At last week’s American Securitization Forum Sunset Seminar, panelists discussed how the proposed Franken amendment creates unintended consequences in applying credit ratings.
The amendment is part of the Senate's version of the financial reform bill. The amendment aims to remove the “issuer-pays” conflict of interest. Under Senator Al Franken’s (D-Minn.) proposal, the issuer will still pay for the rating, but it will not have a say as to which agency provides it. Instead, the government will be choosing the rating agency through the Credit Rating Agency Board, which is tasked with rotating rating assignments.
A main concern for investors with the amendment, according to panelist Nicole Lawrence, a vice president at PPM America, is that the agencies will become standardized and investors will no longer be able to differentiate between them, specifically in terms of how they rate the various asset classes differently.
From the issuer perspective, Andrew White, director of securitization finance at RBC Capital Markets, described the possible diminishing rating agency competition and investor innovation as a “race to the bottom.”
The panelists also predicted that the Franken proposal might lead to ratings becoming a performance-based system, in which an accepted, standard rating of performance is developed for investors to follow. Although Jerome Fons, executive vice president at Kroll Bond Ratings, believes that having a clear definition from a third-party that has an “arm’s length view” would be a step in the right direction, others argued that this approach is too simplistic of a solution.
Investors would not be able to see a deal’s rating over time, which Lawrence said is a huge drawback for investors. She also said investors will end up relying solely on the initial rating and thus not have the opportunity to analyze a rating on an ongoing basis. Therefore, there is an increased reliance on ratings, which is exactly what the Dodd-Frank Act intends to eliminate.
Likewise, White said: “Although it is a nice concept that everyone should shoot toward some kind of norm, these things seek the least common denominator. And by seeking the least common denominator, it doesn’t help promote innovation or doesn’t help prevent the next crisis from coming. It could add stress to the situation with a stamp of approval from a government or a government sanctions type of seal of approval.”
Some panelists agreed that the Franken proposal as it is written currently might cause a loss of creativity on the part of investors because they might find that trusting a standard rating is preferable over conducting their own analysis first.
Lawrence said that more transparency could help calm this concern. John Hwang, a partner at Allen & Overy, agreed with this assessment. “Letting investors and issuers know when there will be changes in the methodology is very important,” he said.
In addition, Rita Bolger, associate general counsel in global regulatory affairs at Standard & Poor’s, fears that issuers will turn to the European market as a solution to avoid the hassle of a mandatory system in the United States.
The European Parliament voted late last week to keep ratings rotation on all structured finance products. The European Commission’s CRA3 proposal introduced several provisions on mandatory rotation for rating analysts and CRAs. The aim was to reduce investors' over-reliance on external credit ratings, mitigate the risk of conflicts of interest in credit rating activities and increase transparency and competition in the sector.
The Parliament’s application of CRA3 to all structured finance product offerings brings up the same concerns as those around the Franken amendment in the U.S. Bolger said that a rotating system makes market professionals worry about frequent transitions and expected instability, which are also the same issues faced by U.S. securitization participants.