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Ready comparisons

  
I attended the Securities and Exchange Commission (SEC) open meeting for adoption  of the Final Rules for credit rating agencies in Washington yesterday … these are the rules which regulate Standard & Poors (MHP) , Moody’s (MCO) and Fitch.

I’ve been writing comments to the SEC on this issue since 2003 and it’s amazing to see how far the Commission has come in its approach and authority over raters.

I’ve watched as an extremely powerful component of the financial markets was reigned in and stripped of their unbridled dominance and influence.

What an astounding journey.

Maybe others have watched as the government has developed oversight for private firms which operate in specific markets… actually you can watch this process now as various regulatory entities, including the SEC and the Federal Reserve Bank of New York, regulate the credit default swap clearing and trading platform space…

The credit markets will never be the same…

The dominant raters now have the forces of transparency and competition battering at their oligopoly…

Those twin forces of the Credit Rating Agency Reform Act of 2006, transparency and competition, have begun to substantially re-form how information moves around this market.

The reallocating and expanding of issuer and rating information is the “magic key” to getting on a path of higher quality and more timely ratings… and I know it was a rat’s nest to untangle… high praise must be given to the SEC for their hard work… and that work is not over… but the framework is in place that should serve the industry for a very long period.

The general framework leverages market forces and specifically focuses on disclosures and having the raters provide enough data for market participants, academics and compeitiors to make “ready comparisons” between firms and the accuracy of their ratings.

The usefulness of credit ratings is twofold… first ratings allow a credit rating agency to express an opinion on the relative creditworthiness of a security and two to provide some quantitative measure of the default probability of the the security.

These two pieces of information play pivotal roles in the pricing of cash fixed income.

Specific amendments for the rules adopted yesterday include more detailed reporting of transition and default statistics, disclosure by the raters of how much verification of the quality of underlying assets has been done for structured finance products and what methods of  survelliance the firms are using as fixed income products age through a credit cycle.

What is brilliant about the new framework is that ratings must be classified into asset classes. These five classes are generalized buckets of securities and cover financial firms and broker/dealers, insurance firms, asset backed securities, corporate securities and sovereign/municipals.

Since the characteristics of each of these market segments differs reporting default probability for each class will make this information very powerful.

For example, most corporate issuers have comparable capital structures and don’t utilize leverage so comparing these firms on a relative basis is useful. Similarly, many financial firms and broker dealers have employed highly geared capital structures and should be compared to other firms with similar leverage.

So under the new rules Moody’s, for example, will be required to make their ratings for financial firms and broker dealers available to analyze as an interactive data set. This will give everyone in the markets a chance to assess ratings accuracy. Imagine the potential of mashing up ratings with cash bond prices, CDS, equity, options and futures prices… actually the potenial forms analysis are very broad. This will open a significant window into the workings of the credit markets. 

One could argue that these default statistics might become as useful in determining the market’s perception of risk as credit default swaps. They certainly will be a powerful supplement to various forms of market data.

My own belief is that the adoption of the first round of credit rating agency rules in 2007 was one of the precipitates of the Credit Crisis of 2007/2008. I believe that the raters got a taste of the power of the SEC to utilize the “books and records” authority and the disclosure components of the 2007 rules and decided they should start cleaning up their act… the whip of enforcement and the heat of disclosure hung over the raters heads… there was new authority.. and in late July 2007 a massive number of downgrades of structured finance products began and the process has only accelerated since that time… the global financial meltdown… 

The findings of the SEC’s 2008 inspection report made it clear, in hindsight, that ratings processes were often not as rigorous as they could be… in fact several Commissioners today identified the poor functioning of raters as a central cause of the Credit Crisis… there is general agreement on the broad need to reign in these firms.

Congress will take up this issue next year and many voices have joined the reformation chorus… the new rules adopted at the SEC go along way in truing up the role of raters in the credit markets. We should have smoother sailing ahead.

SEC Chairman Cox comments on the new rules (Bloomberg video running time 9:30) >>>

Former SEC Chairman Harvey Pitt comments on the new rules (Bloomberg video running time 4:30) >>>

Former SEC Chairman Levitt comments on the new rules (Bloomberg video running time 4:00) >>>

Bloomberg reporting 

WSJ reporting

CFO.com reporting

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