Issuer financing is viewed by some as a conflict of interest too enticing for credit rating agencies to ignore. Investor fee structures are among the solutions being considered by the US Securities & Exchange Commission (SEC) in preparation of a report due to Congress next month.
The report will include the SECs analyses of seven alternative compensation models for nationally recognised statistical rating organizations (NRSROs) outlined by the Government Accountability Office (GAO) in January. But there is a frontrunner.
The SEC requested comment on alternative NRSRO compensation models in May 2011. Almost all of the comments in support of an alternative model favoured one in which a government board would randomly assign securities to credit rating agencies still paid by issuers this is referred to as the random selection model.
The random selection model is similar to a provision of the Dodd-Frank Act that was passed by the Senate but blocked in the House of Representatives. The provision, or the Franken amendment as it was coined, was replaced with section 939F which directed the SEC to conduct a two-year study of NRSRO compensation models.
The SECs two years expire in July, and the random selection model will be implemented unless the commission decides another model better serves investors and the public interest.
Michael Binz, managing director and business leader of asset-backed securities at Standard & Poors, lobbied against the proposal during the American Securitization Forums annual meeting last month.
If one agency provides a higher level of quality and analysis the market will be effectively deprived of that analysis unless the government chooses that particular ratings agency, Binz said.
The SEC may decide other Dodd-Frank regulations like annual NRSRO examinations, the first of which was done last year, might be sufficient solutions to the ratings shopping problem either perceived or real.
The downside of giving the SEC such a long period of time is that it removed the urgency of reform, and now the political winds may be heading in a different direction, Jeffrey Manns, a securities law professor at George Washington University, said.
Other models being considered by the SEC are the investor owned model which requires issuers to obtain a credit rating from an investor run NRSRO, a stand-alone model that allows NRSROs to choose which securities to rate with proceeds coming from transaction fees, a designation model with a third party overseeing fees to be paid to NRSROs in accordance to holder designations, a user-pays plan that is what it sounds like, a modification of random selection called the alternative user-pays model that has NRSROs bidding on the right to rate securities, and an issuer and investor dual pay program.
The alternative user-pays model
Manns thought up this model and submitted it in a comment letter to the SEC last September. It is one of the seven options included in the GAO report. This model is a random selection hybrid in which an agency or independent board is funded by investors to select NRSROs based on both past performance and competitive bidding.
If reforms simply entail random assignment of rating agencies, its not clear the system would incentivise more accurate ratings, Manns says. If we have a purely performance based standard where past performance determines who rates what securities, the danger is every rating agency may converge on the same standard.
Rational agencies would not want to deviate from each other because they would all be rewarded similarly if they follow the heard, an outcome which would defeat the purpose of reforms, he added.
A new compensation system is partly supported as a way to increase competition in the credit rating agency sector largely dominated by the big three: Standard & Poors, Moodys and Fitch Ratings.
We support efforts to promote competition, but we think this government board would do little to create incentives for agencies to compete, Binz said of the random selection plan.
Claire Hill, a law professor at the University of Minnesota, said competition can allow issuers to credibly threaten to take their business to another rating agency if the issuer does not like the rating it receives for its securities.
Certainly, as to the securities involved in the crisis, competition among rating agencies didnt help, and indeed hurt quite a bit, said Hill.
The GAO noted in its report that none of the models were very detailed. The SEC will have to conduct an extensive cost-benefit analysis of which ever model it chooses to propose. Furthermore, language in Dodd-Frank requiring the SEC to implement whatever is in the public interest could mean more of the same. Investors, credit rating agencies and other experts will get a peek at the SECs plans next month.