On Thu, 30 Nov 2023 18:43:05 -0800 (PST), Bok Miklas
<bokmiklas36@gmail.com> wrote:

>Today, the Commission considers adopting long-awaited reforms to the rules governing nationally recognized statistical rating organizations, or, as they are more commonly known, rating agencies.[1] I support these rules and amendments, and commend the staff for their hard work in developing and refining them. Additionally, I would like to call attention to the efforts of the Division of Trading and Markets, the Division of Economic and Risk Analysis, the Office of Credit Ratings, and the Office of General Counsel. I appreciate your hard work and diligence.
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>These accounts lay bare a bleak reality: that instead of acting as gatekeepers and protecting investors, as they were supposed to do, the rating agencies allowed issuers of structured products to prey on investors.[17] That the rating agencies were able to debase their ratings in this way represents a failure on many levels. Internal control structures that were inadequate and easily overridden were certainly one aspect of the problem. A lack of transparency into the ratings process was another.
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>First, the final rule regarding internal controls prescribes a set of factors that rating agencies must consider when establishing, maintaining, enforcing, and documenting their internal controls structures.[20] By requiring rating agencies to consider these factors, the Commission has established a solid foundation upon which rating agencies can build truly robust internal control systems. This approach has the added virtue of giving each agency the flexibility to tailor its internal control structure to meet its specific risks.
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>Second, the Commission should consider prescribing the policies and procedures that would govern the look-back reviews required by Dodd-Frank.[26] The rating agencies currently have discretion to develop these procedures themselves, and this may have led to predictable results. As far as my office has been able to determine, in 2013, rating agencies conducted a number of look-back reviews prompted by employees going to work for issuers.[27] Nonetheless, my office was unable to identify any rating that was revised because of such a conflict. This suggests that many of these reviews are not as robust as they need to be, and I urge the Commission to consider whether any action is necessary.
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>Given how poorly the credit rating agencies performed, one might expect the financial crisis to have vastly reshaped the industry. But this is not so. The three largest rating agencies remain dominant, controlling 95% of the global ratings market.[28] And, profits at two of these rating agencies are at or near record highs.[29] You can also expect that, as the market for structured products stirs back to life, as it appears to be doing,[30] rating agencies will once again play a significant role in that market. Hopefully, the rules and amendments being adopted today will keep the rating agencies from once again succumbing to the temptation to sacrifice the quality of their ratings just to get hired.
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>In the run-up to the financial crisis of 2007-2008, market participants relied heavily on the ratings that credit rating agencies assigned to financial instruments, including mortgage-backed securities, to determine creditworthy investment options. As mortgage holders began to default on their loans and many highly rated securities lost value, the poor quality of these ratings became apparent. Policy makers pondering financial regulatory changes to avoid future catastrophes should understand how regulatory actions facilitated a noncompetitive credit rating industry and propelled its members into the center of the bond information process, which in turn contributed to the financial crisis of 2007-2008.
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>A credit rating agency is a potential source of information for market participants who are trying to ascertain the creditworthiness of borrowers. Essentially, rating agencies offer judgments (they prefer the word "opinions"1) about the quality of bonds issued by corporations, governments (including U.S. state and local governments, as well as "sovereign" issuers abroad), and mortgage securitizers. These judgments come in the form of letter grades. The best-known scale is that used by Standard & Poor's (S&P) and some other rating agencies: AAA, AA, A, BBB, BB, etc., with pluses and minuses as well.2
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>This relationship between the rating agencies and the U.S. bond markets changed in 1936 when the Office of the Comptroller of the Currency prohibited banks from investing in "speculative investment securities," as determined by "recognized rating manuals" (i.e., Moody's, Poor's, Standard, and Fitch). "Speculative" securities were bonds that were below "investment grade,"6 thereby forcing banks that invested in bonds to hold only those bonds that were rated highly (e.g., BBB or better on the S&P scale) by these four agencies. In effect, regulators had endowed third-party safety judgments with the force of law.
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>In the following decades, insurance regulators and then pension fund regulators followed with similar regulatory actions that forced their regulated financial institutions to heed the judgments of a handful of credit rating agencies.
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>In 1975, the Securities and Exchange Commission (SEC) issued new rules that crystallized the centrality of the rating agencies. To make capital requirements sensitive to the riskiness of broker-dealers' bond portfolios, the SEC decided to use the ratings on those bonds as the indicators of risk.
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>To solve this problem, the SEC designated Moody's, S&P, and Fitch as "Nationally Recognized Statistical Rating Organizations" (NRSROs).7 In effect, the SEC endorsed the ratings of NRSROs for the determination of the broker-dealers' capital requirements. Other financial regulators soon followed suit and deemed the SEC-identified NRSROs as the relevant sources of the ratings required for evaluations of the bond portfolios of their regulated financial institutions.
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>Also importantly, in place of the "investor pays" model established by John Moody in 1909, the agencies converted to an "issuer pays" model during the early 1970s whereby the entity that is issuing the bonds also pays the rating firm to rate the bonds. This change opened the door to potential conflicts of interest: A rating agency might shade its rating upward so as to keep the issuer happy and forestall the issuer's taking its business to a different rating agency.
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>In the bond-information market, experience, brand-name reputation, and economies of scale are important features. The industry was never going to be a commodity business of thousands (or even hundreds) of small-scale producers. Nevertheless, regulators' actions surely contributed heavily to the dominance of the three major rating agencies. The SEC's belated efforts to allow wider entry into the NRSRO category during the current decade were too little and too late.9 The entrants could not quickly overcome the advantages of the "big three's" incumbency.
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>To a large extent, subprime lending fueled the U.S. housing boom that began in the late 1990s and ran through mid-2006.10 The securitization of the subprime mortgage loans, in collateralized debt obligations (CDOs) and other mortgage-related securities, encouraged subprime lending and led to the development of other financing structures, such as "structured investment vehicles" (SIVs), whereby a financial institution might sponsor the creation of an entity that bought tranches of the CDOs and financed its purchase by issuing short-term "asset-backed" commercial paper (ABCP). If rating agencies rated the CDO tranches in an SIV favorably, that favorable rating concomitantly meant high ABCP ratings (interest-rate risk and liquidity risk were apparently ignored in the ratings). Hence, the agencies' favorable ratings of mortgage-related securities were crucial for the securitization process.
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>Meanwhile, the profits from gaining higher ratings on a larger percentage of tranches also motivated securitizers. These higher-rated tranches carried lower interest rates, which issuing firms would have to pay to the investors in those tranches, leaving a greater spread for the securitizers. Consequently, securitizers would be prepared to pressure the rating agencies, including threats to choose a different agency, to deliver those favorable ratings.
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>There is another, better route: Suppose that instead of granting credit rating agencies' judgments the force of law, regulators placed the burden of a safe bond portfolio directly on their financial institutions, but permitted them to make their own choices (subject to regulatory oversight) as to where and how they gained the information that would guide those safety judgments. Under this alternative policy route, banks (and insurance companies, etc.) would have a far wider selection as to where and from whom they could seek information and advice as to the safety of the bonds in their portfolios.
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>In this scenario, some institutions might choose to do the necessary research on bonds themselves or rely primarily on the information yielded by the credit default swap market. Others might turn to outside advisors that they consider reliable based on the advisors' track records, business models (including the possibilities of conflicts of interest), other activities that might pose conflicts, and anything else that the institutions considered relevant. Though they may still turn to credit rating agencies, institutions will also be able to seek the advice of investment banks, industry analysts, and upstart advisory firms that are currently unknown.
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>With this competitive approach, the bond-information market will open up to new ideas about ratings business models, methodologies, and technologies, as well as new entrants, in ways that have not actually been possible since the 1930s. The answer to whether the "issuer pays" business model could survive under this alternative policy scenario rests on whether bond buyers can ascertain which advisors provide reliable advice. If they can (which seems reasonable, since the major transactors in the bond markets are financial institutions), then they would be willing to pay higher prices (and thus accept lower interest yields) on the bonds of any given underlying quality that is rated by these reliable advisors. The competitive process would determine the outcome of the "issuer pays" business model.
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