Why CRA3 must be scrapped

Author: | Published: 18 Sep 2012
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Europe’s securitisation market has just weeks to persuade EU policy-makers to scrap or heavily-amend proposed credit rating agencies regulation (CRA3) set to take effect before year’s end. The rules could kill securitisation in Europe if introduced in their existing form.

The Association for Financial Markets in Europe (Afme) has been lobbying EU authorities for months to amend some of the rules’ more contentious elements. They warn that changes are to be introduced without meaningful opportunity for feedback on their implications.

CRA3 is the third round of EU CRA regulation to be proposed since 2008. The reforms includes a variety of proposed rules, affecting the use of ratings in regulatory standards, processes for changing ratings and methodologies, civil liability for breaching regulations, selection of rating agencies and issuer disclosure requirements. It aims to inject more transparency into regional credit rating activities, enhance the quality of ratings and improve investor protection.

As Europe’s policymakers meet are set to finalise the changes this month.

Santander Global Banking & Markets’ securitisation head Steven Gandy, Afme’s securitisation division managing director, Richard Hopkin, and Mayer Brown’s Kevin Hawken spoke with IFLR on the most damaging aspects of the rules and why the market must help to scrap the rules

How will new credit ratings agency rules proposed by the European Commission affect the market?

Kevin Hawken: These rules overlap with existing, recent and proposed financial markets regulations in Europe and in other jurisdictions. It's hard to predict specific effects from the combination of all these regulatory changes. But it's clear that in combination they will increase costs and uncertainty. They're therefore likely to hamper re-development of a healthy structured finance market.

We don't know yet whether the proposal, in Article 6b of the rules, to require rotation of credit rating agencies for some class of debt instruments will apply to all instruments other than sovereign debt, to all structured finance or only to re-securitisation. Limiting rotation to structured finance would serve only to further stigmatise and increase costs of structured finance transactions.

However, the boundaries of re-securitisation are unclear, the costs would still be great and I believe the benefits would be none.

Rotation could also distort the market by encouraging parties to limit maturities so as not to have to change rating agencies for a short remaining term. I'm sceptical as to whether it would result in much increased competition or improvement in ratings integrity.

The Article 8a requirement for structured finance issuers, originators and sponsors to disclose all relevant information on a public website could also be very damaging, as it overlaps, and adds to, disclosure requirements that already exist in securities laws, Capital Requirements Directive (CRD) Article 122a and - for loan-level data requirements - central bank collateral eligibility requirements, without incorporating the exceptions and existing guidance that surround those disclosure regimes.

As proposed, this rule would apply to every transaction that falls within the CRD’s broad definition of securitisation, which was designed for an entirely different purpose and includes many private transactions whether or not rated. If the parties have to disclose all the details and the underlying assets in an otherwise private transaction, they won't want to or won't be able to complete the deal in many cases.

Steve Gandy: Some of the proposed changes are unbelievable. The requirement to subject CRA’s to liability for their opinions is a fundamental shift. It’s a big departure from the understood role that the rating agencies have of simply giving opinions. You can’t fine someone, and make somebody criminally liable for opinions. That’s just a basic violation of free speech. That the burden of proof also falls on the CRA in defending themselves against a lawsuit instigated by an investor or issuer will certainly kill the rating market, causing huge disruption to the bond market.

Meanwhile, the stipulation that CRAs pay a tax to ESMA also seems a very clever way of keeping the CRAs in line, especially when the CRAs will have to report methodology changes to ESMA before they implement them. It is clear to me that the reporting of methodologies in this instance, will subject methodologies to political influence, and that gives rise to all sorts of conflicts of interest. There will be humongous political pressure on rating agencies to tow the official line on how they see sovereign risk if they don’t want to be penalised for publishing unpopular opinions.

Other requirements simply don’t make sense. It’s hard to understand why sovereign analysts may be required to disclose their physical location, for example. What, so it’s easier for the lynch mobs to get to them? There are also inconsistencies within the drafts. In one section it is stated that ratings must consider environment risks, in another that ratings must only address credit risks. Which is it?

Rating agencies provide a very necessary service to smaller investors in supplementing their own due diligence. Introducing rules that aim to lessen investors’ reliance could create an uneven concentration of very large investors within the investor base, as it is only the sophisticated market players that will have the money and resources available to build the technical expertise to do their own due diligence. That’s not going to help cultivate an investor base outside of the banking system.

Richard Hopkin: The requirement that companies change the ratings firms they use for some classes of debt instruments every few years is a particularly dangerous experiment, for which the case has neither been made nor properly considered. The requirement formed no part of the European Commission’s public consultations on CRA3 in 2010. It’s simply not good process to make a big change like this without first soliciting meaningful discussions with the market.

A credit rating agency has to have credibility with investors. Achieving that takes time. Mandatory rotation will destroy necessary continuity in the CRA’s monitoring of the issuer and its business sector. It may also negatively impact CRA quality in bringing in firms without the necessary experience or reputation to provide sound analysis. That applies not only to structured finance but also to any other fixed-income products.

Another worrying aspect of the Commission’s proposals is a provision to force an outgoing credit agency to hand over company files to an incoming CRA. When you have a relationship over a period of years with a credit rating agency, confidential information is discussed. If, however, an issuer knows that within a year or two that information could be in the public domain, because that CRA may be forced to hand it over, that creates an incentive for issuers to withhold information. It’ll undoubtedly have a chilling effect on what would otherwise be open discussions.

How should the market prepare for the introduction of these rules?

Kevin Hawken: It's important that market participants communicate their concerns to lawmakers who will be debating and working to finalise these rules and to the regulatory authorities who will then have to draft and implement detailed rules and guidance. Especially in the case of Article 8a, we need to point out and convince them of the need for more coordination and consistency where there are different sets of rules covering the same transactions.

Steve Gandy: We need to get the word out to make people aware. We have to have greater attention to lobbying efforts. We need more market participants to support groups like Afme and all those who are trying to keep the barbarians at bay.

We need to get the press on our side to rescue this whole business, and the political miasma that it’s in. Rating agencies are not the source of all evil; they were not the sole cause of the financial crisis. It’s not helpful to create scapegoats and go after them with all guns blazing.

We need to take some of the emotion out of this and begin more rational discussion on the topic.

Richard Hopkin: It’s been disappointing to see issuers in other sectors of the fixed-income market become less willing to speak out against rotation as a matter of principle. Certainly, since the proposal was cut back to only apply to structured finance, the volume of objections has fallen. I think that’s short-sighted. 

At a time when banks face years of forced deleveraging of balance sheets, increasingly hard to find capital, and more expensive unsecured funding, structured finance plays an absolutely key role in helping hard-pressed homeowners, consumers and small businesses in the real economy. 

For the full interview, see The 2012 guide to Securitisation & Structured Finance out from September 25 in IFLR magazine’s October issue.

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