Two weeks ago, the Securities and Exchange Commission adopted a new set of credit rating agency regulations. Credit rating agencies are at the top of many financial crisis blame lists because they seemed to blithely give high ratings to all manner of mortgage-backed securities and related products. As is often the case with purported market failures, the government set the stage for failure. Government regulations shaped and molded the credit rating industry, and the SEC's latest set of regulations does more shaping and molding.
For years, regulators forced banks, money-market mutual funds, and others to rely on ratings issued by the few credit rating agencies that enjoyed the SEC's blessing. For example, asset-backed securities were not securities eligible for inclusion in money-market mutual fund portfolios unless they were rated by a government-blessed credit rating agency. Not surprisingly, this led investors to care more about getting the desired credit rating than getting an independent third party's actual assessment of the credit risk.
Dodd-Frank, in a rare flash of rationality, put into motion a plan to remove references to credit ratings from statutes and regulations. Regulators are no longer allowed to mandate reliance on ratings. But Dodd-Frank did not take the necessary next step: It did not get rid of the SEC's system of recognition for credit rating agencies. Credit rating agencies can still sign up to be "nationally recognized statistical rating organizations [NRSRO]." If the SEC approves them, they are subject to an array of rules and an inspection program extensive enough to suggest that the SEC is double-checking all of their work. So even though Dodd-Frank took credit ratings out of statutes and regulations, the government is still implicitly encouraging investors to rely on the work of rating agencies.
We see this "just trust us ‘cause we're on it" message in the SEC's hundreds of pages of newly minted credit rating agency rules. The new rules include detailed requirements related to the internal controls, "training, experience, and competence" of credit analysts, recordkeeping, disclosure, and certifications. Some of these requirements-such as enhanced disclosure about changes in particular credit ratings over time-may make sense. But, taken together, these new rules are costly and generate a lot of paperwork without much promise of delivering ratings of higher quality. Given that the industry is not particularly competitive, investors likely will bear much of the cost of the new rules.
Small credit rating agencies will get stuck in the niceties of ever-thickening compliance manuals as they try to compete with their larger, more established and compliance-savvy rivals. As SEC Commissioner Daniel Gallagher put it, "[t]he more burdensome NRSRO status becomes, the greater the chance of smaller NRSROs deregistering and potential new NRSROs eschewing registration altogether." The SEC is offering smaller firms relief from some of the new requirements, but plenty of requirements remain to trip them up.
The compliance cost burdens of rules are daunting, but an even worse problem is that the rulemaking is an enforcement case generator. SEC Chair Mary Jo White, in her statement on the latest set of rules, thanked enforcement staffers for their "substantial contributions to this rulemaking." SEC enforcement lawyers do not typically get to write the rules that they will later enforce. They might be tempted to write the rules in a way that generates lots of easy cases. That appears to be just what happened here.
One part of the rule prohibits employees who participate in determining or monitoring credit ratings or developing and approving credit rating methodologies from being "influenced by sales or marketing considerations." Commissioner Michael Piwowar correctly points out that "every NRSRO employee, including those involved in ratings determinations, has an interest in the success of the enterprise." Producing effective methodologies and solid ratings is one way to make a credit rating agency grow and attract more business. An aggressive enforcement lawyer does not even have to stretch the language of the rule to argue that an employee working hard to produce high quality ratings was influenced by sales and marketing considerations in exercising such diligence. In Commissioner Gallagher's words, this new prohibition is a dangerous foray by the SEC into the policing of "thoughtcrime."
The desire to get tough on credit rating agencies is certainly understandable, but tightening up the regulatory framework is not the best way to do it. Instead, we need to let the markets punish credit rating agencies that are doing a poor job. Investors are best served by the free flow of information from credit rating agencies and others. Investors can then decide how much credence to give various sources of information. The SEC's attempts to vet certain credit rating agencies' processes, procedures, products, and even thoughts will only lead people to treat information coming out of the SEC's stable of credit rating agencies with more deference than they ought to. And that is what got us into trouble the last time.