The WSJ reports this morning on changes to be announced Wednesday by the SEC “that may diminish the longstanding importance of credit ratings across various markets.”
Specifically, it seems, the SEC is intent on addressing the glaring shortfall at the heart of the current regulatory fudge: on the one hand, the agencies are subject to only the loosest of oversight regimes, while on the other, the ratings they assign are scripted in tablets of stone as the basic currency of Basel II.
The most significant portion of the rules, to be proposed Wednesday, would make it possible for U.S. money-market funds to invest in short-term debt without regard to ratings put on those securities by firms such as Moody’s Investors Service and Standard & Poor’s, people familiar with the matter said. Currently, SEC rules generally require that money-market funds purchase only short-term debt with high investment-grade ratings. The new rule would put more discretion in the hands of money managers to determine whether the debt is investment grade.
The gist of the proposal then is to rekindle decent due diligence practice among the debt markets’ biggest players.
Is this folly?
The situation the SEC wants to create is that which already exists in the rating agency literature: ratings purely as abstract “editorial” opinions, which investors shouldn’t — and don’t — use as anything other than flimsiest piece of preliminary sales advice. The rating agencies like this classification because it suits well their legal situation as “reporters” under the first amendment.
The reality, of course, is that this isn’t remotely the case, because if it was, there would be no call for rating agencies to be involved in structured finance in the first place. What use would ratings serve, if buyers wanted to spend days pouring over the seasoning, granularity and FICO data of a CDO?
Ratings are intrinsic to the structured finance world: they “give birth” to a structured finance bond, in the words of one market participant. They affect yield, and of course, capital risk weighting for banks.
Ratings serve a purpose and that purpose is to provide a buyer with a trusted, accurate and universal measure of default risk (albeit not a definitive one). Ratings are, to a degree, the outsourcing of due diligence.
The trick then, is in striking the right balance. Too much due diligence outsourcing, and you create a rating bubble; too little and the market becomes painfully inefficient. Righting that balance is what the SEC is trying to do, but further action is also needed.
Because no matter how much or how little ratings are relied on, they should always be accurate. The implication of the SEC’s solution - to rely on ratings less - seems to take rating inaccuracy as inevitable.
Incentivising the agencies to more directly benefit from accuracy and suffer the consequences of inaccuracy - instead of arming them with a shield - might be a starting place.
There’s the Sean Egan solution - make the issuers pay. There’s the legal option - drop the first amendment protection. And there’s the government regulatory way - stricter controls, enforcement options and transparency. As yet, all three options have been avoided.
Related links
EU Commissioner: time to end the “rot” at the heart of the rating agencies - FT Alphaville
