This blog post continues our expert analysis of complex investments and their regulation.
The SEC has issued a report (as part of the ongoing Dodd-Frank Act implementation) that addresses the credit ratings of structured finance products. (SEC) While this 82 page, 591 footnote, plus appendix report will surely be at the top of everyones Christmas reading list, I have taken the time to give you the highlights. It all comes down to conflicts of interest in the payment structure of the ratings agencies. Right now, it is presented as a false dilemma between issuer-pay and subscriber-pay models.
Obviously, there could be myriad other payment models. Nevertheless, here's the latest thinking on these options:
Under the issuer-pay model, the NRSRO is paid by the arranger to rate a proposed structured finance product. As discussed above, investors may not purchase a structured finance product if it is not rated at a specific level because, for example, they are subject to laws or regulations that provide benefits or relief based on credit ratings. Investors also may be subject to investment guidelines that require the instruments they hold to be rated at or above a certain category in a rating scale (e.g., the four highest categories). Arrangers also desire higher credit ratings to lower financing costs of the products they structure as lower ratings generally result in higher interest rates. For these reasons, this payment model presents an inherent conflict of interest because the arranger has an economic interest in obtaining credit ratings that are demanded by investors and that lower the issuer’s financing costs and the NRSRO has an economic interest in having the arranger hire it in the future.38 This creates the potential that the NRSRO will be influenced to issue the credit ratings desired by the arranger.
As with the issuer-pay model, the subscriber-pay model also presents certain conflicts of interest. These conflicts result because subscribers – the source of the NRSRO’s revenues – could have an interest in specific credit ratings and, consequently, could exert pressure on the NRSRO to determine or maintain credit ratings that will result in outcomes that favor the subscriber.69 For instance, subscribers may use the credit ratings of the NRSRO to comply with, and obtain benefits or relief under, statutes and regulations using the term “NRSRO,” or subscribers may own investments or have entered into transactions that could be favorably or adversely impacted by a credit rating issued by the NRSRO. In other words, a subscriber (like an issuer) may have an interest in the NRSRO determining or maintaining a particular credit rating. In cases where the interests of a substantial number of subscribers are aligned, this potential conflict may be heightened.
See our previous coverage of NRSROs under Dodd-Frank here.