Who's Afraid of the CRAs?

 | Oct 15, 2012 | 3:00 PM EDT
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SEC staff have reportedly finally completed a study on the Franken amendment's notion of creating a board to assign the ratings function on structured finance offerings, having sent it on to the commissioners.

That measure -- venting anger at the rating agencies and designed to potentially disrupt their issuer pays business model -- was one of the most iconic symbols of the populist fever that spread on the Senate floor as the Dodd-Frank Act was legislated 28 months ago. 

Meanwhile, in a parallel universe, investors have bid up the shares of industry leaders Standard & Poor's, owned by McGraw-Hill (MHP), by 98% and Moody's (MCO) by 136% since they bottomed in June 2010. And developments suggest that regulatory risks are also subsiding in Europe. This could return investor focus to potential for CRAs as the Continent moves toward more bond financing.

All of which raises a question. With the CRAs still having a "growthier" feel than also-recovering banks and financial services companies -- and the Volcker rule and other new reforms still emerging -- might MCO and MHP  represent the purest near-term plays on Dodd-Frank implementation, regardless of who wins on Nov. 6? I'd say it's a decent bet.

I've  long been on the sanguine side of the risk story facing credit rating agencies. To be sure, the industry is widely seen as complicit in the securitization orgy and housing bubble at the heart of the financial crisis. It also has few friends in Congress Moody's and S&P are only "red" by virtue of Republicans' stated interest in repealing the broader Dodd Frank Act and their general pushback against the trial bar.

To clarify, I DO NOT expect Dodd-Frank repeal, nor any serious effort to strike the Franken amendment, which, after all, was converted into a study, rather than a mandate. Most of the GOP focus in the event of a Republican White House or Senate will be on changing the corporate governance model, annual funding process and scrutiny regarding the Consumer Financial Protection Bureau (CFPB). But any serious movement toward a DFA reform bill of any scope could further reverse the populist fever that gave rise to the Franken amendment's Senate floor passage. This could give the SEC ample cover to slow walk or down scope any notionally disruptive CRA reforms where it can't find consensus.

A DFA-related bill could also provide a vehicle to repeal the Act's language removing the industry's previous Securities and Exchange Act (Section) 436(g) exemption from "prospectus" or "professional" liability. Since ratings are characterized as opinions, the industry was given the exemption several decades ago as an incentive to allow the ratings to become attached to debt prospectuses. Repealed when the then-Democratic Congress, at the Obama White House's urging, adopted a kitchen-sink assortment of proposals from both chambers, the exemption has been reestablished, on a de facto basis, as a result of the SEC's issuance of a no action letter in response to a plea from Ford Credit, literally within days of DFA's July 21, 2010 signing. Still, commissioners have expressed unhappiness with being forced to play that role, and have urged Congress to restore the previous exemption language in federal law.

When the financial crisis hit, the ratings industry was fortunate to be able to point to the wide authorities freshly granted the SEC by the Credit Rating Agency Reform Act of 2006. In enduring passage of a bill largely focused on reducing barriers to entry, creating more competition and removing conflicts of interest, the CRAs avoided 2009-10 consideration of what would surely have been a far more prescriptive and intrusive set of reforms.

Nevertheless, Congress, to some extent, took up where the 2006 Act left off. Besides repealing the 436(g) professional liability exemption and tasking the SEC to conduct the two-year study compelled by Franken, lawmakers enacted language forcing bank regulators to help remove "embedded references" to NRSROs in federal laws and also creating a tougher legal liability standard.

Finally, Dodd-Frank compelled the SEC to establish a new Office of Credit Ratings and mandated a host of studies by the SEC, Government Accountability Office (GAO) and others, including a study of alternatives to the industry's prevailing "issuer pays" business model.

Fortunately, the new liability standard will apply only prospectively. So, it's not clear whether it will create much new legal exposure for the industry, particularly as the agencies are now operating under more scrutiny, adjusting to new rules and largely refraining from issuing opinions in the moribund structured finance space.

Meanwhile, even though the SEC has held public conferences and widely-solicited opinion about the prospect of forcing or engendering a shift away from "issuer pays", no alternative has seemed to gain traction. 

Perhaps most importantly, bank regulators, after a slow start, seem to be progressing toward adoption of boilerplate language that financial institutions can substitute for past "embedded references" providing a legal defense for those who could point to having secured two high-quality NRSRO ratings.

And fortunately for the ratings industry, the new language will allow for NRSRO ratings as one of a number of methods to attest to a security's credit worthiness, but not make them a safe harbor in and of themselves. This should allow for ratings to remain preeminent in this regard.

Though it's not clear how the SEC might handle the Franken amendment, a leading candidate has seemed to be the  Rule 17g5 approach, which would even further compel public sharing of data in order to encourage unsolicited ratings.  This notion has been seen as an effective tool, in that agencies might be exposed or humiliated if their work or conclusion was to be publicy contested by a would-be competitor.

As for Europe, with a growing percentage of the agencies' business coming from the continent, perhaps the bigger questions for CRA investors have concerned the reforms being considered by the EU.

The Europeans are following a similar path to that considered in the U.S., but on a delayed timeline. So far, they also appear to be backing away from hard-edged reforms. 

The EU is on a path to remove statutory references to ratings, for instance, although there are far fewer such mentions (which have only recently begun to proliferate as a result of Basel II). An early proposal to force a more regular review of sovereign ratings (at least once every six months, down from one per year) has been abandoned, as has the notion of mandatory reviews with a change in government. 

On the legal liability front, CRA officials have recently told shareholders they are concerned that the EU is moving toward adopting the very "gross negligence" legal standard that the U.S. considered but avoided in Dodd-Frank.   But sources point out that it would merely establish an EU-wide standard like the one that already exists in the majority of individual countries and they add that the European culture is much less litigious than that in the U.S., anyway. Meanwhile, also unlike in the States, neither a First Amendment defense, nor a stricter professional liability standard exists. For these reasons, the question of additional legal risk from Europe should be less worrisome from that in the U.S., although at least some marginal increase in litigation is probably likely.

Perhaps the most worrisome idea has been the notion of forcing issuers to rotate agencies every three years. In subsequent meetings, the EU Commission clarified that only one of any issuers' two ratings sources would have to be rotated, allowing them to maintain continuity with at least one firm. In addition, the rotation requirement will apply only to "structured finance products with underlying re-securitized assets," and small ratings firms will be exempt. Separately, also dropped along the way were contemplated provisions that could have been read as compelling European firms to use indigenous raters. 

The likely result of emerging changes is that CRAs may lose some pricing power, as their margins come in for closer scrutiny by ESMA. But prospects for growth in EU debt market financing should greatly outstrip any impact from new regulatory friction. Since corporate finance among EU nations has been 34% financed via the capital markets and two-thirds (66%) through bank lending, in contrast to 75% capital markets to 25% banks in the U.S., decreasing confidence in EU banks should continue to spur rapid growth (and for CRAs, opportunity) in the EU bond market.  

This long-term happy ending to the story could remain in prospect for years to come. But continued economic weakness could offset this opportunity and suppress CRA Euro opportunities in coming months.

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