Capital Markets

Treasury Treads Lightly on Rating Reform

A top Treasury official says proposed reforms walk a fine line between interfering with the rating agencies' business and giving the raters too muc...
Sarah JohnsonAugust 5, 2009

The Obama Administration’s laundry list of proposals for fixing the rating agencies got a ho-hum response Wednesday from longtime reformers who had been hoping for stronger demands.

For those critics who question the reforms the Administration left on the cutting-room floor, the U.S. Treasury Department, which is spearheading changes to the U.S. financial regulatory framework, has a quick answer: too much interference into the raters’ business could lead to further reliance on their work.

Michael Barr, assistant secretary for financial institutions for the Treasury, continually used that reasoning during his testimony before the Senate Banking Committee on Wednesday, two weeks after the department proposed legislation. “We would want to be careful not to take steps that would suggest excessive confidence in the ratings themselves,” he said.

As it is, Barr and a number of senators observed, shareholders have been overly reliant on the agencies — mostly the Big Three of Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s — when making investment decisions involving corporate and municipal bonds and structured-finance products. It’s the latter, of course, that got the agencies in hot water when the credit crisis hit.

That’s because some of their ratings of financial products tied to the subprime-mortgage market didn’t accurately depict the risk of default. The raters have also been blamed for contributing to the crisis by not reacting fast enough to changes in the marketplace.

For the past two years, lawmakers and regulators have been mulling how to repair the credibility of what many believe is a failing niche industry. Among the questions raised:
•Is the Big Three’s issuer-pay model inherently flawed — and should it be scrapped?
• On the other hand, don’t investor-pay models have their own conflicts of interest?
• Should the government change rules used by banks and insurance companies that require the use of certain rating agencies?
•Is the Securities and Exchange Commission doing enough to keep the agencies in line?
•Or should a newly created entity — à la the Public Company Accounting Oversight Board — take over?

Nevertheless, as Senate Banking Committee chairman Christopher Dodd (D-Conn.) lamented, “No one has a quick solution.”

In the bill it’s pushing, Treasury’s proposals include banning raters from providing consulting services to issuers they rate and forming a separate SEC office to oversee the raters. (The job currently falls under the commission’s Division of Trading and Markets.) Further, Treasury would put some onus for ratings transparency on the companies that hire the firms to rate their debt. Issuers would disclose how much they paid for each rating along with any ratings they were offered by raters that were trying to win their business.

Barr was open to the senators’ suggestions for refining Treasury’s legislation — but only in minor ways. “We tried to draw a line to be quite clear that the government shouldn’t be in the business of designing the methodologies of the rating agencies or validating them in any way,” he said.

Dodd prompted that response after suggesting the rating agencies should be formally required to do their own due diligence. (They currently base their ratings on information issuers give them.) Dodd said he was “stunned” to learn the agencies don’t consider other kinds of information from outside sources that could contradict that data.

What Treasury’s proposal would do, Barr said, is cut back the agencies’ conflicts of interest, make their processes more transparent, and reduce so-called ratings shopping, wherein companies grant their business to the agency that promises the best rating.

None of the proposals were surprising, participants said. James Kaitz, president and chief executive of the Association for Financial Professionals, said the legislation does not reflect “substantive change.”

“We could not support the legislation in its current form,” he recently told

Kaitz, a longtime advocate for reforming the ratings industry, has suggested that the agencies adopt a new business model that would rid them of their biases by limiting their business to ratings issuance. That concept, however, would erase their lucrative consulting business.

Barr said Treasury considered a range of business models, but feared legislating one system over another could “enshrine the rating agencies even more…[by] giving them the government seal of approval.”