The causes of the global financial meltdown have been pored over ever more vividly and frequently since banks started folding and bailout measures were passed in the last half of 2008.
While it was easy at first to find a quick scapegoat,namely, the admittedly troubling concept of corporate greed and the role it played in the downfall,analysts, regulators and laymen alike came to the lamentable conclusion that the credit crisis had not happened so simply.
Much of the responsibility for the subprime mortgage explosion lies with the companies that structured these securities and those that rated them higher than they should have. It’s also important to remember that across the globe, risk managers relied too heavily on one rating, or embraced the same short-sighted methods as issuers and rating agencies, such as Standard & Poor’s, Moody’s and Fitch.
The biggest, most notable charge leveled at credit rating agencies is that their pricing structure leaves room for potential problems and impropriety. When a company or institution is seeking a rating, they approach one of the agencies and pay for their rating themselves at a negotiable price.
Conventional wisdom would lead one to believe that having big companies pay to have their own securities rated isn’t the best way to keep the ratings impartial. But such wisdom has eluded the industry and regulators for as long as the industry has been around.
Aside from this somewhat glaring quandary, which new proposals by the U.S. and the European Union address in their own ways, other issues led to the global reexamination of the credit rating industry. They include a disparity between the expertise of those who were structuring mortgages and securities and those who were rating them.
This fact has not been lost on the Securities and Exchange Commission or the EU. But up until this point, regulators have approached credit rating agencies with uncharacteristically gentle methods of supervision.
Regulations have already been considered and enacted by regulators the world over. The regulations passed by both the SEC and the EU share several similarities and seek to combat the same problems and loopholes that allowed the credit rating agencies to contribute so notably to the financial meltdown.
The SEC’s rules, derived from the power granted to the Commission by the Credit Rating Agency Reform Act of 2007, include measures that prohibit any rating agency employee responsible for issuing a rating from also negotiating the price of a rating.
Conflicts of interest have been targeted as negative influences on the credit rating system. They are partly what led the SEC to also include a measure in the regulations that forbids credit rating firms, and any of their affiliates, from issuing a rating to a company that the rating agency is advising, underwriting or sponsoring.
The EU’s regulations actually forbid credit rating agencies from providing any advisory services at all, as well as prohibit them from rating any financial instrument if they lack sufficient quality information upon which to base the rating.
Transparency in the industry has also been addressed by both the EU and the SEC’s regulations, as they require credit rating agencies to disclose a great deal about their models, methodologies and other information.
Specifically, the SEC’s regulations require agencies to publicize the data and history of 10% of their ratings, while the EU will require the agencies to disclose their models, methodologies and key assumptions on which they base their ratings as well as require an annual transparency report.
Even though the issuing of these newer regulations as a reaction to the crisis was easily predictable, what happens next, to both the agencies and their ratings, is harder to foretell. While the regulators themselves see their work as a means to making ratings more reliable and more consistent, many have claimed that the effect will mostly be noticed by the rating agencies themselves, rather than users.
Regardless of the effect these changes have on ratings and their users, whether they become more accurate, more reliable or whether there’s little change at all, the case of credit rating agencies serves as a reminder to risk managers the world over. No matter how accurate a rating or a score seems or how many promises a product seems to make, there’s no single silver bullet that determines anyone’s or anything’s creditworthiness.
Barron is a staff writer and the government affairs liaison with Columbia, Md.-based National Association of Credit Management, a trade group for business credit and financial management professionals.
