Corporate Governance

Credit Ratings Agencies Reach Agreement with New York Attorney General

By Jim Hodgson

Wall Street?s top three credit ratings agencies -- Standard & Poor?s, Moody?s Investors Service, and Fitch Ratings -- finalized an agreement yesterday with New York Attorney General, Andrew Cuomo, which is designed to improve transparency in the mortgage-backed securities industry.  As we have reported, these agencies came under attack earlier this year for issuing unjustifiably high ratings on mortgage-backed securities and for failing to lower those ratings once the securities started to perform poorly.  Under the new agreement, then, the credit ratings agencies will alter their fee structure and will require investment banking due diligence reports before they will be permitted to issue ratings.

With regard to fees, the agreement has investment banks -- which, since the 1970s, have paid directly for ratings only after they have been issued -- paying the ratings agencies in stages for their various financial analysis tasks.  This change in payment procedure stands to reduce the pressure on agencies to issue higher-than-warranted ratings (in an effort to ensure payment after all of the analysis is done); and investment banks should experience increased incentive to remain with the agency chosen from the outset, knowing that there have been cash outlays at various stages of the analysis and rating process.  The agreement also contemplates the disclosure of every deal each agency has worked on, making it more difficult for a bank to walk away from something less than the coveted triple-A rating.

With respect to due diligence, the agreement states that ratings firms will require banks to submit due diligence reports before any ratings may be issued.  The agencies will set substantive standards for such reports, ensuring that they are useful and relevant to the agencies in the ratings process.

This agreement with the Attorney General appears to be a step in the right direction.  It allows the ratings agencies the freedom to analyze new securities with increased integrity; and it locks an investment bank into a particular rating agency once the agency is chosen -- upon penalty of losing initial analysis fees and of having the marketplace learn of any change in agency midway through the ratings process.  And everyone will be kept more honest knowing that investment banking due diligence exists to back up (or not) an agency?s rating.

One might wonder, though, whether the entire ratings process is inherently flawed.  For, why is it that investment banks, themselves -- the entities that are marketing and selling securities -- are the entities that pay for ostensibly independent ratings of those securities?  As various economists have suggested, until we experience a return to the old ratings model, according to which investors paid for ratings, we will never escape the feeling that the fox is guarding the henhouse.

Full post as published by PomTalk on June 06, 2008 (boomark / email).