Under their proposed rules, issuers would be allowed to ask as many ratings firms as they want for preliminary grades. The firms would get paid for doing that work, and would have to show the criteria they used to come to their conclusion. The most lenient grade would be tossed out, and the remaining firms would get a bigger fee.
Determining how lenient raters were would be based on how much “subordination” a deal has -- in other words, how much of the loans backing the bond have to default before investors in the safest securities suffer losses. That tends to be the factor that gets weakened when ratings firms are looking for business, Esaki and White said. In the 1990s, about 30 percent of mortgages in a bond would have to fail before the highest-rated bonds suffered credit losses, but by 2008 that figure fell to as low as 2 percent, they wrote.
Public Findings
The issuer would still choose the graders from those that remain, which means that ratings firms that are too strict won’t win business either, according to Esaki and White. All preliminary findings would be public.
That information could end up being useful for investors, who could find patterns that might make it clear which ratings firms are trying to bend criteria to win market share, said Kim Diamond, a founding employee at Kroll Bond Rating Agency. Diamond said she wonders if Esaki and White’s proposal would encourage ratings firms to focus on engineering criteria to win business instead of honestly assessing credits.
Fixing the incentives that go along with how bond graders are paid isn’t easy. The 2010 Dodd-Frank reform law required the SEC to come up with ways to rein in bond graders’ conflicts. The agency came up with rules to do so in 2014, but stopped short of requiring the firms to change their business models. Kara Stein, then a commissioner, said at the time that “our work is far from complete” in improving incentives for the firms.
Forcing investors to pay rather than issuers may eliminate some conflicts, but has problems too. For one thing, fund managers are reluctant to pay for grades that they are used to receiving for free, as Jules Kroll discovered when he looked at setting up a ratings provider based on investors footing the bill. He ended up instead creating a firm, Kroll Bond Rating Agency, where issuers pay.
This article was provided by Bloomberg News.