Almost one year after the rating agencies had their first bloodbath of structured finance downgrades, and after months of market outcry for increased transparency and further ratings oversight, the Securities and Exchange Commission (SEC) has responded with an initial set of regulations. But while further ratings disclosure is needed, market pundits agree that these reforms do not solve the root of the problem.

"One of the problems is that ratings are a crutch, and [these reforms] don't deal with the fact that investors place undue reliance on these ratings," said Bert Ely, banking consultant and principal of Ely & Co. "Five or ten years from now, people forget the past and we will be back to a reliance on ratings."

Since structured finance vehicles are notably complex, part of the SEC's regulation effort is to try and reveal more of the differences between these investment vehicles and other securities, which will in turn aid investors in their own due diligence.

This means there could be a mandatory subscript attached to each rating or a report published alongside it explaining the difference between a structured finance transaction and another security, for example, corporate bonds.

After the SEC first announced it could introduce a different ratings scale for structured finance securities, one in which the ratings would have some sort of attached modifier to distinguish them from other ratings, market players pushed back on the concept, which they did not feel would add much value to the ratings.

A lot of people in the industry are using the term scarlet letter' to capture the idea that a modifier would create the sense that this triple-A rating is not as good as a general corporate bond triple-A rating, said Dave Krohn, a partner in DLA Piper's corporate finance practice. "That would impair the ability of the market to recover, and it would continue to undermine investor confidence by creating a second-class tier of ratings."

The Securities Industry and Financial Markets Association's (SIFMA) Credit Rating Agency Task Force called the modifier idea a "cosmetic solution to a fundamental problem."

In its official release of the proposal, the SEC came up with another option: a standard disclosure for structured finance deals. This may actually be more helpful than an alternative set of ratings.

"Clearly the industry is very strongly against the alternative ratings scheme," said Edward Gainor, an attorney at McKee Nelson. "This rule appears to allow the rating agencies to attach a couple of paragraphs of standard disclosure that wouldn't vary at all from deal to deal but will still distinguish asset-backed ratings from other ratings. I think this will be a welcome improvement over the alternative for the ABS industry."

Alex Pollock, resident fellow at the American Enterprise Institute, suggested that rating agencies be allowed to decide whether they want to choose a different ratings scale or disclosure and leave it up to investors to make the ultimate decision as to its effectiveness.

Checking Out the Competition

The new proposal also mandates that rating agencies make public the information that they use to rate any transaction whenever they are selected to do a deal. This will provide investors with a more comprehensive understanding of a deal's rating and the show them the collateral for an underlying security while also giving other nationally recognized statistical ratings organizations (NRSROs) the ability to shadow rate the deal. This will encourage competition in the industry to keep the ratings process in check, the SEC said.

But the time frame to do a second rating appears to be quite short, Krohn said. "In a public deal, the information has to be put out there no later than pricing, and the time between pricing and closing is relatively short in a public transaction. The whole point of the SEC's proposal is to get that information out to purchasers of securities before they buy."

In order to ensure accurate ratings, the SEC wants to prohibit discussions between the rating agencies and arrangers about structuring the transactions, which could create a conflict of interest. While the proposal does not restrict all interactions between the NRSRO and the obligor, issuer or sponsor during the rating process, Krohn said the parties would have a very hard time differentiating what communication would be appropriate and what wouldn't in the context of structured securities.

Furthermore, he did not necessarily think it was bad that the agencies and arrangers discuss the deals. "In these deals, if the rating agency looks at the structure and says 15% credit enhancement won't get you a triple-A rating but 20% will, I don't see why that is problematic in the same way that the SEC does," he said.

However, when the issuer pays, the rating agency becomes an agent of the issuer, Ely said, which creates a lot of problems with the agency's role when the ratings are being structured. "When a rating agency is being paid by an issuer and gets into bed with an issuer in terms of the structuring, are they a publisher the same way The New York Times is? I would say no. They should be liable the same way investment banks or accounting agencies are."

To tackle this issue, Ely suggested the answer lay beyond cutting off communication between the parties. He suggested that the rating agencies be freed of protections against lawsuits for damages under the first amendment. "Keeping pressure on the rating agencies through the litigation process may in turn make them more cautious about what they rate," Ely said.

Private, Public Information

Another question is how to release information on private placement transactions. The SEC has proposed that, on the pricing date of a transaction, all of the information is posted on a Web site that investors in the offering will be given a password to access. On the day after the closing date, the password protection is removed and the information is available to the public in general. But this does not address the fact that very frequently there is still an unsold allotment after the closing date that has not yet been placed with investors, Gainor said. "How do you reconcile the continuing private offering with the worldwide publication of all of this information?" he said.

Still, while the market was quick to point out the flaws of the new proposal, overall they welcomed the SEC's efforts to increase market transparency and combat the opacity in the ratings process - even if it is not the shot in the arm the industry was hoping for.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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