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Extend Regulation Fair Disclosure to the fixed income markets

US and global bond markets have been in deep distress. The reverberations have been manifested in the worldwide banking system. Substantial public and private capital has been injected into the banking system to stabilize the largest banks and other financial institutions. Lawmakers have been examining issues in the banking and finance areas. The flow of credit has been reestablished at a reduced level.

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In September Lehman Brothers, although rated investment grade, was denied support at the Federal Reserve and filed for bankruptcy.  Credit markets froze, with more severity than the previous March at the time of Bear Stearns collapse, because firms abandoned lending to their counterparties. These counterparties had investment grade credit ratings. The investment grade ratings were paid for by issuers. But institutions and investors no longer trusted their counterparties or their ‘paid-for’ ratings. The credit default swap market (CDS) was signalling massive instability for issuers.

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Lehman’s bankruptcy substantially destabilized the financial system. Investors had relied on the implicit backstop of the central bank and federal government for “too big to fail” institutions. Because of Lehman’s failure investors questioned the solvency of all counterparties and were unwilling to commit capital even in overnight funding markets (repo). Institutions withdrew substantial monies from money market funds. The US financial system endured a “run on the bank”. Congress agreed to a $700 billion infusion of capital for the banking system.

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Investors, after years of accepting the stability of their counterparties had no reliable means of verifying the solvency of those they lent to. Why the great uncertainty? Why not rely on credit ratings of their counterparties? Investors did not have credit ratings that were unconflicted and embodied full disclosure of the capital structure of the issuer. The current regulatory framework allows issuers, like Bear Stearns, Lehman Brothers and AIG, to selectively disclose material non-public information about themselves to credit raters of their choosing and pay the chosen raters. This privilege, related to the disclosure of material non-public information, comes from an exemption in Regulation Fair Disclosure for credit rating agencies. The SEC is addressing this shortcoming for structured finance products (ABS) in current rulemaking. But this corrupt privilege will continue for financial institutions, insurance firms, government issuers, and corporate issuers.

Financial institutions are some of the largest issuers of debt to fund their trading activities (this is what is embodied in “leverage”). There is an increasing tendency for the wide divergence between the paid for credit rating of the issuer and the CDS implied rating for the issuer. This is data from Moody’s (note the 10 notch differential for GE Capital Corporation):

Market Implied Ratings (as of 3/25/2009) General Electric Capital Corporation

Rating Gap
Moody’s Senior Unsecured or Equivalent Aa2
Moody’s Loan Rating Aa2
Bond-Implied Baa2 -6
Credit Default Swap-Implied Ba3 -10
Moody’s Default Predictor-Implied
Loan Credit Default Swap-Implied Ba2 -9

Market participants rely on the information implied by ratings to measure the risk, price, and trade fixed income securities. Hundreds of federal and state laws rely on the analysis of NRSROs to determine the suitability of securities for various investors, fiduciaries and institutions. The stability of the financial system is predicated on NRSROs providing accurate analysis and rating methodologies. Stability also requires transparency and a free flow of information.

Proposed Amendment to Regulation Fair Disclosure

The ability of issuers to selectively disclose material non-public information to NRSROs is a substantial regulatory gap. This gap reduces market transparency and stability. It was always puzzling why Federal statutes and regulations gave issuers the right to selectively disclose material non-public information to chosen NRSROs. This practice seems fundamentally unfair and potentially abusive on the part of the issuers.

It could be argued that the issuer’s right to selectively disclose material non-public information to favored NRSROs (who they pay) is one cause of the significant concentration of ratings from the dominant NRSROs  (Fitch, Standard & Poors and Moody’s). And the reason that investors abandoned the use of credit ratings when the financial system froze.

During the Internet boom the equity markets had their own form of selective disclosure and corrupt market practices. Prior to the adoption of Regulation Fair Disclosure (Reg FD) equity issuers would disclose material non-public information to favored equity analysts. Those analysts would impart this material non-public information to their favored clients (generally institutional clients) who would trade on this knowledge ahead of other market participants. This inequality of information flows to market participants was cured with the adoption of Reg FD for the equity markets.

Former SEC Chairman William Donaldson made the following remarks to the Subcommittee on Capital Markets, Insurance, and GSEs, House Committee on Financial Services, May 21, 2001 in reference to the adoption of Reg FD.

“Selective disclosure raises several concerns. The primary issue is the basic unfairness of providing a select few with a significant informational advantage over the rest of the market. This unfairness damages investor confidence in the integrity of our capital markets. To the extent some investors decide not to participate in our markets as a result, the markets lose a measure of liquidity and efficiency, and the costs of raising equity capital are increased.

Further, if selective disclosure is permitted, corporate management can treat material information as a commodity to be used to gain or maintain favor with particular analysts or investors. This practice could undermine analyst objectivity, in that analysts will feel pressured to report favorably about a company or slant their analysis to maintain access to selectively disclosed information. Thus, selective disclosure may tend to reduce serious, independent analysis.”

The proposed change to SEC Rule 17g-5 will began to address this significant information inequality for structured products. This change should be adopted for all classes of credit ratings and apply equally to all types of issuers. Issuer and investor compensated NRSROs should have equivalent disclosure upon which to render credit analysis.

Professor John Coffee of Columbia Law School stated in his testimony of September 26, 2007 to the Senate Banking Committee the following:

“Although I doubt that subscription-funded agencies will displace the traditional rating agencies, subscription-funded rating agencies are less conflicted, and they could play an important watchdog role. But such new entrants face barriers, as issuers may not wish to deal with them or disclose sensitive information. Indeed, the issuer may withhold access to non-public information for precisely the same reason that public companies use to withhold data from securities analysts who were skeptical of them: to punish them. Thus, some have sensibly proposed that an equivalent of Regulation Fair Disclosure (“Reg FD”) should be adopted to require “equivalent disclosure” to all NRSROs of any information that is given by an issuer to any NRSRO.”

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One of the most substantive changes the SEC and Congress can make to increase the relability and transparency of the financial markets would be to amend the rules to give all NRSROs access to the material non-public information of issuers in every asset class. Stable, liquid markets demand free flowing information and unconflicted analysis. The credit markets suffer from conflict and opacity. We urge change that will bring sunlight to the dark corners of this critical market.