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Are Regulators Retreating From Dodd-Frank?

by Michael W. Stocker and Lisa Lindsley
Institutional Investor |
Before the passage of the Dodd Frank Act, investors had little recourse under the law even if one of the NRSROs issued a materially misleading rating opinion

Less than a year since the Dodd Frank Wall Street Reform and Consumer Protection Act attempted to hold credit rating agencies to a higher standard of conduct, legislators and regulators appear to be beating a hasty retreat.

The timing could not be more ironic. Ratings agencies were lambasted in Senator Carl Levin's April 13, 2011 report investigating the causes of the financial crisis. The report detailed, among other things, the fact that the principal rating agencies continued to bestow AAA ratings to mortgage-backed securities long after evidence emerged that the housing market was undergoing a drastic decline.

Levin's report explained: "It was not in the short term economic interest of either Moody's or S&P, however, to provide accurate credit ratings for high risk RMBS and CDO securities, because doing so would have hurt their own revenues."

As set out in the report, the root of the problem with credit rating agencies was their business model. Agencies originally made their money by offering subscription services to investors - so they were being paid by the people who relied on the accuracy of the ratings. Beginning in the 1970s, however, this model began to evolve, and the agencies came to make their money on a fee-for-service basis, paid by the companies whose securities were being rated.

These practices naturally led to some huge conflicts of interest. The agencies were being paid by the companies whose products they were rating, and if a good rating was not forthcoming, their customers might go elsewhere.

Making this situation much worse was the fact that these badly flawed credit ratings were deeply embedded in banking and securities regulations. Many regulations, including rules used to determine bank and broker capital, require the use of ratings issued by certain government-approved credit rating agencies, called Nationally Recognized Statistical Rating Organizations or NRSROs. One of these rules, Regulation AB, requires that offerings of asset-backed securities include the rating opinion of an NRSRO.

Before the passage of the Dodd Frank Act, investors had little recourse under the law even if one of the NRSROs issued a materially misleading rating opinion. Under the Securities Act of 1933, experts like accountants or appraisers who give consent for their opinion to be used in an offering are subject to liability if they make a materially false statement. However, ratings 2 agencies that offered opinions in connection with asset backed securities were spared from exposure to liability under a special exemption found in Section 436(g) of the Securities Act.

The great stride that the Dodd Frank legislation made was to remove 436(g) - the upshot of which was that credit rating agencies would be subject to liability under the Securities Act just as other experts would be.

This, of course, did not sit well with the agencies, and they had the power to resist regulation. After Dodd Frank passed, they simply refused to give their consent for their ratings to be disclosed as part of offerings of asset backed securities, bringing the whole ABS industry to a halt last summer.

The SEC quickly backed down, issuing a series of "no action" letters saying that it would not require that NRSROs give consent for their ratings to be used in securities, which largely spared the agencies from legal exposure. So even though Congress made it clear that it wanted to hold the agencies to a higher standard of care, legislators and regulators have been prevented from enforcing the new rules.

From an investor perspective, there is opportunity for things to get even worse. Representative Steve Stivers has sponsored a new bill that would simply restore section 436(g), giving agencies the same protection from liability that they enjoyed before the crisis.

Even if Stivers' bill is not passed, however, another provision of Dodd Frank may make the repeal of 436(g) moot. Dodd Frank required that NRSROs be removed from federal regulations, in an effort to discourage investor reliance on ratings. As part of that effort it is likely that references to ratings will be removed from Regulation AB. This does not mean that ratings will not be used by private parties in structuring asset backed securities - it just means that ratings of asset backed securities will likely not be disclosed, which would vastly reduce the agencies' exposure to liability.

It is only too easy to find evidence that flawed ratings are still a serious problem for investors. In December S&P announced that it would downgrade 1,196 securities tied to U.S. residential mortgages after it "incorrectly analyzed" the bonds because of the way interest payments on the debt are structured. Ironically, the securities are "re-remics" which are formed by taking asset backed securities that were downgraded after the last crisis and repackaging them for investors.

While investors can take comfort that recent reforms have done much to improve oversight and regulation of financial markets, the looming threat posed by credit rating agencies is as large as ever.