A Poor but Standard Model
With the business model of the credit rating agencies in the news again, we wonder if there will be more than partial repairs.
Since U.S. Attorney Eric Holder filed suit against the market leader, Standard & Poor’s, seeking $5 billion in damages, we are about to find out.
The lawsuit alleges that S&P "falsely represented that its credit ratings of [issuer’s securities] were objective, independent, uninfluenced by any conflicts of interest that might compromise S&P's analytical judgment, and represented S&P's true current opinion regarding the credit risks”.
The lawsuit is taking aim at two critical aspects of the industry’s inner workings: conflicts of interest and what a “rating” actually means.
These conflicts of interest, involving issuers hiring and paying the raters to rate the investment worthiness of their securities, have been in the forefront since the mid-1970s when the big three — S&P, Moody’s and Fitch — changed from an investor-payer model to an issuer-payer model. In fact, our research reveals that the regulatory attempts in 2006, 2009 and 2010 not only failed to outlaw the industry’s issuer-payer model, institutionalizing widespread complicity, but instead may have opened up new opportunities to mislead investors.
All three agencies have continually asserted that ratings are merely opinions and therefore protected by the First Amendment. But the Attorney General’s suit is taking a different tack, suggesting that S&P knowingly issued a false opinion amounted to an elaborate scheme to defraud investors.
After nearly four years of heightened regulatory scrutiny following the 2008-09 market turmoil, critics are frustrated by the failure of the industry to meet its own standards or to document its ratings decisions. Flouting standards is a violation of the Securities and Exchange Commission’s rules requiring firms to follow their publicly established criteria. In 2011 the commission warned S&P that it intended to file civil charges regarding two specific deals but has so far been working with S&P behind the scenes. Among other issues they are looking into is whether banking clients, in an effort to shop around for the best rating, put pressure on the issuers to alter these criteria.
Also, as part of the 2010 Dodd-Frank legislation, the SEC created an Office of Credit Ratings last summer, at the same time that reports began to appear about whether S&P used different standards to rate deals that were backed by commercial real estate. In the SEC’s annual report for year-end 2012, it said that despite these efforts, the ratings industry is falling short of these standards.
Based on our research, we recommend four important reforms:
- Full disclosure about the way these ratings are determined and the implications of the current payment model on the quality of these ratings — and not just at S&P.
- Raters must change their payment model to rid the industry of the conflict — one suggestion is to begin charging a user fee, paid for by the investor, which would be subsumed in the fees already paid for investment advice or trading fees, like a user fee or toll.
- An industry-wide effort must reduce the dominance of ratings in what has become a global financial, quasi-regulatory oligopoly. Banks are the place to start, given they are required to use ratings for assessing risk, and attempts to find a workable alternative already underway.
- Lastly, these ratings agencies need to take responsibility for their opinions because they are expressing a specialized knowledge of how to rate and therefore have an obligation to serve that interest — rather than their own.
Full disclosure, payment reform, reducing the importance of ratings, and agency responsibility are all needed if we are not to repeat the scandals of the past.
Cynthia Clark is assistant professor of management at Bentley and director of the Geneen Institute for Corporate Governance. Her research was conducted with Sue Newell, Cammarata Professor of Management and director of Bentley's PhD program.