The Unintended Consequences of Rating Agency Liability

Only a few days old, the financial reform bill is already making trouble for the markets. One new provision holds credit rating agencies liable for their ratings. Scared about future lawsuits, the agencies have forbidden issuers from putting their ratings in official bond offering documents this week, which shut down the asset-backed securities market. This is a mess, but may be a way to make the regulation work.

The Problem

First, why is this new rule a problem? Barclays Capital analyst Joseph Astorina (via FT Alphaville) explains:

Issuers have to take into account fees charged by rating agencies when they decide whether to do a securitization. Increased costs will be passed through to consumers and investors one way or another.

You could also look at the rating agencies charging a higher fee to cover their liability, though it's not clear how much pricing power the rating agencies are going to have.

Felix Salmon thinks he smells a rat, however:

And the language about "increasing funding costs to issuers and consequently consumers" is a dead giveaway that the note is part of a political lobbying effort, rather than anything particularly objective: consumers of what, exactly? Whenever there's a potential market development that the banks don't like, their knees jerk and they start talking about "increased costs to consumers" even when doing so makes little if any sense.

While this is lobbyist speak, the criticism makes sense. Most of the asset-backed securities (ABS) we're talking about here are based on pools of consumer loans, like those for mortgages, autos, or credit cards. So if issuers' funding costs increase -- and they will if the raters face liability -- then it will be more expensive for lenders to provide these consumer loans. Consequently, that cost will be passed on to pretty much all consumers. So this new regulatory burden is a legitimate problem.

The Solution

But figuring out a solution gets sticky. One possibility, suggested here, would be for the agencies to simply provide their ratings through some new third-party medium. But when regulators go wild, unexpected consequences result. It turns out that a separate SEC regulation requires that public ABS deals contain ratings. This makes the reason for the market shut-down clearer. Raters don't want to be held liable so won't allow their ratings in official deal documents, but these bonds can't be issued without those documents containing ratings.

The SEC has offered a temporary solution to a permanent problem. It has allowed a six-month hiatus on the requirement that ratings are included in official documents. So these deals can now be issued without ratings disclosed, getting the agencies off the hook. Investors can just obtain ratings through some third party instead. But after six months, the problem will persist. Time alone won't provide an answer.

Salmon suggests that these deals could just be offered privately, so to escape the regulatory barriers. They only apply to public deals. But this would make matters worse. The securitization market will then become even less transparent, which is precisely the reverse of what financial reform hoped to accomplish.

Instead, the SEC's temporary solution should be made permanent. There's a chance that, if ratings aren't in official documentation, the market could eventually function even more effectively. First, investors won't really be able to as legitimately blame the agencies, since the official deal documents won't contain ratings. They may begin to be viewed as what they really are: opinions.

That could inspire investors to do a little more of their own analysis and due diligence going forward, but it probably won't. Instead, this solution might just work as a loophole for the agencies to remain just as vital to the market, but escape liability. Despite this likely result, there is a possibility that would be a positive development for the market.

In fact, these ratings could come to be obtained only through the agencies' websites. Perhaps investors could just rely on purchasing subscriptions to view ratings for some given industry segment. If the raters shifted their revenue model to stress such subscriptions instead of being paid by issuers, then this could also help to correct the conflict-of-interest problem. Currently, the agencies ratings income mostly consists of fees paid by the issuers, which leads some people to believe that the agencies feel obligated to provide more favorable ratings.

If you really think about it, the SEC regulation was nonsensical from the start. Why should the opinions, even of experts, be considered official deal data for investors to consider in a prospectus? If you get rid of this rule, the problem will work itself out, and there's some chance leaving the liability rule in place could ultimately leave the financial community even better off.