Rating Agencies May Face Restrictions in Structured Finance

Although it’s merely talk at this point, international regulators are considering how to reform rating agencies’ role in structured finance, which in hindsight contributed to many parties buying paper that was considerably riskier than they realized,

One notion is to limit their their role in advising issuers on the design of structured finance products, which is where the biggest conflict of interest lay for the raging agencies. The problem, as this Bloomberg article notes, is that this approach may still leave a great deal of room for mischief.

An aside: while this article does not purport to present all the ideas under consideration, it seems odd that there is no discussion of the fundamental problem with the rating agencies’ posture, namely, that (save new agency Egan Jones) they are paid by issuers, when their ratings are meant to serve investors. But perhaps no one believes that the investors in aggregate will pay as much for the service as the issuers did (and the idea of depriving the agencies of revenues, no matter how badly they screwed up, seems verboten. Why are parties thriving under a regulatory umbrella being treated with kid gloves, particularly when no one questions that their failings have caused considerable harm?)

Note that the rating agencies are hiding behind the canard that they don’t advise on deal structure when even industry textbooks confirm that that is precisely what they do. And also note that they have had the temerity to tell that lie in Congressional hearings.

But a bigger question looms: so many investors are holding paper that has fallen sharply in value that the future of the structured finance market itself is in question, and that poses a very fundamental challenge for the entire financial system. A recent article in the Financial Times indicated that while market participants (ie, the people who’ve been selling and trading this stuff) expect the market to come back soon, central bankers are pessimistic, and anticipate that we will see a return to much more bank intermediation (that is, banks holding much of the loans they lend).

History suggests the pessimistic view may be accurate. After the crash of 1929, investment trusts, the speculative vehicles culpable in the stock market bubble, were deeply suspect. So many people had been burned that even with the new securities law regime of 1933-1934, investment trusts (rebranded as mutual funds) did not become popular again until the 1950s, which was roughly when the stock market had made up its losses.

From Bloomberg:

Moody’s Investors Service and Standard & Poor’s may be restricted from advising banks on structured debt securities after criticism the firms failed to downgrade subprime-related notes as investor losses mounted.

Ratings firms may face a code of conduct prohibiting “advice on the design of structured products which an agency also rates,” the International Organization of Securities Commissions in Madrid said today. IOSCO, the forum of securities regulators, also called on financial institutions to disclose their risk of losses from structured finance.

Regulators including Michel Prada, France’s chief securities official and chairman of IOSCO’s Technical Committee, have rebuked ratings companies for being involved in creating the securities responsible for at least $146 billion of losses in the wake of the subprime slump.

“This doesn’t address the core issue, which is ratings being paid for by issuers,” said Christian Stracke, a strategist at CreditSights Inc. in London. “It’s a good first step but it leaves a lot of wiggle room.”

Borrowers pay for credit ratings rather than investors. Potential conflicts of interest between rating companies and the banks that pay their fees were flagged last year by European Central Bank President Jean-Claude Trichet and U.S. Senate Banking Committee Chairman Christopher Dodd. The Securities and Exchange Commission said in August it was examining the way the companies assign ratings.

Prada, France’s securities regulator since 2003, focused on possible conflicts between ratings companies and investment banks that create collateralized debt obligations. “The first depends more and more on the second in their business development,” he said in September.

“S&P’s ratings business doesn’t provide consulting services and our analysts do not provide consulting services,” said Martin Winn, a spokesman at the company in London. “Together with the other rating agencies, we are proposing changes to the code that would explicitly prohibit ratings firms from carrying out these activities.”

Moody’s earned $884 million in 2006, or 43 percent of total revenue, from rating so-called structured notes, securities that package asset- and mortgage-backed debt, according to Neil Godsey, an equity analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. That’s more than triple the $274 million generated in 2001.

CDOs are created by packaging assets including bonds, loans or credit-default swaps and using their income to pay investors. The securities are divided into different portions of varying risk, offering a range of returns.