The Bond Raters Still Need to Be Fixed
The reforms adopted after the financial crisis didn’t resolve the industry’s inherent conflicts.
Bloomberg, August 14, 2019
Standard & Poor’s 1, Moody’s and Fitch Ratings, the biggest credit-ratings companies, were major causative factors in the financial crisis. Even free-market acolyte Alan Greenspan admitted as much. Little has changed since then, other than that enough time has passed to allow investors to forget this fact.
I have been following this issue since 2007, so here is a brief history.
With the economy still sluggish after the dot-com crash and 9/11, the Federal Reserve slashed interest rates to 1%. Bond managers were under intense pressure to generate yield. This sent them on a mad scramble to find investment-grade debt with higher returns.
This is where the credit raters come in. Moody’s and S&P (Fitch was a relatively small player) slapped investment grade ratings on securities backed by junk subprime loans because they were literally paid to do so by debt issuers. Issuers shopped for ratings — if Moody’s refused to provide a desired grade, then S&P would (and vice versa). When it all went south, the debt raters made feeble attempts to claim their ratings were “opinions,” or protected political speech under the First Amendment. These arguments failed, eventually leading to fines for their malfeasance. S&P paid $1.5 billion to settle with the U.S. and individual states; Moody’s paid a much smaller fine.
In the aftermath of the financial crisis, regulators concluded that the way to fix the problem of the raters’ conflict-riddled, issuer-pays model was to introduce more competition. But this market-based solution seems to be no better; because the newcomers are hungry for business, their ratings tend to be even laxer. If anything, the solution has only made the conflicts of interest more apparent.
To fix this problem requires a radical rethink of the business model. Here are some things regulators should consider:
• Sell ratings to bond buyers, not bond issuers: The ratings companies date back to the panic of 1837. The defaults and bank failures that followed led to creation of new businesses to help rate the debt of merchants. During the 19th century, investors in railroads paid for information on the quality of the bonds they were buying, which is how S&P and Moody’s got their start. In the 1970s, the raters began the practice of charging issuers for their services, displacing the subscriber-pays model. That the investor-pays model once prevailed suggests that under the right conditions and with the right incentives it could work again.
• Assign and rotate rating companies randomly: After the many accounting scandal of the early 2000s — Cendant, Computer Associates, Enron, WorldCom, Tyco, Adelphia, AOL, Global Crossing, Halliburton and many more — a number of reforms were made to the accounting industry. Included in the Sarbanes-Oxley Act was the establishment of the Public Company Accounting Oversight Board, or PCAOB. This established new standards for independence, created audit rules and mandated quality control. Perhaps most importantly, it required whoever the lead partner was on an audit to rotate off that project every five years, reducing the tendency of those who are supposed to work at arm’s length from getting too cozy. 2 The incentive to cheat was replaced with a high probability of getting caught. The result has been a dearth of the kind of accounting frauds that were so common in the late 1990s and 2000s.
• Eliminate the government stamp of approval: The credit raters were granted special government dispensations in 1975, setting them up as the official arbiters of corporate credit quality. This unique status created a moral hazard, with raters facing few consequences for their actions; it is also what enabled the structural problem in the first place. Compare this situation to the equity side: the dot-com implosion taught stock buyers not to rely on Wall Street analyst ratings, which exist (mostly) for the benefit of investment bankers, not investors.
The financial crisis should have taught the same lesson to bond investors. But there’s still the imprimatur of government credibility to fall back on. If we eliminate that special status, the structural problem should disappear. At the very least, there should be some form of legal liability for misleading ratings.
• Create stronger capital reserve standards: This is a big part of the problem: Higher credit ratings give banks and other financial companies cover for holding less capital. If more specific capital requirements were mandated, the need for AAA ratings would change dramatically; ratings would be explicitly structured for the benefit of bond buyers, and not the needs of the borrowers. Today, the ratings serve as a way for issuers to engineer their way to lower borrowing costs.
As the Financial Crisis Inquiry Commission concluded in its autopsy of the crisis: “The three credit-rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval.”
The ratings companies were broken in 2008; they are still broken today because post-crisis reforms didn’t address the root problems. Don’t be surprised if it turns out that the credit raters provided some of the kindling the next time the financial system goes up in flames.
1. Disclosure: The original publisher of my book on the financial crisis, “Bailout Nation,” was McGraw-Hill, which also owns S&P. After an editorialdisagreement about thechapter on the credit raters, including S&P, I withdrew my manuscript. The book was later published by Wiley.
2. Auditor rotation was abandoned under intense pressure from the accounting industry.