Tag: Rating agencies

The SEC and Rating Agencies

The SEC examined all 10 firms registered Nationally Recognized Statistical Rating Organization (.pdf 23 pages) and found all 10 had “apparent failures”. The SEC has requested remediation plans from each of the agencies within 30 days and is continuing its investigation.

The issues found included “apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest.”

Personally, I think the rating agencies have not gotten enough of the blame for their roles in the events leading up to the 2008 financial crisis. Without the golden top rating they issued to the toxic mortgage-backed securities,  I think the popping of the housing bubble would not have been so vicious.

In 2006, the Credit Rating Agency Reform Act granted the authority to establish a registration and oversight program for credit rating agencies to the SEC and gave them oversight over those credit rating agencies that register with the Commission as Nationally Recognized Statistical Rating Organizations (“NRSROs”). However, it expressly prohibits the SEC from regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.

The Dodd-Frank Wall Street Reform and Consumer Protection Act enhanced the regulation and oversight by imposing new reporting, disclosure, and examination requirements. The new law also requires the SEC to conduct an examination of each NRSRO at least annually.  The 2011 Summary Report of t Commission’s Staff Examinations of Each Nationally Recognized Statistical Rating Organization (.pdf 23 pages) is the first to look at the ten under the new framework.

  1. A.M. Best Company, Inc.
  2. DBRS Inc.
  3. Egan-Jones Rating Company
  4. Fitch, Inc.
  5. Japan Credit Rating Agency, Ltd.
  6. Kroll Bond Rating Agency
  7. Moody’s Investors Service, Inc.
  8. Morningstar Credit Ratings, LLC
  9. Rating and Investment Information, Inc.
  10. Standard & Poor’s Ratings Services

The SEC did not determine that any finding discussed in this Report constitutes a “material regulatory deficiency”. That would have meant a referral to the Division of Enforcement and gotten more lawyers involved. The SEC does not single out by name any credit-rating agency for questionable actions in the report, but it does describe specific problems it found.

It will be interesting to see what happens next year. As most compliance people know, the failure to fix a problem pointed out by the SEC is likely to lead to trouble the next time they show up.

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Nationally Recognized Statistical Rating Organization (.pdf 23 pages)

Credit Rating Agencies and Conflicts of Interest

Personally, I place a big chunk of blame on the Credit Rating Agencies for the Great Panic of 2008. They were throwing AAA ratings at piles of garbage. There is an inherent conflict in the rater being paid by the security issuer instead of the security purchaser. They are beholden to the customer and the customer wants a great rating for its security.

Exchange Act Rule 17g-5(c)(1) prohibits a Nationally Recognized Statistical Rating Agency from issuing or maintaining a credit rating solicited by a person that, in the most recently ended fiscal year, provided the NRSRO with net revenue equaling or exceeding 10 percent of the total net revenue of the NRSRO for the fiscal year.

“The Commission’s rules were designed to further the goals of the Rating Agency Act to “improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry.” To meet these goals, it is critical that firms provide accurate information to the Commission and the public in their Form NRSROs and financial reports, that they do not have prohibited conflicts, and that they establish, maintain, and enforce policies and procedures to address conflicts of interest.”

LACE Financial submitted an application to register as an NRSRO on October 31, 2007. LACE also requested an exemption from the 10 percent rule, which the SEC granted. LACE requested the exemption because LACE’s largest client (“Firm A”) provided LACE with more than ten percent of LACE’s total revenue during fiscal year 2007. Firm A managed Collateralized Debt Obligation (“CDO”) and hired LACE to prepare regular reports that Firm A distributed to investors in these CDOs.

According to the SEC Release, in an attempt to keep the 2007 revenue from Firm A as close as possible to ten percent of its total revenues for the year, LACE postponed billing Firm A for reports completed during December 2007 until January 2008. In its exemption request letter, LACE stated that its estimated annual revenues from Firm A for 2007 would be $119,000 when calculated on a cash basis and $179,000 when calculated on an accrual basis. “The total value of work performed for Firm A by LACE during 2007 was in fact $233,268.28, approximately 28 percent of LACE’s revenues for the year when properly calculated on an accrual basis as required by GAAP.”

LACE got slapped with a civil money penalty in the amount of $20,000 and an injunction not to break the law again. They also charged Damyon Mouzon, the president of LACE, blaming him for trying to shift revenue and deliberately hide the conflict of interest.

It seems clear to me that the rating agencies were not trying to protect investors. They were trying to generate revenue. That means keeping their clients, the securities issuers happy.

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What About the Rating Agencies?

There has been lots of criticism aimed at Goldman Sachs over the Abacus 2007-AC1 deal. They help set up a CDO so their client, Paulson & Company, could make a bet on a downturn in the residential real estate market. To make that bet, they allowed Paulson to influence the securities that went into the CDO. Most of them turned out to be dreck and the CDO ended up tanking. Paulson made money from his short position and the investors in the CDO lost more than $1 billion.

Who Was the Client?

Paulson & Company hired Goldman Sachs and paid them $15 million for the structuring of the Ababcus 2001-AC1 CDO. So they were clearly a client.

The purchasers of the CDO were clients of Goldman Sachs. Since they were purchasing securities from Goldman Sachs as a broker-dealer, they were not owed a fiduciary duty by Goldman Sachs. That is one of the current differences between the law governing investment advisers and broker-dealers. Goldman made a statement in the materials that they do not have a fiduciary obligation to the investors.

Goldman Sachs had a split loyalty that is common with Wall Street transactions.

Disclosure

In selling securities you are required to disclose all material information and risks in a prospectus for the security and deliver that prospectus to purchasers.

Goldman claims that its Abacus investors had all the information needed to evaluate risks for themselves in the prospectus.

The SEC is claiming that Goldman should have disclosed that Paulson influenced the selection of securities placed in the CDO and that they were engaged by Paulson to build the CDO so Paulson could take a short position against it.

Illegal or Unethical?

Obviously, the SEC is taking the position that Goldman acted illegally. Personally, I’m not sure it was illegal. If it turns out that they said Paulson was long on the CDO, when he was actually short, then they are in trouble.

Lots of people are arguing that they acted unethically. That is a stronger argument. Goldman may not have been required to disclose Paulson’s role in the transaction, but they probable should have disclosed it.

I prefer to use the very technical term “yechy.” Goldman looks very bad. As a company, they seek to have a better reputation than this.

They should not have structured the transaction this way. They should settle this case, chalk it up as a mistake and act better. (I own some stock in Goldman Sachs that I bought when the price dropped because of these accusations.)

What about the Rating Agencies?

Even with all the dreck in this CDO, the rating agencies still gave a AAA rating to the $480 million Class A, AA to the $60 million Class B, AA- to the $100 million Class C, and A to the $60 million Class D.

Clearly one of the factors in the sub-prime market was the failure of the rating agencies. They were giving AAA ratings to collections of dreck.

S&P defines the AAA rating for structured finance as “judged to be of the highest quality, with minimal credit risk.”

Maybe this chart is better explanation of the ratings:

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Rating Agencies and the First Amendment

s-and-P

Rating agencies have long argued that their ratings of securities are constitutionally protected opinions. Many people have pinned some of the responsibility for the financial markets meltdown on the rating agencies. It sure looks like they gave a fair number of these securities a high rating when they were actually toxic.

Abu Dhabi Commercial Bank and King County, Washington decided to bring a class action because of their losses in a structured investment vehicle. They included the arranger, placement agent, the rating agencies, the administrator and others involved in the structuring of the securities issued by the structured investment vehicle. The plaintiffs included a full slate of claims against these parties.

The first decision in the law suit was a ruling on a motion to dismiss that was issued last week. U.S. District Judge Shira Scheindlin ruled in this opinion that the investors in the structured investment vehicle containing mortgage-backed securities sufficiently alleged an actionable misstatement against the credit rating agencies and the investment bank that placed the rated notes.

Under typical circumstances, the First Amendment protects ratings agencies, unless there was actual malice. (See Compuware Corp. v. Moody’s Inv. Servs., Inc.., 499 F.3d 520 (6th Cir. 2007) [pdf.]) But are the ratings of securities that were distributed to a limited number of investors deserving of the same free-speech protection as more general ratings of corporate bonds that were widely disseminated? Judge Scheindlin said no and rejected the rating agencies’ First Amendment argument.

Judge Scheindlin also rejected the argument that the ratings are merely non-actionable opinions. “[A]n opinion may still be actionable if the speaker does not genuinely and reasonable believe it or if it is without basis in fact.”  Judge Scheindlin also found that the disclaimers in the offering materials are insufficient to protect the rating agencies from liability for promulgating misleading ratings.

This decision is only an early step in the litigation and has not imposed liability on the rating agencies. The plaintiffs will still need to prove the facts that they alleged in the initial pleadings.

But the ruling does open a door that was previously thought closed. The stock prices of McGraw-Hill, which owns Standard & Poor’s, fell 10%, and Moody’s Corp., parent of Moody’s Investors Service, fell 7.1% in New York Stock Exchange composite trading on Thursday.

Other plaintiffs are likely to use this decision to persuade other judges to open rating agencies up to potential liability. I’m sure that plaintiffs’ lawyers involved in subprime lawsuits are amending their complaints this morning.

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Credit Rating Agency Reform

sec-seal

Last week the Securities and Exchange Commission held a roundtable on the credit agencies to consider a range of ideas to get tougher on them. Securities and Exchange Commission Chairman Mary Schapiro lead the discussion and pointed out that “rating agency performance in the area of mortgage-backed securities backed by residential subprime loans, and the collateralized debt obligations linked to such securities has shaken investor confidence to its core.” The SEC has exclusive authority over rating agency registration and qualifications as a result of the Credit Rating Agency Reform Act of 2006.

There seems to be a conflict of interest when the fee for the rating agency is paid by the issuer of the debt instead of the investor who is relying on the rating. This issued-paid model accounts for 98% of the ratings.

The rating agencies are are faced with lots of litigation over their  ratings of mortgage-back securities. One of their defense tactics is that their ratings are “opinions” and are protected by the First Amendment. That would probably mean having to prove actual malice and not just making a false statement. If the ratings are found to be more of a private commercial transaction then it is less likely that the First Amendment would apply.

One thing that has struck me as odd about the ratings is that they give the same designation to company debt as they do to structured products. It seems to me that there is a big difference between (1) the bonds issued by GE, payable from GE’s revenues and (2) the bonds issued out of a fixed pool of assets like Mortgage-Back Securities.

There are only a few dozen companies that have AAA ratings on their debt. These companies are actively managed looking for the long term success of the company. There are many variables, making the rating process more complicated.

On the other hand, the structured finance products are not actively managed. You have a bunch of income coming in and you structure that income flow into tranches. The default rate is governed by the quality of the assets and the larger economy’s effect on the cash flow from those assets. The rating process is complicated in a different way because you need to look at the variables that may affect the performance and how they may be correlated. I wrote before on how the rating agencies got this wrong: The Risk Management Formula That Killed Wall Street.

Maybe its time to break the ratings into separate categories so that investors will not be mistaken into thinking that a AAA rated mortgaged back security has less chance of a default than ExxonMobil.

What do you think?

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