Here's the final set of Challenges in this series:
NYT's Thomas Friedman said there are two superpowers in the world - the US, with its destructive weaponry, and Moody's, with its destructive downgrades - and it's not clear who's more powerful!
The tremendous global clout of Wall St. Toll Collectors is a double edged sword. It gives them enormous pricing power and profitability protected by a very wide and deep moat. Unfortunately, it also routinely attracts regulatory and political attention like bees to honey. With elections ahead, those bees are going to be very busy.
The President's Working Group on Financial Markets (Treasury, Fed, SEC and Commodity Futures Trading Commission), in addition to a House of Representatives panel, is looking into CRAs' subprime roles and conflicts of interest. The EU's CESR watchdog has just been tasked to sniff out any funny business in subprime ratings. Various lobbies and Congressional committees will of course contribute their share of noise to the sound-bite buzz. All this on the heels of several years of US and EU regulatory reviews culminating in the CESR report and the passage of the CRARA which hasn't even been fully implemented as yet!
The Committee of European Securities Regulators (CESR) issued a Dec 06 report on MCO, S&P, Fitch & DBRS assessing their compliance with the International Organization of Securities Commissions (IOSCO) code:
- CRAs' own Codes of Conduct comply to a large extent with the IOSCO Code
- Common non-compliance items were (1) CRAs don't think their "rating assessment services" are IOSCO-defined 'ancillary services' which need to be operationally and legally segregated from the ratings service (2) Due to differences in interpretation of what constitutes an 'unsolicited rating' there are differences among CRAs in the extent of IOSCO-required disclosure on issuer participation, issuer solicitation, and unsolicited rating policies
CESR also invited comments from users of CRA services. 17 EU based financial associations / institutions responded saying:
- No need for further regulations
- Oligopoly driving high prices
- In general ratings based on accurate information - impossible to account for everything
- Ratings were not influenced by pressure from issuers or other interested parties
In the subprime context, two significant concerns are issuer fees and late changes in ratings.
MCO gets almost all of its revenue from issuer fees. So, presumably, does S&P's Ratings Services. For standard corporate debt issuance, the fees are ~4basis points, i.e. $400K for a $1B issue. These also generate annual or upfront fixed monitoring fees. Structured Finance fees are several multiples higher based on issue value, asset class, complexity, etc. MCO says its issuer fees for appraisal and rating services range from $1.5K to $2.4MM.
- The Association of British Insurers commented to the CESR in 2006 that some CRAs tend to notch down competitors' CDO component ratings to encourage issuers to pay for their 'shadow ratings' of the components and get better overall ratings
- In 2003, SEC Chairman Donaldson wrote to the Subcommittee on Capital Markets: "While most agree that the issuer-fee model creates the potential for a conflict of interest, many believe the rating agencies historically have demonstrated an ability to effectively manage that potential conflict.... The fees received from individual issuers tend to be a very small percentage of a rating agency's total revenues, so that arguably no single issuer has material economic influence over a rating agency."
In its CSER submission, MCO wrote, tersely: "The key conflict across our rating groups remains the "Issuer Pays" model and the need to maintain our independence and objectivity and the quality of our analysis."
S&P, however, vigorously defended Issuer Fees in its CSER submission:
- It enables free, real time publishing of ratings for anybody to review and criticize
- It enables ongoing surveillance (i.e., continued monitoring of rated issuers after the publication of a rating).
- The subscriber-pays model (e.g. Egan Jones) typically allows only subscribers to have access to the ratings, preventing open review by all interested parties.
- In a December 2003 study, two Federal Reserve Board economists concluded that CRAs consider their reputations in the marketplace to be of "paramount importance" and, in fact, are "motivated primarily by reputation-related incentives."
LATE CHANGES IN RATINGS
Toll Collectors are routinely criticized for being slow to downgrade their Institutional and Structured Finance ratings. In contrast, Egan Jones claims to be faster on the trigger because it dropped Enron below investment grade a month before it collapsed, and rated WorldCom debt as junk for almost a year before it went bankrupt. (Moody's downgraded Enron only after its surprise disclosure of billions in off-balance sheet liabilities in Oct 01, resulting in its bankruptcy filing in Dec '01)
However, investors aren't too thrilled when ratings change frequently - akin to a doctor changing his diagnosis with every new development. It creates additional volatility - not quite what the doctor recommends for stress-free investing. The relative stability (read conservatism) of Toll Collector ratings is thus one of their advantages over (arguably) more trigger-happy competitors.
As NYT's Friedman wrote : "Moody's is the credit rating agency that signals the electronic herd of global investors where to plunk down their money, by telling them which countries' bonds are blue-chip and which are junk." This global make-or-break power of Wall St. Toll Collectors has to be exercised with great care and deliberation because, used positively, it can drive market reform.
Used negatively, it can drive markets into the ground.
Given the current financial mess and shifting political winds, some regulatory action is inevitable. So far, both EU (Basel II, IOSCO) and US (CRARA) have opted for better voluntary controls, which are always good for both industry and its key stakeholders in encouraging mature behavior. Hopefully the sound-bite artists will quickly figure out how much market power their Toll Collectors confer on a US increasingly challenged to maintain its global economic clout.
As Friedman put it - "Don't mess with Moody's"!
Here's the final set of Challenges in this series: