million to influence lawmakers. That’s 59 percent more than the $2.1 million the three companies spent in 2007, just as the housing market began to teeter.
Still, it’s just a fraction of the total spending on financial reform. The securities and investment industry spent nearly $106 million on lobbying in 2010, according to the Center for Responsive Politics.
When the House and Senate got together to reconcile their versions of financial reform, the assigned ratings system disappeared. The law instead ordered the SEC to study the issue and change the system if it considered it to be in the public interest.
The SEC published that study in December 2012, in which it described a variety of methods for assigning credit ratings but offered no opinion. S&P, Moody’s and Fitch all opposed a ratings assignment system in comment letters to the agency.
The study concluded by recommending a roundtable on the issue, which was held in May 2013. An agency spokeswoman said the SEC staff is developing a recommendation for the commission but declined to say when that would come, and refused to say whether the agency believes it must act at all.
Congress also mandated, as an alternative to the Franken amendment, that issuers of structured bonds make all the offering information available to every credit rating agency so those that aren’t hired to do the rating can publish one independently, without pay.
Such unsolicited ratings could impose some discipline on credit raters that won the business, who would presumably not want to look like they were too generous with their AAAs. The system would also allow smaller companies to build a reputation in the market by issuing good ratings on their own.
Since the law was passed four years ago, not one company has issued an unsolicited rating.
S&P said in comments to the SEC that bond issuers designate all the deal information confidential, making it nearly impossible for the rater not officially hired to analyze the bond to publish an opinion without violating that confidentiality.
The rule “was designed to address, among other things, the ‘issuer pay’ conflict of interest and to improve the quality of credit ratings,” the SEC’s Aguilar said. “The Commission should assess why this rule has failed to accomplish its goals and what else should be done.”
Even with the evidence that competition for market share led to a “race to the bottom” in ratings standards, some lawmakers and advocates argued that boosting competition in the ratings industry — and diluting the power of the S&P-Moody’s duopoly — was the answer to fixing low-quality credit ratings.
With that in mind, lawmakers also urged the SEC to increase the number of qualified credit raters by designating more companies Nationally Recognized Statistical Ratings Organizations. Now ten companies carry that title, but the industry is still dominated by S&P, Moody’s and to a lesser degree Fitch because private investors such as Calpers and Pimco still demand ratings from them.
“You have the SEC granting a designation — an anointment … that has nothing to do with the quality of their ratings,” said Dan Alpert, managing partner at the investment bank Westwood Capital in New York.
The Congress also tried to diminish the clout of the raters by ordering all federal agencies to delete any references to credit ratings – such as in rules on how banks measure the quality of their capital -- from federal regulations. Government agencies such as the Federal Reserve, the Securities and Exchange Commission and the Federal Housing Finance Agancy are busy coming up with alternative ways to measure creditworthiness.
The change may make ratings less important in some fields, but as long as private investors continue to rely on them, the ratings firms will continue to hold sway in the markets, analysts and investors said.
Today, credit ratings for mortgage bonds and other complex debt securities are issued exactly as they were before the crisis. Bond issuers ask several raters their opinions and then choose which they want to rate the deal.
When Redwood Trust, the largest post-crisis issuer of mortgage bonds, sought ratings for an offering last year, it provided information to Moody’s, S&P, Fitch and Kroll Bond Rating Agency, a relatively new and growing company.
Redwood then dropped Moody’s from the group “because the sponsor disagreed with the preliminary assessment by Moody’s of the risks,” the company said in its SEC filing.
When Goldman Sachs Group Inc. in March wanted to sell commercial mortgage bonds, it sought ratings from six companies and eventually chose three, Moody’s, Fitch and Kroll, and acknowledged in its filings that the other companies might not have given the deal the same ratings.
In another offering, however, Redwood chose Moody’s, Fitch and Kroll over S&P even though S&P appeared to be giving it the most favorable rating terms.
Redwood says it now has a policy of alternating between S&P and Moody’s since so many investment funds require a rating from one of those two.
“A large number of the deals being brought to market have not only two, but generally three or four ratings,” said Guy Cecala, CEO of Inside Mortgage Finance, a trade publication that tracks mortgage-backed securities. “You never saw that in 2006 or 2007.”
Cecala said companies may be getting several ratings to reassure investors that the ratings are credible after the reputational beating the ratings firms took during the financial crisis.
With companies getting so many ratings, it’s hard to identify “ratings shopping” in the pre-crisis sense. Still, there are no regulatory or legal backstops in place to prevent the raters from lowering their standards to attract business.
Good ratings equal good business
While Dodd-Frank gave the SEC a way to avoid revamping the industry’s business model, the law did require the SEC to “prevent the sales and marketing considerations” from influencing credit ratings. The law says the SEC can revoke a credit rater’s federal registration if it violates that law.
The SEC took a narrow view of this mandate however and wrote rules that simply prohibit sales personnel from being involved in the ratings process, a restriction that would do little to prevent the kinds of abuses that happened before the crisis, such as pressure from top management to boost market share or face consequences if an issuer went with a competitor with lower standards, according to Barbara Roper of the Consumer Federation of America.
During the housing boom, mortgage bonds generated huge revenue and profits for credit raters. S&P’s 2006 revenue was $2.75 billion, primarily due to growth in so-called structured finance ratings, the company said in its annual filings.
Structured finance products accounted for 44 percent of Moody’s $2.04 billion in revenue in 2006, according to the company’s annual report. “As in 2004 and 2005, U.S. structured finance was the largest dollar contributor to Moody’s revenue growth,” the company said. By 2008, Moody’s revenue had plummeted to $1.76 billion, with structured finance accounting for the biggest decline.
The Senate report showed that during the boom years Moody’s managers threatened to fire analysts who were too conservative in their ratings of mortgage bonds.