Like reversing the epigram in T.S. Eliot’s “Murder in the Cathedral,” Congress’s last temptation in financial reform is to “do the wrong deed for the right reason.” The credit rating agency liability concepts in both the House and Senate financial reform bills are “wrong deeds” in this sense.
A number of academics, industry bodies, regulatory agencies and Congress have been working on ideas to strengthen the securitization process. As we know only too well, rating agencies downgraded thousands of Triple-A residential mortgage-backed securities (RMBS), which, because of interconnected investor rating requirements, had a devastating impact on the financial system.
It is reasonable to assume that some types of conflicts of interest may have incentivized rating agencies to provide inflated ratings. Leaving aside whether a conflicted issuer (who wants to sell more AAA bonds) or a conflicted institutional investor (who wants high-yielding AAA bonds because he doesn’t bear any responsibility for loss) may have a worse incentive to demand inflated ratings, many hold rating agency exemption from liability for the quality their ratings to blame.
But most who advocate rating agency liability have imagined liability on par with that elsewhere in the financial system. Not, apparently, those in Congress. Hence, Congress is entertaining a strange provision to set a lower pleading standard for rating agency liability, making it easier to sue rating agencies than other financial market participants.
The liability standard for rating agencies established by the House bill hinges on “gross negligence as the requisite state of mind,” while the Senate bill would make it sufficient to show that the credit rating agency “failed to conduct a reasonable investigation” or to “obtain reasonable verification” of factual elements used in the rating process.
Both of those standards are lower than liability imposed on private securities lawsuits under the Private Securities Litigation Reform Act (PSLRA), making the agencies the lightning rod for securities lawsuits. That doesn’t make sense unless you want to reduce incentives to rate small businesses, municipalities and emerging technologies, increase their cost of capital, and weaken our already anemic economic recovery.
This form of discriminatory liability is bad law. As Warren Buffett testified before the Financial Crisis Inquiry Commission, rating agencies “made a mistake that virtually everybody in the country” — including bank regulators with true inside information — made. We didn’t know what we didn’t know. Hence, it is easy — even if specious — to argue after the fact that one should have done something different to avoid a loss without reference to materiality or ex ante information.
The real question for regulatory reform, then, is how can we know more so that rating agencies and others can make better decisions for which they can reasonably be held liable? The key — discussed early in rating agency hearings and the press but lost in the political shuffle of reform — is the due diligence function. Due diligence, it seems, has been confused with rating agency analytics and has therefore not gotten the attention it should receive.
Third-party due-diligence firms, like Clayton Holdings in Connecticut and the Bohan Group in San Francisco, are hired by investment banks to re-underwrite a sample of mortgage or other loans in the pool to be securitized as a check on how well the pool matches the seller’s stated underwriting standards. A sample of sufficient size should yield a reasonable representation of the quality of loans in the pool.
But as mortgage lending boomed, many due-diligence firms scaled back their statistical sampling at Wall Street’s behest. “By 2005, the firms were evaluating as few as 5 percent of loans in mortgage pools they were buying, down from as much as 30 percent at the start of the decade,” according to Kathleen Tillwitz, a senior vice president at DBRS, a credit-rating firm.
Subprime mortgage security prospectuses do not enumerate the methods or findings of due-diligence reports, and the firms are not authorized to release the detail of the reports, even to the rating agencies, without written permission from the underwriter or trustee. While trustees used to allow junior investors to hire due-diligence firms to perform follow-on analyses, trustees have rebuffed such investor requests since early 2008. As a result, the market continues to impose a “lemons discount” on mortgages, and both the primary and secondary securitization sectors remain suppressed.
It seems, therefore, that the first step to securitization rating problems would be to require minimum levels and reporting requirements for due diligence.
Moreover, the due-diligence problem and the causes of the financial crisis are largely confined to structured finance. The unduly harsh liability concepts, however, penalize issuance in all sectors, even those where rating agencies provide valuable and high-quality information. Sectors like municipal bonds — which will be crucial to smoothing the local effects of the crisis in the face of declining property tax revenues — will be needlessly affected by the proposed legislation.
U.S. capital markets are one of America’s greatest contributions to the world, enabling the creation of roads, schools, small businesses and new technology in scores of countries and towns around the globe. At a time of great economic volatility and sluggish job growth, Congress and the president should not jeopardize capital markets by unnecessary and punitive proposals.
Let’s craft reform that relates to the specific causes of the crisis — even including removing ratings mandates for investors — but let’s keep the focus on helping the industry move forward without creating needless impediments to growth.