New Ratings Agency Rules From the SEC

As part of the implementation of the Dodd-Frank financial industry overhaul, the U.S. Securities and Exchange Commission (SEC) yesterday proposed new rules for credit ratings agencies.  These are not the agencies that rate consumer credit.  No, these are the folks who rate the various financial products sold by the big investment bankers.  Things like mortgage backed securities, for example.

During the Real Estate Bubble ratings agencies had rampant conflicts of interest.  Investment banks selling investments paid the ratings agencies to rate the credit worthiness and safety of the assets they were wanting to sell.  Not surprisingly it has been demonstrated that there were many tacit and implicit “pay to play” relationships that developed.  That’s a polite way of saying the ratings were bought.  [Sometimes its very easy to level criticisms of capitalism.]

What do you think happens when the watch dog joins the foxes in raiding the hen house?

Analysis:

Under the new rules the ratings agencies would have to:

• Report on internal controls.

The new rule would require each credit agency to report their management’s responsibility in establishing internal controls and an assessment as to the effectiveness of those controls.  Effectively, this is similar to the provisions that publicly traded firms’ management teams have to put in place under the dot.com manifested legislation, Sarbanes-Oxley.

SarbOx, in requiring executives to publicly declare the soundness of their financial reporting, opens them up to prosecution, possible prison terms, and to be personally sued in the event there are financial shenanigans that take place.

I think this new rule will help a lot.  Essentially it is like the farmer shining his flashlight on the dog and saying, “I can see you.”

• Protect against conflicts of interest.

Here the SEC rule would prevent analysts that issued a credit rating from also marketing her firm’s products and services.  In other words, the rule would prevent the dog guarding the hen house from selling his services to the foxes.  Duh!

• Establish professional standards for credit analysts.

It is common practice in the credit ratings agency world and Wall Street for investment banks to hire employees of the credit ratings agencies.  In other words, the foxes frequently hire guard dogs.  Unfortunately fox food is better than dog food so a lot of dogs abandon their duties.

The new SEC rule would require credit ratings agencies to review the ratings issued by their analysts who eventually moved to Wall Street to look for any conflicts of interest that might have been involved.  This provision, tentatively called the ‘look back review’ would require scrutiny of ratings issued for up to one year prior to the credit ratings analyst being hired on Wall Street.

Implied, but not stated in the text of the proposed rule, is that analysts offered up more favorable ratings to firms in the hopes of getting hired there.  It’s like the guard dog telling the hens not to fear a particular fox because he has checked him out and that he won’t eat the hens.  Then the guard dog joins the foxes.  It might make a hen wonder.

Further, if it is found that there was a conflict of interest present then the credit ratings agency would be publicly required to state the conflict, put the credit rating on “watch,” promptly review the rating, and then make any change, if needed.

• Publicly provide disclosure about the issuance of a credit rating and the methodology used to determine it.

More, and better information, is always desirable as an investor.  By requiring public disclosure of the methodology, investors can evaluate for themselves the quality of the analytical techniques.  Here the farmer has to disclose how he evaluates and instructs his dogs.

If you are an individual investor, don’t worry, chances are you rarely directly invest in a product underwritten by a credit agency.  Instead, you find your monies in these investments because of a mutual fund, wealth manager, financial adviser, or another investment professional.  As part of their training they are supposed to know how to do this.

Word to the wise: you should ask an investment professional about their ability to assess the methodology of a credit ratings agency.  If they stare at you blankly then you may have the wrong adviser.

• Enhance public disclosures about the performance of their credit ratings.

Right now there is no standardized tracking mechanism in place for the performance of the credit ratings agency.  In other words, the hens can’t tell the difference between guard dogs because there is no standard way of evaluating them.  With standardized rules in place it forces each of the agencies to disclose the same information so that consumers of the data can properly evaluate.

This is very important.  Why?  Because with a standardized disclosure it provides an incentive to the ratings agencies to do a good job, lest they lose business to a rival agency.  Amen!

There are several other minor rules proposed, but the above five are the biggies.  In short, I love the rules.  I am certain that they will have a profound effect on how the ratings agencies are run going forward.

But might I point something out?  There are many levels of investment evaluation in the chain between investment issuer and investment buyer, and ultimately that chain stops with you.

I am not suggesting that you become an expert on all financial matters, but if there were one thing that you should do as an investor, its learn how to evaluate your investment professional.  This person is your weeder of over grown jargon and light shiner on investment obscurities.  Your decision of who to trust with your hard earned and preserved money is one of the most important decisions you will ever make.  It pays to invest as much time in this decision as in choosing curtains for the den.

Importance grade: 10; nuff said.

Jason