Fitch Ratings caused a stir last month when Credit Suisse dropped the firm's rating of an RMBS because it took a more critical view of the deal than two of its rivals.

But what's really notable is how rarely rating agencies give differing opinions on deals, despite rules adopted by the Securities and Exchange Commission (SEC) more than two years ago that were designed to discourage sponsors of structured finance transactions from shopping around for the most favorable ratings. The rule hasn't produced the activity that it was intended to encourage.

Fitch published its analysis of the private 144A CSFB Mortgage Securities Corp. 2012-CIM1, which was backed by approximately $1.3 million of Jumbo prime mortgages originated by MetLife. In an unsolicited comment issued on March 30, it said the credit enhancement levels for the Class A1 and Class A2 tranches were not sufficient to support the triple-A ratings assigned by Standard & Poor's and DBRS.

Fitch stopped short of assigning an unsolicited rating to the deal, despite the fact that it had been engaged by Credit Suisse and received a fee for its work.

It was only the fourth time Fitch has publicly disagreed with its rivals under the SEC Rule 17g-5, which came into force on June 2, 2010. In addition to CSMC 2012-CIM1, it issued unsolicited commentary on three deals last year: City Center Trust 2011 CCHP and DECO 2011-CSPK, both CMBS, and a servicer advance receivable deal issued by American Home Mortgage.

Moody's Investors Service and S&P have been even more reluctant to share dissenting views. In 2010, S&P published a report saying it disagreed with Moody's rating of a transaction sponsored by Redwood Trust called Sequoia Mortgage Trust 2010-H1 ($290 million). Meanwhile, Moody's has only commented on Sequoia Mortgage Trust 2011-1 ($289.5 million).

Under the new regulation, rating agencies have access to all of the information they need to provide unsolicited ratings. The rule requires issuers, sponsors and underwriters of structured finance deals to maintain a password-protected Web site containing all of the data and documents they provide to the credit rating agencies they hire as well as transcripts of interactions with these agencies; the agencies that are not hired must have access to these Web sites as well.

Issuing unsolicited ratings would also seem to offer a way for the agencies to boost their credibility in the wake of accusations that they contributed to the financial crisis by failing to accurately gauge the credit risks behind the mountain of now-downgraded triple-A debt.

What's Stopping Agencies?

Predictably, one reason that rating agencies have been reluctant to stick their necks out is the cost, in terms of time and resources, of reviewing complex transactions. "Rule 17g-5 is critically flawed," said Paul Forrester, a partner at law firm Mayer Brown who works on CLOs and other kinds of transactions that must comply with Rule 17g-5. "The assumption that a credit rating agency would do the work required to shadow rate a complex transaction without being paid to do so is unrealistic."

Rating agencies are also concerned about the potential legal liability of providing unsolicited ratings, although some people think these concerns are overstated. One issue is the onerous terms of the confidentiality agreements that rating agencies must sign before accessing information on deals. "The concern is that if you have to explain your rating based on that confidential information then the company can come after you and sue you because the rating agency violated the confidentiality of the Web site," said a rating industry veteran.

Forrester downplayed this risk; he said the confidentiality agreement is really there to protect an issuer that is likely to be providing non-public information to the agencies. It should not prevent a rating agency from issuing an unsolicited rating.

Another concern is that SEC rules require rating agencies to issue one unsolicited rating for every 10 deals that they monitor on a 17g-5 Web site. The quota was designed to prevent rating agencies from undertaking "fishing expeditions," according to the rating veteran. Instead, the rule has had the unintended effect of discouraging rating agencies from reviewing deals, this industry source added.

Rating agencies can avoid any legal liability with accessing confidential information on the 17g-5 Web sites by issuing unsolicited commentary that is based solely on publicly disclosed information. This is the strategy that Moody's and S&P have adopted to date. But it presents its own challenges, since the amount of publicly disclosed data available for a given transaction might be limited.

Mike McMahon, managing director at Redwood Trust, said that the unsolicited comments that have been issued on the Redwood deals, Sequoia Mortgage Trust 2012-1 and Sequoia Mortgage Trust 2011-1, were all based on public information, not the information made available through the 17g-5 site.

McMahon believes that the requirement that a rating agency must provide an unsolicited rating on one-in-10 of the deals it reviews "encourages" the rating agencies not to access the sites. The amount of resources necessary to rate a deal makes unsolicited ratings uneconomic so the agencies just avoid accessing the information.

"One of the challenges in rating structured finance deals is that you must access pretty detailed information in order to be able to offer a valuable opinion," said Kevin Duignan, head of U.S. structured finance at Fitch. "In many ways, it's easier if you are engaged because you have access to that information, and you are in regular dialogue with the issuer or sponsor. At some point, you may depart in your view from how the other rating agencies are approaching the deal, but at least you have a good basis for your decision."

Duignan said investors place more value on unsolicited commentary or ratings that are based on very detailed criteria and offer a detailed description of why one rating agency's view differs from the others.

This is the reason some ratings agencies have been reluctant to issue too much commentary that is based solely on public disclosures. "They are afraid of being accused that they did not even consider the confidential information on the 17g-5 Web site, which, it could be argued, offered information that would have led to a different result," said the rating industry veteran.

"Usually, an unsolicited comment or rating will happen in transactions where we are ultimately not asked to rate the transaction," Duignan said. "We offer commentary where we have not assigned formal ratings; we just indicate our view of the transaction if different from others and we publish a detailed description on how we arrive at our conclusions."

It goes without saying that rating agencies risk alienating issuers when they express opinions that are more critical than those of their competitors."You don't want to turn them [issuers] off to you because you want them to choose you for the next rate," said the industry veteran.

Although the idea of a central repository for all of the data and documents and all other requirements the rating agencies have makes it easier for issuers to ensure that all parties have access to the same information, at the same time, the major downside of Rule 17g-5 is that the language restricts how issuers and ratings agencies communicate. "The rating agencies could have a very difficult time having a conversation with a seller or originator to get clarity on any kind of information they receive because anything and everything that is communicated on that call must be provided to all rating agencies," explained Bill Moliski, managing director at Redwood Trust.

"While in theory this makes sense, it is not practical to thoroughly document conversations," added McMahon.

Information Dissemination

The rule also stipulates that "all information" must be made available "at the same time." The logistics of disseminating pertinent information across all rating agencies means that if an individual rating agency had a particular query, the originator would have to figure out a way to give an answer that would be available to all other agencies at exactly the same time."What that has done is that it has nearly shut off any conversation that originators, servicers or due diligence providers would have with the rating agencies because we can't ensure that we can meet these two aspects of the rule," Moliski said."So instead of facilitating conversation, it is actually shutting down conversation."

On the other hand, while the commentary falls short of fully committing to what regulators intended, it has led to more disclosure on what is happening behind the scenes of the rating process. As in the case of both the Redwood RMBS deals and the recent Credit Suisse RMBS offering, the information that a rating agency had been engaged but not selected to rate the final deal was fully disclosed prior to pricing the deal.

On its second post crisis deal, Sequoia Mortgage Trust 2011-1, Redwood engaged both Moody's and Fitch. According to Moliski, Redwood had a "disagreement in Moody's view of the ratings impact related to earthquake risk." It decided that "it was important and material to the investors to know that we had engaged Moody's and received the preliminary credit enhancement levels they had proposed and that we decided not to have them on the deal," he said. "That disclosure was not required; it was our decision to disclose it."

Before the financial crisis, ratings shopping - typically defined as consciously appointing a rating agency that is known to have the most liberal credit criteria in a particular sector, or engaging several agencies and subsequently dropping the agency with the least favorable rating outcome or implied capital structure from the transaction - was endemic across the capital markets. But it was a particular concern in structured finance, where transparency had traditionally been weak.

The losses investors sustained during the crisis, not to mention the regulatory reaction, has changed the way issuers look at ratings and how they market their bonds to investors."We are mindful of what all the rating agencies write, and we take their comments into consideration," said McMahon at Redwood Trust."In general, more opinions and research are better than less for restoring the mortgage securitization market."

This new willingness to disclose to investors information about other ratings stances means that issuers are more self-conscious about opting for the best rating on the deal."It was previously unabashed and blatant the way issuers would take a deal to the rating agencies and go with the one that gave the best credit enhancement," said the industry veteran. "The strategy was to play the rating agencies against each other and to precipitate a race to the bottom."

Upside for Rating Agency

Fitch pointed to an additional strategic benefit to providing unsolicited ratings."We think that Fitch's value to the market will continue to increase as more investors see and hear our perspective on credit, so any potential short-term losses will be offset in an overall increase in Fitch's franchise value because our opinion is deemed valuable by investors," Duignan said. "The more investors value our opinion, the more it will accrue to positive franchise value for the firm."

Rating agencies are also mindful that they could face possible repercussions from investors if they fail to disclose that they have a materially different point of view on a transaction. "For firms that don't ultimately rate the deal, there is a need for them to raise their hand and say why," said a source at an investment bank. "This is a post-crisis thing, and post-crisis [the agencies] are trying to differentiate themselves from one another much more than they did in the past."

Duignan said Fitch views "unsolicited rating" as a fairly generic term that ultimately means that it was not asked to assign ratings to a transaction but still wants to offer valuable commentary to the market. From a technical basis, a credit rating in the SEC documents is defined as a statement about opinion on credit.

Fitch said in an October 2011 report that it "aims to issue any such commentary or rating before investors are required to commit to purchase a security, i.e., typically after an offering circular has been published, but before pricing/closing."

Essentially, two key requirements drive the issuance of unsolicited commentaries or ratings for Fitch and S&P: first, investor interest in the deal should be strong; second, the rating agency should have a materially different credit opinion on the transaction than the mandated agencies.

"Moody's frequently publishes views on credit issues that differ from other published views," Claire Robinson, senior managing director at Moody's. "Sometimes our opinions reference transactions in the market - whether we've rated them or not. Our comments on transactions we haven't rated are based on publicly available information."

Ron D'Vari, co-founder and CEO of NewOak Capital, believes that the practice of issuing partial commentary can ultimately be unproductive to the goal of informing investors because it is based on information to which investors already have access. This is particularly the case when it is based on limited disclosed information by issuers introduced in the middle of marketing a transaction. The commentary then functions more as criticism rather than as an articulate and full analysis that might be evaluated and taken into account by investors.

D'Vari said that while investors should welcome the additional opinion and potential risks, he believes unsolicited commentaries criticizing other ratings opinion do affect pricing on deals. "There are other aspects to consider, such as risk weighting and potential capital requirements that will certainly make participants have to analyze any alternative credit metrics," he said. "The arrived ratings determine the capital required to get into position."

For example, D'Vari said that the number of investors who can buy a triple-A versus a double-A security is different. Thus unsolicited ratings can affect the pricing of securities through influencing demand.

Post-Issuance Impact

Post-issuance, unsolicited commentary also affects investors who may or may not be able to hold that security in their bucket. This also affects how much capital they will have to put against that security.

The investment banking source said that investors reviewing CSMC Trust 2012-2 were aware that Fitch had been engaged for, and ultimately dropped from, the deal, even before the ratings agency issued its unsolicited commentary. "The offering circular stated that S&P and DBRS were going to rate the deal 'AAA' and it also said that Fitch advised the bank that it would require higher credit enhancement so it wouldn't be rated 'AAA', that was already out to investors before it priced," this source said. He added that the issuer welcomed Fitch's disclosure of its reasons for not rating the transaction.

Investors look for ratings mainly to satisfy their requirements to buy only securities that have a rating, and they pay attention to negative comments in the reports. "Our view has always been that rating agencies provide a view, an opinion on collateral and performance and the more opinions that you have, the better it is for investors to make an educated investment decision, coupled of course with any credit work they do on their own side," Moliski said.

Mayer Brown's Forrester agreed that prospective investors do more of their own due diligence and certainly understand the rating agency methodologies and how they differ from agency to agency. However, he said these buyers must also be able to predict why issuers or sponsors are using one rating agency versus another.

The good thing about rating agencies is that they do not trade any bonds and therefore never have inventory that they are talking up and can therefore give an unbiased review. "Even when an investor has done a lot of work and reached its own conclusion it should still want to know what other reasonable people think, especially people who aren't trying to sell them the bond," the industry veteran said.

Forrester said that, on the CLO deals he has worked on, both Moody's and S&P have rated the senior bonds, but only S&P has rated the rest of the capital structure. "It's been that way forever, but if something changed and we had a particular investor saying that they needed Fitch on the double-B, Fitch is hired to do the double-B," he said.

And while the mere threat of an unsolicited rating would potentially put a chill on issuers engaging in rating shopping, Forrester believes that what regulators intended - to promote healthier competition among rating agencies - is not going to happen under Rule 17g-5.

"Issuers, at the first instance, would quickly change the rating agency" on a deal if they get a sense that investors would want another rating firm on an offering, Forrester said.

If regulators really want to see competition among the rating agencies, the so-called Franken amendment, first proposed in 2010, might offer a better alternative if it is revised properly. The amendment to the Dodd-Frank Act, sponsored by Senator Al Franken (D-MN), proposed that the SEC establish a board that would assign which rating agency would rate certain structured finance transactions. The board - compromising primarily by investor members, one issuer member, one rating agency representative and one independent member - would randomly assign rating agencies to individual transactions. That original amendment did not make it into law, but it did call for the SEC to conduct as study on the ratings process and to consider the feasibility of establishing the board.The SEC must complete the study and come up with recommendation by July 2012.

"It's an interesting idea but issuers and sponsors will still want the ratings that are going to be required to gain maximum investor interest so that the investors price the deal aggressively and they get good execution," Forrester added. "I think there is still work to be done here."

The Franken Amendment also fell short of preventing ratings shopping in that it wouldn't exclude any other ratings outside of the one that was assigned by the board. If the rating that was assigned by the board was deemed insignificant or not good enough, and as long as investors were for it, an issuer could go to another agency.

"If someone were to create a rating agency that got the NRSRO designation and then the SEC were to come up and say that this new rating agency is assigned to the deal, the transaction would carry that rating," the industry veteran said. However, "the issuer would also shop the deal to Moody's, S&P and Fitch. So it wouldn't make the issue go away."

The dilemma rating agencies face in deciding whether to publicly air their differences goes to the heart of their business model. They can try to get more business either by lowering their standards, endearing themselves to issuers, or by raising their standards in order to make themselves more valuable to investors.

In theory, it is the second way of gaining business to which rating firms should aspire. "The CRAs want to build their credibility and gain an investor base that will avoid buying bonds that do not carry a rating agency rating," the rating agency veteran said. "But it's theoretical, and the reality is that rating agencies are aware and feel the pressure from issuers to be as easy as the next guy."



Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.