The Dodd-Frank Act's call for the creation a self-regulatory organization (SRO) or other entity to assign new ratings was mostly panned by structured-finance industry participants, but relying on existing Rule 17g-5 - the industry's preferred alternative - may have a fatal flaw.
Rule 17g-5's amendment requiring nationally recognized statistical rating organizations (NRSROs) to freely share the underlying data of deals they're paid to rate with competitors was adopted in November 2009 and became effective the following June. Since then, however, there have been no unsolicited ratings - anticipated to ferret out conflicts - and just a handful of less rigorous ratings commentaries.
"Rule 17g-5 by itself is not doing a good job reducing conflicts of interest in the marketplace," said Robert Dobilas, president of Morningstar Credit Ratings.
Dobilas said his firm, which began providing issuer-paid ratings for new issues of CMBS in 2009 and recently started up a similar service for RMBS new issues, agrees with the rule's intent to spur more competition among NRSROs. Its weakness, however, is that it provides no means to compensate NRSROs for unsolicited ratings and investors have not been willing to pay for ratings and analysis on new-issue securities.
"The small NRSROs don't have the resources to do that," Dobilas said."They can't absorb those kinds of costs."
The Securities Industry and Financial Markets Association (SIFMA) and the American Securitization Forum (ASF) devoted most of their letters responding to the SEC's request for comments on the issue - deadline Sept. 13 - to criticizing the notion of an entity to assign ratings. Toward the end of their letters they each argue that Rule 17g-5 already provides the independence, accountability, transparency, competition and other attributes the market requires in the wake of the financial crisis, and that tweaks to the rule will generate more unsolicited ratings.
The ASF, for example, argued in the bulk of its letter that the entity assigning new ratings to NRSROs would face its own conflicts of interest, increase securitization costs, and potentially be susceptible to political pressure. The ASF also said the assignment approach could limit the development of new ratings methodologies and prompt NRSROs to migrate to more similar methodologies.
Like the SIFMA, the ASF said that Rule 17g-5 provides the most effective way to promote an independent and viable ratings process. The current rule limits the number of sponsor Web sites an NRSRO not hired to rate a deal can access, and both trade associations recommended loosening that restriction as well as the minimum percentage of deals it must rate relative to deals it views.
"By increasing the number of Web sites NRSROs may access and permitting ratings commentary to count toward the 10% threshold, smaller or new NRSROs also might more easily develop a track record in ratings commentary than in unsolicited ratings, thereby gaining exposure and credibility with investors and issuers," the ASF stated.
The Investment Company Institute (ICI), representing mostly mutual funds, devoted more of its letter to noting the Dodd-Frank provisions that increase NRSRO accountability and liability, and recommended that the SEC actively pursue actions against NRSROs for failure to comply with their stated policies and procedures. It, too, recommends similar tweaks to Rule 17g-5, to increase NRSRO competitiveness.
Morningstar said, however, that investors tend to be unwilling to pay for unsolicited initial ratings when sponsors already provide two ratings from agencies they select. And if an NRSRO does decide to pursue an unsolicited rating, the information provided under Rule 17g-5 is typically provided with insufficient time to market the unsolicited rating to investors.
"While it may be noted that Rule 17g-5 has resulted in NRSROs issuing commentary on certain initial ratings, these commentaries are provided without liability and are outside of the scope of the regulatory rules designed to protect the integrity of credit ratings," Morningstar wrote in its comment letter. It added that the analysis in such commentaries may be inconsistent with the NRSROs' published methodology, and so "are not particularly meaningful as a means of comparison for investors."
Dobilas said in the interview that the biggest roadblock to competition between the established rating agencies and the newcomers is that institutional investors' guidelines too often require ratings from the top-three NRSROs. A benefit to creating an entity to assign ratings is that it would force those investors to rejigger their investment guidelines to look at all NRSROs.
"We have said frequently that the market needs to do things differently, and investors have to be on the frontline of change," Dobilas said.
Morningstar also suggested a way to enhance 17g-5 by selecting NRSROs on a rotational basis to provide an unsolicited rating and compensating them at market value. Another possible solution, Morningstar said, may be for regulators to mandate the disclosure of the preliminary ratings NRSROs develop to compete for ratings assignments, as long as they can somehow also be compensated for them.
The Council of Institutional Investors (CII) noted in its comment letter that it has not publicly endorsed a system or model to assign NRSROs to rate securities. It suggested compensating NRSROs over the life of the securities they rate and tying compensation to a rating's performance over time.
Laurel Leitner, a senior analyst at the CII, said the numerous regulations approved over the last few years regarding NRSROs, including Rule 17g-5, require more time before their impact can be fully gauged. One overlooked issue that could spur competition and potentially bring more smaller NRSROs into the mix, however, is that currently there's the lack of a standardized way to compare the performance of NRSROs' ratings.
The NRSROs must disclose their ratings performance statistics over set time intervals, but they each calculate those statistics in different ways. "There should be a standard method for computing those statistics, and they should all be readily available in one place, in an easily understandable format," Leitner said, adding that would enable investors to compare the quality of NRSROs' ratings, whether solicited or not.
The American Federation of State, Country and Municipal Employees (AFSCME) appears to be the only other party submitting comments to the SEC besides Morningstar that viewed establishing an entity to assign ratings as a potentially effective way to reduce NRSROs' conflicts of interest. Gerald McEntee, the international president, wrote that it is unlikely either issuer- or subscriber-paid fee models can sufficiently reduce NRSRO conflicts of interest, since in the latter case they may pressure the NRSRO not to downgrade a security they hold.
The AFSCME said that an entity that assigns ratings could be designed to provide economic incentives to NRSROs to produce high-quality ratings, as defined by input from investors and other users of ratings. "NRSROs that produce the highest quality ratings could be eligible for a larger number of assignments, thus fostering competition on ratings quality rather than accommodation of issuers, as is currently the case," McEntee said.