Please refer to important disclosures at the end of this report.
In reviewing the agreement between New York State Attorney General and the NRSROs (credit rating agencies with governmentally outsourced authorities) we are struck by the reality that his agreement does little to advance fundamental changes in rating processes and rewards the rating agencies with the ability to create more revenue streams from issuers. These fees will almost certainly be passed on to issuers and, in turn, borrowers. In fact, given what we know of the rating agencies practices, of ongoing flaws in their models and of cultures that lead us to very strongly believe there are smoking gun “Henry Blodget era like” emails it seems curious that at his second time at bat in this investigation Cuomo has settled on rewarding those institutions that were the gatekeepers who frequently wrongly rated and therefore enabled the sale of high risk securities to banks, insurance and pension investors.
He has crafted a solution that will likely result in increased consumer borrowing costs and, by effect, erodes the authorities of Federal regulators. There is nothing of substance in the agreement that achieves the public good that would be best served by reducing investor reliance on rating agencies.
In his first ‘at bat’ he handed Fannie and Freddie the keys to functionally enforce and set the appraisal standards of conduct that all banks and mortgage originators are required to meet in order to be able to sell mortgages to these Government Sponsored Entities.For a State official to craft national standards for entities that were created, and are (even in the minds of S&P officials) Federal government obligations, is unusual and probably unworkable.2 We expect that he will ultimately be challenged on this action and OFHEO may ultimately have to back away from their uneasy support of it. Were Cuomo, or any of the regulator’s, to seek meaningful reforms they could take a number of specific and discreet actions. We detail some of our recommendations at the end of this report.
We find the, just released, rating agency agreement to be even more worthy of public scrutiny. Below we detail the items listed in the Attorney General’s statement (http://www.oag.state.ny.us/press/2008/june/june5a_08.html ) and review them:
• Fee Reforms. Credit rating agencies are typically compensated only if they are selected to rate an RMBS by an investment bank. Credit rating agencies will now establish a fee-for-service structure, where they will be compensated regardless of whether the investment bank ultimately selects them to rate a RMBS.
Other than increasing the revenues for these rating agencies this part of the Cuomo agreement does nothing to address the underlying truth stated by former Moody’s Executive Brian Clarkson “you start with a rating and build a deal around a rating”.3 While it certainly does exist, rating shopping appears to be a more significant issue in single-issuer debt ratings than in structured ratings. Given that single issuers (corporations, municipalities, sovereign governments) exist prior to their rating and it is more difficult to change their existing businesses, balance sheets, income statements or structures in anticipation of review, rating shopping is a rightful concern. In the world of structured securities, however, where the corporation (trust) does not exist prior to the rating and the structure that must be achieved in ordered to garner a desired rating are largely defined by the rating agencies. As a result rating shopping is less a concern than is the pre-rating back and forth negotiations and substitution of underlying collateral which allows issuers to work with the rating agency until they create the structure that achieves the desired rating.
• Disclosure Reforms. Credit rating agencies will disclose information about all securitizations submitted for their initial review. This will enable investors to determine whether issuers sought, but subsequently decided not to use, ratings from a credit rating agency
The details of this item are still somewhat unclear. That said, unless the rating agencies are specifically required to disclose the details of all “pre-rating feedback” they provide to issuers of proposed transactions this item is fails to achieve the desired ends. Were the rating agencies required to inform investors if and how the originally proposed pool of securities or structures were changed during the pre-rating process there would utility to investors. Unfortunately, such a demand might result in issuers deciding not to go through with the rating assignment. Instead, the issuer could return to the rating agency with the same deal slightly recomposed, pay a fee to consider this a new deal and then have it rated without any history having to be disclosed.
• Loan Originator Review. Credit rating agencies will establish criteria for reviewing individual mortgage lenders (known as originators), as well as the lender’s origination processes. The credit rating agencies will review and evaluate these loan originators and disclose their originator evaluations on their websites.
The rating agencies have had criteria for rating “servicers” of Residential Mortgage Backed Securities (RMBS) and for “collateral managers” of Collateralized Debt Obligations (CDOs) and these evaluations became nothing more than another rating business upon which rating agencies generated revenues. Recent history demonstrates that the rating agencies appear not to have been any more accurate at rating the servicers or collateral managers than they were at rating the underlying securities. In fact, the growing disparity in the application of loss mitigation (especially loan modifications) efforts by different mortgage servicers does not seem to be as prominent a consideration as they should be in rating agency views of the quality of either servicers or the underlying mortgage pools.
• Due Diligence Reforms. Credit rating agencies will develop criteria for the due diligence information that is collected by investment banks on the mortgages comprising an RMBS. The credit rating agencies will receive loan level results of due diligence and review those results prior to issuing ratings. The credit rating agencies will also disclose their due diligence criteria on their websites.
Rating agencies have largely had the ability to demand, of issuers, any documentation they chose to. A refusal to submit the requested documentation could have been used as a basis to refuse to rate or could have negatively been imputed into the ratings of those issuers that refused to provide the information. In fact, the rating agencies often exercised this power and are routinely provided non-public information from issuers as part of the rating process. This segment of the Cuomo agreement ignores the reality that rating agencies often have useful information that they do not review on a timely basis or that they chose not to properly consider in their rating processes.4 It also ignores that the Voluntary Code of Conduct the rating agencies have committed to with the International Organization of Securities Commissioners already expects “the CRA should adopt, implement and enforce written procedures to ensure that the opinions it disseminates are based on a thorough analysis of all information known to the CRA that is relevant to its analysis according to the CRA’s published rating methodology.”5 Even so, Moody’s claims “ no obligation to perform, and does not perform, due diligence with respect to the accuracy of information it receives or obtains in connection with the rating process. Moody’s does not independently verify any such information. Nor does Moody’s audit or otherwise undertake to determine that such information is complete. Thus, in assigning a Credit Rating, Moody’s is in no way providing a guarantee or any kind of assurance with regard to the accuracy, timeliness, or completeness of factual information reflected, or contained, in the Credit Rating or any related Moody’s publication”6 and Fitch has held a similar view.7
Cuomo’s proposal will certainly provide a boost to the due diligence firms, creating a further public dependence on the proper functioning of yet another unregulated industry segment and embedding that industry segment into the further systemic institutionalization of ratings. It will not necessarily require the agencies to use the information, to verify the information or to act upon the information.
• Credit Agency Independence. Credit rating agencies will perform an annual review of their RMBS businesses to identify practices that could compromise their independent ratings. The credit ratings agencies will remediate any practices that they find could compromise independence.
If S&P Executive Vice President Vickie Tillman is correct in her statement “our reputation is our business; when it comes into question, we listen, learn, and improve”8 then there is really no value to this part of the Cuomo agreement. Unfortunately, we believe that revenue generation is (rightfully) their business and as a government sponsored business with conferred powers and obligations there needs to be either a reduction in the government sponsorship or appropriate and verifiable regulation and benchmarking to make sure that their revenue generation is properly balance with their public utility and public good. It is important that Arthur Anderson regularly argued that their reputation was critical to their business. Unfortunately, like most failed businesses it was the rapid and serious destruction of their reputation and not liquidity, credit or operational risk that sealed their fate.
• Representations and Warranties. Credit rating agencies will require a series of representations and warranties from investment banks and other financially responsible parties about the loans underlying the RMBS.
The issuers of RMBS are already required to provide representations and warranties to investors. To require that they be provided to rating agencies is strange given that the rating agencies are supposed to review deal documents and structure in their rating processes. Moreover, part of the problem in the credit market is that there are not industry standards. The creation of industry standards would be a valuable addition to industry practice and would also obviate the need for any such provisions.
In an attempt to offer productive to regulators who appear flummoxed and lost in the woods of structured securities we offer a non-comprehensive but sincere group of proposals that we hope would be considered or at least stimulate a more robust and productive policy response.
– Requiring that any regulated institution that was required to invest only in highly rated securities should generally hold only securities listed on a major exchange. They would be allowed to hold non-exchange traded securities only if they were able to demonstrate to examiners their own independent analysis in support of rating agency assessments. This listing would result in increased levels of public disclosure about the securities and reduce investor reliance on ratings. It would also foster an environment where both price and value would become apparent in the market and likely result in a lower cost of funding to the issuer in offset of the listing fees. Moreover, it would create disincentives for issuers to pool poor collateral as their public disclosures would make the features of the collateral clear and create reputational risk for those issuers. Issuers that chose not to list could still issue securities but the pool of available buyers would be greatly diminished
– Reducing the structured finance liability exemptions for rating agencies would allow investors, where the rating agency was demonstrated to have knowingly been party to structuring deals in violation of an issuer’s fiduciary obligations. This would cause the rating agencies to refuse to rate bad deals and to increase their level of analysis. While some could argue that this would enrich the trial bar we believe that, given the onus on proving a charge, the ability to seek private action can result in better industry behavior and less need for Federal government intervention (this is a traditional conservative view).
– When a rating agency finds that their model needs to be updated or corrected the rating agency should be required to, on a timely basis, re-rate all existing securities that were rated using the prior model. This would reduce rating migration between differing vintages.
– Unlike single issuer debt, structured securities are intended to be static (outside of a revolving period) and pre-defined lived assets and ratings are an assessment of an estimated default loss-curve over the life of the asset. Therefore, the rating agencies should be required to automate an objective method of utilizing the originally modeled assumptions and re-rating the security monthly using the original assumptions, originally assumed loss curve and tied to the monthly servicer remittance reports. This would reduce the incidence of multiple notch downgrades, would reduce rating migration and would result in a productive information feedback loop by which they would be able to verify and enhance their modeling.
– A qualified team that is fire-walled from revenue line pressures and reports directly to a committee of independent Board members should create ratings models. We are hopeful the Attorney General has announced but not yet entered into such a flawed agreement.
4 Moody’s Revised US Mortgage Loan-by-Loan Data Fields, Apr. 3, 2007. Even in the existing data fields that the agency has used between 2002 and 2007 Moody’s did not ask for pertinent information nor include, as “primary” inputs into their “mortgage matrix” model, important loan information such as a borrower’s debt-to-income (DTI), appraisal type and which lender originated the loan. (“the data fields essential for running the model were established when the model was first introduced in 2002. Since then, the mortgage market has evolved considerably, with the introduction of many new products and an expansion of risks associated with them”)
5 Committee of European Securities Regulator’s Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code – Ref: CESR/06-545 at 13 available at http://www.cesreu.org/data/document/06_545.pdf.
6 Moody’s Investor Service, Code of Professional Conduct 6 (June 2005), available at http://www.moodys.com/cust/research/MDCdocs/01/ 2003400000425277.pdf
7 http://www.cesr-eu.org/data/document/06_545.pdf p.21 (Fitch claims “no obligation to verify or audit any information provided to it from any source or to conduct any investigation or review, or to take any other action, to obtain any information that the issuer has not otherwise provided ”)
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