Pull A Madoff — in that the Commission will miss the shenanigans that are right underneath their noses, just as they did with Bernie years ago.
Yesterday the SEC announced a set of regulations that would curb some of the abuses of the rating agencies (Moody’s Corp. (MCO), Standard & Poor’s, a McGraw-Hill Cos. (MHP) subsidiary, and Fitch Ratings).
First, let’s talk about the basic problem. The issuer of debt pays for the rating. It’s a naked conflict of interest. Here’s an oversimplified example. Bank of America has a bunch of sub-prime mortgages it securitizes in a bond offering it wants to offer for sale to pension funds, university endowments, charitable trusts and the like. They need an Aaa rating or something close to it; it is called investment grade, since many institutions cannot invest in anything lower.
They go to Moody’s where they’ve had some luck before (wink, nod). Moody’s, being a bit “moody” after all the bad publicity post-2008 disaster, says: “You know BofA there is a lot of risk in these underlying bonds (“really”). Sorry, best we can do is Ba1.”
Bank of America, undaunted, and knowing how to play the game, comes back with: “Come on guys, how ‘bout if we sweeten the deal a little and increase your fee… and we’ll throw in some Legend Seats at Yankee stadium.”
“Against the Red Sox?”
“Fine, against the Red Sox.”
“You know those bonds are looking more Aaa every day,” says the Moody analyst, as he pulls his favorite Red Sox cap off the shelf. It’s a conflict of interest at its simplest. And guess what, if a BofA bondholder wants to sue the rating agencies after the bonds default, good luck. The rating agencies have a “get out of jail card” at the ready. “We were merely exercising our First Amendment right to render an opinion.” Wins every time in court.
Second major problem: the Revolving Door. That same Moody’s analyst who loves the Red Sox and will see them up close on BofA’s dime has already sent her resume to Bank of America and hopes to enjoy a 100% salary increase when she takes a job as a newly minted Vice President in the debt securities division.
Dodd-Frank provides the SEC with new authority to fix these conflicts. What is the Commission doing? A little window-dressing is all, nothing more. For instance, the SEC has suggested rules that would have rating agencies clearly define and disclose the meaning of any symbols used by the rating agency. The proposed rules attempt to directly address conflict of interest issues, but half of the section is devoted to exemptions and exceptions. It is also seeking to set up qualification standards for credit analysts, to make sure they meet new training and experience standards. Ho hum. And indeed, the rating agencies are fighting even these minor reforms.
What the SEC must put on the front burner instead is the organization of a government-mandated clearinghouse intermediary through which credit raters would be assigned blindly to work on various bond offerings. (No more Legend Seats.) This intermediary was called for in Dodd-Frank and is being pushed for by Senator Franken. Alas, in the way of Washington, the SEC will study the issue and issue a report, next—yes next—summer.
I can see the headlines a year in advance: SEC Misses Trillion Dollar Losses Caused by Continued Rating Agency Conflicts.