The credit rating agencies that provided securities packaging subprime mortgages with investment grade ratings have been in the cross-hairs of regulators and plaintiffs since the mortgage meltdown first began in the spring and summer of 2007. Yet very little has been done to change the way that they are regulated.
So last week new SEC Chairwoman Mary Schapiro hosted a round table on what more should be done. Many see the fundamental problem with the current structure is that the rating agencies are generally paid by the issuer or underwriting of the security they are asked to rate. This "issuer-paid model" accounts for 98% of all bond ratings. There is an inherent conflict of interest in this model, where issuers will shop around for the highest rating.
Although the SEC has adopted some new regulations to address this conflict of interest problem (for example prohibiting any employee involved in rating a issue to also be involved in the fee negotiations), Ms. Schapiro acknowledged there was more to do. Many of the proposals at the meeting focused on solving this conflict of interest dilemma. Some participants suggested all firms should be required to switch to an investor based model, or have the rating fees paid out of a portion of the bonds' interest payments. Others went further, suggesting that a new regulatory body, similar to the Public Accounting Oversight Board (PCAOB), should oversee rating agencies.
Ms. Schapiro suggested that the structure the SEC set in place when it settled a 2003 enforcement action with ten of the largest investment banks could be applied to rating agencies as well. The settlement, which resolved claims that the investment banks provided slanted research in companies in which they had a financial interest, required the banks to distribute independent research along with the firm's own research in certain circumstances.
Legislators are apparently getting involved as well. According to a Wall Street Journal article (here), Senator Schumer is considering introducing a bill that would require rating agencies to separate any consulting business from the ratings business. Another Senator, Jack Reed, would outsource the regulation to the class-action bar. He supports passing legislation that would make it easier for investors to bring class action securities lawsuits against the rating agencies (rating agencies have traditionally had success asserting a first amendment privilege, claiming that, like a newspaper, they simply provide information to the public).
Putting the legislative proposals aside, I think that the PCAOB-like oversight structure may be worth pursuing, particularly if nothing is done about changing the issuer-paid model. Moreover, the issuer-paid model does seem to support capital formation by allowing the most bonds to get ratings, so we may not want to do away with it entirely.
Coverage of the roundtable is available here, here and here.
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Posted by: buy a business | July 06, 2009 at 09:19 AM