Securities: US questions value of "ratings agencies" as part of securities industry review

For more than a decade, the USA's SEC has insisted that the ratings of listed companies should include a rating by one of three companies, leading to their securing a position of considerable strength in the US and beyond.

Even though there has been criticism of the system, in some cases regarded as the outsourcing of risk assessment without adequate review of the results, and of conflicts of interest, the SEC has persisted with its approach.

Further, when, in the early days of the global financial crisis, it became apparent that rated were valued not on assessment of the quality of the asset but, to a significant degree, on the reputation of the financial institution standing behind them, the credit ratings companies remained untouched. When Fed chairman Bernankie was asked in a senate hearing in November 2009 how an asset-backed security filled with low quality loans could be assigned a AAA rating, his answer was that that was a matter for "the ratings agencies."

But sufficient voices were raised so that questions began to be asked - and the Dodd-Frank Act included a requirement for the downgrading of the value of ratings assessments in a wide range of asset classes.

Now, with the USA bordering on insolvency, the ratings companies are rumoured to be considering downgrading US debt for the first time in its history. The USA is panicking: downgrading its debt could have serious negative repercussions for the US dollar and for the US economy - and, of course, for international trade and dollarised economies.

The US has started a rearguard action. It has proposed a new rule relating to "an expedited registration process known as shelf registration." It is not the first time this subject has been approached: in April 2010, the SEC undertook a process of consultation. But now it has revised its documents and re-issued them. The SEC says "Asset-backed securities are created by buying and bundling loans... Often a bundle of loans is divided into separate securities with different levels of risk and returns. Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities. Most public offerings of ABS are conducted through expedited SEC procedures known as “shelf offerings.” The crisis revealed that many investors were not fully aware of the risk in the underlying mortgages within the pools of securitized assets and over-relied on credit ratings assigned by rating agencies, which in many cases turned out to be wrong."

The wording is fluffy: it means that people bought shares in an investment vehicle having no idea what was in it, often based on little more than an assessment of its credit rating by one of the companies.

In short, they bought a pig in a poke because someone else said it was a good idea.

After the initial consultation, responses said that the SEC was not going far enough to ensure that those managing asset backed securities made available the detail of what was in the package. The new proposals add more requirements for disclosure of the nature of the bundled assets. And for less reliance on a blanket third party recommendation.

It is not the only way the SEC is bringing pressure to bear on the ratings companies.

On 26 July, 2011 " The Securities and Exchange Commission voted unanimously to adopt new rules in light of the Dodd-Frank Wall Street Reform and Consumer Protection Act to remove credit ratings as eligibility criteria for companies seeking to use “short form” registration when registering securities for public sale."

"The new rules eliminate the credit ratings criteria and replace it with four new tests, one of which must be satisfied for an issuer to use Form S-3 or Form F-3. In order to ease transition for companies, the rules include a temporary, three-year grandfather provision," says an SEC statement.

“This action is part of our effort to reduce reliance on credit ratings, as the Dodd-Frank Act requires all financial regulators to do,” said SEC Chairman Mary L. Schapiro.

As the battle lines are drawn, an interesting situation is developing. How far with the financial regulatory parts of government go in relation to Dodd-Frank - and how much will the US Treasury take into account the possible downgrading of its own debt when considering how much influence to exert on the regulators in relation to the value of credit ratings.

The battle is not yet over. Indeed, it has been exported. Credit rating of several European countries has been highly influential in hampering the ability of those countries to raise money as they struggle with the long-tail effects of the financial crisis which, to be fair, tipped already teetering economies into a huge hole. As Greece, Ireland, Portugal and Italy, in particular, are lined up to be the next one to see their debt downgraded in a death-roll worthy of a crocodile, those countries are fire-fighting on multiple fronts. However, in the great scheme of things, they are marginal economies. There the threat is not whether individual countries fall into a mess - they are already there - but whether their problems bring down the Euro.

It is that threat that, ultimately, the credit ratings companies have over the USA. When Japan's debt was downgraded, it entered and remained in a cycle of recession and stagflation. The USA is, in many parts of the economy, heading the same way. With government borrowing seemingly out of control, its public debt is already heading towards levels, in percentage terms, not unlike some of those troubled European countries. It already exceeds, as a percentage of GDP, that of some of the world's poorest and most troubled nations.

With both sides of the US government re-looking at their figures after being told today that both sides have got the numbers wrong, the risk of the USA breaching its budget ceiling in the next few days is looking likely. But we've been here before and the US Treasury has said that there are ways of buying a few extra days by postponing non-essential (for which read not credit rated) payments. But if the US were to default on its debt, then the credit ratings companies would have little alternative but to assess the country as less reliable.

The reality is that the USA's credit is already under serious doubt: the only way it survives is by increasing its borrowing requirement and increasing taxes. This is, on any sensible analysis, insolvency.

The question, then, is not why are the credit ratings companies looking at downgrading now but, rather, why have they not done it before?

Was it in the hope that the expected assault on their business practices under Dodd-Frank would be less stringent than feared and now the plans are out, a little muscle is in order?

Or was it because the USA has always wriggled its way out of trouble and the global economy needs faith in its ability to do so again and that the country's debt rating is as important a part of keeping that illusion alive as the platitudes from Washington?