"What we see in terms of shopping is that the rating agencies do the preliminary work and they are either hired or not hired,” said Calvin Wong, CCO of Morningstar.

Morningstar thinks that there is a way to stop issuers of asset-backed securities from shopping around for the best ratings: compel them to publicly disclose the level of credit enhancement required by each rating agency for each tranche.

Before the deal prices. 

Reforms enacted since the financial crisis give rating agencies access to information about deals in the hopes that those not hired to rate the transaction will publish unsolicited ratings.  To date, however, no credit rating agency has issued an unsolicited rating prior to the closing of a transaction as a result of this rule, 17g-5.

And rating shopping remains rampant. According to Morningstar, the practice is most prevalent in commercial mortgage securitizations; typically the arranger or issuer will invite up to six of the rating agencies active in the sector to conduct a preliminary review of an initial asset pool and transaction structure.

This means that each conduit deal gets a full underwriting analysis of the underlying properties and ultimately, the required credit-enhancement levels for each rated class within the capital structure by each of the six agencies - Moody’s Investors Service, Standard & Poor’s, Fitch Ratings, Kroll Bond Rating Agency, Morningstar and DBRS.  

In most cases, the arranger/issuer will hire only the two or three credit rating agencies, those requiring the lowest enhancement levels or generally the least onerous terms, according to a report published by Morningstar on Friday. Sometimes, however, the arranger/issuer will hire a rating agency based on investor preferences, mandated investment-management guidelines, or for other business reasons. Only the work that is done by the chosen rating agencies sees the light of day.

“What we see in terms of shopping is that the rating agencies do the preliminary work and they are either hired or not hired,” said Calvin Wong, chief credit officer of Morningstar and author of the report. He said that Morningstar itself is picked to rate three out of every 10 deals that it does preliminary work on.

Morningstar points to two reasons why reform hasn’t worked. First, an unsolicited rating requires a full analysis without compensation, which most credit rating agencies, particularly the smaller ones, are not inclined to do.  Second, credit rating agencies are concerned that the arranger/issuer may exclude them from future ratings business, particularly if the unsolicited rating undermines the marketing and pricing of a transaction.

Instead, rating agencies have been conducting less formal, and less costly, evaluations and publishing unsolicited commentary on deals. This allows them to communicate their views to investors but is based solely on publicly disclosed information.  Several CRAs, including Moody’s and Fitch, have issued such commentary.

However Morningstar believe that a better solution would be to make it a regulatory requirement that the initial work done by the agencies that are ultimately not hired be made public, either in the form of a new SEC rule or an extension of Rule 17g-5. Access to this additional layer of information would add another level of transparency for investors, according to Morningstar.  

Morningstar isn’t the only rating agency pushing for better disclosure of their analysis. Fitch was the first rating agency to endorse investors having access to the 17-G5 web sites. In an August 2011 comment letter, the ratings agency stated that restricting access to the site to CRAs only “limits its usefulness to investors.” “Enhancing 17g-5 to make the list available to investors and, in fact, all of the public, will help overcome this weakness”.

Eric Thompson, a senior managing director responsible for commercial mortgage backed securities at Kroll, believes that issuers should be required to use the ratings that selected agencies have assigned across the entire capital stack, rather than selectively use them for certain tranches.  "We have more transparency than we've ever had, but if we want to get at the fundamental root of the issue, we need to get to a place where the offering documents disclose the preliminary and final feedback each and every agency provided," he said.

 Wong also thinks that ratings agency that are asked to provide preliminary analysis but are ultimately not hired should be entitled to receive partial compensation to cover their costs. These requirements, stated Wong, could be implemented in the form of a new SEC rule or an extension of Rule 17g-5.

“Investors are being tasked to do their own analysis to underlying ratings; yet they don’t have access to the same level of information that the rating agencies used to rate to the deal, and the information from the ratings agencies that are not hired is not available either,” Wong said.

“This puts investors in a difficult decisioning position especially with the short time frame they have to make the decision on whether they want to even circle a deal.”

If regulators can’t reach a solution on the SEC may have to consider a scheme proposed by Sen. Al Franken (D-Minn.): a board overseen by the SEC would select qualified rating agencies to offer an initial rating for structured-finance transactions. Under Dodd-Frank, the Franken proposal will eventually become law unless the SEC comes up with an alternative.

Over the near term, the scheme could benefit smaller credit rating agencies by enabling their participation in deals they might otherwise not have access to. However once those players become more established, it is likely that they too would rather “realize their potential under open-market competition” stated the Morningstar report.

One offsetting factor to ratings shopping today is that it doesn’t impact the integrity of the ratings. The concern of shopping, immediately after the crisis, was that bankers would try and play the rating agencies off of each other to get the execution level. “Unlike in the past there isn’t as much back and forth between the rating agency and the issuer, to try and reshape the levels; today it’s more like ‘here is the analysis and this is what it is’; the issuer either accepts it or not,” said Wong.  

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