Caught napping, sorry folks…

A surprise for the ratings agencies, the bond market, and me, too – this has to be a late change in the Financial Reform bill, and it’s a corker. From the WSJ:

The nation’s three dominant credit-ratings providers have made an urgent new request of their clients: Please don’t use our credit ratings.

The odd plea is emerging as the first consequence of the financial overhaul that is to be signed into law by President Obama on Wednesday. And it already is creating havoc in the bond markets, parts of which are shutting down in response to the request.

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days.

Update: a few more details here and here.

Monster update: I can’t find the final text of the Bill, and nothing but broken links to older versions, so it will have to be the House press release. The big sticking point for the ratings agencies is evidently the liability clause here:

Liability: Investors can bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. NRSROs will now be subject to “expert liability” with the nullification of Rule 436(g) which provides an exemption for credit ratings provided by NRSROs from being considered a part of the registration statement.

So yeah, June 29th at the latest. Missed it. Liability was always part of  Partnoy’s script for Ratings Agency reform, which is a  source for the changes that went into the bill:

Historically, the threat of liability has been an effective tool in encouraging gatekeeper accountability. In general, gatekeepers are less likely to engage in negligent, reckless, or fraudulent behavior if they are subject to a risk of liability.

Although most financial market gatekeepers have been subject to serious threats of civil liability, credit rating agencies have not. Some market observers believe that, with appropriate changes in policy, litigation could become a viable tool for ensuring NRSRO accountability.

Rating agencies have been sued relatively infrequently, and rarely have been held liable. As rational economic actors, rating agencies factor in the expected costs of litigation, including the cost of defending lawsuits as well as any damage awards or settlements. Given the litigation track record, the fact that the rating agencies have published unreasonably high ratings should not be surprising.

Litigation against the credit rating agencies often is deterred by statutory provisions and judicial precedent that limit the liability of NRSROs. NRSROs are immune from liability for misstatements in a registration statement under Section 11 of the Securities Act of 1933. Securities Act Rule 436 explicitly provides that NRSRO are exempt from liability as an expert under Section 11.

The demise of Ratings Agencies’ exemption from Reg FD, which these chaps mentioned as another issue, is also addressed by Partnoy:

For years rating agencies have enjoyed an exemption from Regulation Full Disclosure, or Regulation FD, which allows the rating agencies to receive inside information from issuers that is not shared with the market. The agencies contend that the exemption is needed in order to fully evaluate credit risk. NRSROs say the Regulation FD exemption allows them to alert the public to any substantial changes in the status of a security more quickly and clearly through rating upgrades, downgrades, and watches. Moreover, some argue that credit rating agencies should be able to receive material non-public information from arrangers for the purpose of developing unsolicited credit ratings.

But a strong case can be made for removing this exemption. Rating actions, without a substantial increase in transparency, can cause confusion and speculation. And unsolicited credit ratings are rare. Unless that practice becomes common, there is scant justification for giving credit rating agencies access to inside information through a Regulation FD exemption. Moreover, it is far from apparent that credit rating agencies have incorporated inside information in their ratings. Most notoriously, even though Enron made non-public credit rating agency presentations, information about the risks described in those presentations was not reflected in Enron’s credit ratings. The same has been true of structured finance ratings. For these reasons, the board should have the power to limit the subsidy given to credit rating agencies to obtain, and act upon, material non-public information.

So – this part of the change is the demise of a subsidy (in the form of insider information) that the agencies often didn’t exploit anyway. I bet they wish they had used more insider info in their ratings process now…

So it’s the liability clause that really matters; the Reg FD part is just griping. What happens next? Well, Partnoy wouldn’t like the way adding  this liability clause has panned out:

…it is not feasible or practical for regulators and investors simply to stop using ratings. Mandates to use ratings have become part of the fabric of financial markets, and cannot be unwoven instantaneously.

Let’s see if the pleas by ratings agencies have that instantaneous unweaving effect, shall we? Remembering that ratings are embedded both in investment mandates round the globe, and in Basel II definitions of bank capital, what will their declarations do to investor appetite for new corporate bonds, new ABS, and new sovereign debt?

Possibilities, half-baked and possibly hyperventilating wildly:

  • Total logjam of all classes of new debt issuance everywhere.
  • Ratings agencies’ pleas quietly ignored, because you can’t rewrite Basel II and tens of thousand of investment mandates in a day; and we all carry on in some sort of la-la land where officialdom pretends to think the agencies are now liable, but everyone knows they still aren’t really.
  • Someone gets the Tipp-Ex out before the Bill lands on Obama’s desk (later today).
  • Someone tells the ratings agencies to stop fooling around.

“Informed reader input is most welcome”. I note that there’s very little newsflow on this so far, which does suggest that the more lurid outcomes above may be on the fantastical side.

I’ll do some archaeology on how this change got under my radar, for my own peace of mind, in slower time.

Final update:

Well, I’ll be damned, something got watered up in the final version! Here’s the timeline:

Konczal in May bemoans the absence of the stiff 436(g) language (present in the House Bill), from the Senate Bill.

Ritholtz spots some late tightening fiddling with this part of the Bill in mid-June.

And some time after that, the stiff House language (or something like it, because I still can’t find the final version of the words) gets reinstated: and here we are with the sulking RAs.

That’s a reminder of the perils of jaded cynicism…not enough to make me discard the “la-la land” option, above, though.

Final final update – Tracy A. at FT Alphaville filling in all sorts of gaps.

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  1. alex black

    Faster than a speeding bullet, the Law of Unintended Consequences becomes the first aspect of another of Obama’s initiatives to go into effect.

    Although in this case, maybe neutering the ratings agencies isn’t such a bad idea

    1. Byzantine Ruins

      > Faster than a speeding bullet, the Law of Unintended
      > Consequences becomes the first aspect of another of
      > Obama’s initiatives to go into effect.

      > Although in this case, maybe neutering the ratings agencies > isn’t such a bad idea

      I find it hard to muster much sympathy for the raters. It amounts of ‘rats, years of cheating undone!’ How did they ever get this position where they are written into statute yet not held to any standard for that behavior? Great legal fiction if you can afford to buy it.

    2. Anthony

      Why do you assume unintended consequence? Don’t you believe in the FREE MARKET? How does protection from litigation = FREE MARKET? Protection from litigation sounds like a good example of bad government intervention.

    1. Richard Smith Post author

      Indeed. I’ll be following up again shortly, once I’ve scrabbled around a bit.

  2. Skippy

    Its fees fees fees until your words actually mean something, as in taken to court for them, have legal weight.

    What a racket.

  3. John Maynard Keynes

    Priceless – from the Globe and Mail link in the updates:

    Fitch is not a fan of the new rules and, ironically, argues that it should not be considered an “expert” under the Securities Act “since ratings are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts.”

    1. jdmckay

      Hilarious indeed.

      Fitch (…) argues that it should not be considered an “expert” under the Securities Act

      Implies they consider themselves “experts” as long as no accountability required, right?

      “since ratings are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts.”

      Geezus… that embodies mentality of entire WS $$ management directing US investment AFAIC. Could be an epitaph on grave of our K-Street driven “capitalism” snorting spree.

  4. i on the ball patriot

    Another ‘historically guided possibility’ …

    After a little flurry of adoring ‘Snowbama — Change You Can Believe In’ propaganda it will be business as usual.

    The phony issuers will still “rate shop” and the cost of possible litigation will be factored into higher ratings fees. Lawyers will now get in on the fee churn and ratings agencies at the bottom will be consolidated into the top three or four agencies — part of the grand plan. Don’t forget that scam ‘rule of law’ where guys like Lloyd Blenkfein simply pay comparatively small fees for grossly outrageous crooked profits.

    Snowbama gets brownie talking points and the masses get dicked a little harder.

    Deception is the strongest political force on the planet.

  5. Bates

    “since ratings are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts.”

    Then rate them accordingly! Finally, some ‘change we can believe in’! If these rules had been in place prior to the explosion of sub prime lending, would the tranches of sub prime mortgages, no doc, liar loans, alternate A, outright fraud, etc, have been rated investment grade by various ratings agencies?

    How would the Goldman Sachs ‘guaranteed to fail’ structured assets, bundles of home loans known to be very likely to fail, have been rated? These piles of crap were sold to ‘investors’ that had not a clue what was in them. But, the ratings agencies had rated them investment grade. GS sold them as investment grade and had structured them for a particular client that had requested a ‘structured asset’ that was almost a lead pipe cinch to fail…Why, because the client wanted to short the structured asset and guess what, he made a bundle. What about the fools on the other side of that trade? Of course they were stupid but if the raters had done due diligence and rated the piles of crap accordingly there would probably have been no business conducted in those tranches of crap. So, the new rules make sense. If a rater knowingly commits fraud, or does not perform due diligence, that rater should be liable when the ‘asset’ blows up. If this rule goes into effect then every asset will have to be re-rated…and ratings will be going down, not up.

    I am not saying an ‘investor’ should be let off the hook for bad decisions. I am saying that a ratings agency should be looking very closely at any asset it rates. Former employees of ratings agencies have come forward and admitted that some ratings were given over the phone after a few minutes conversation. How can anyone rate a 2,500 page very complex document describing an asset after a 20 minute conversation and without ever even seeing the documentation? In my opinion such action is negligence at best and perhaps fraud.

    It’s past time for the raters to begin performing due diligence…do your homework, or get out of the business.

    I hear the whine coming…but, but, if we perform due diligence those investment banks and customers seeking a higer rating will go elsewhere for a rating. So be it. Smart investors will believe the ratings agency that is honest (wich will probably be the ratings agency offering the lower rating). Dumb investors will go broke. Why bother to have ratings agencies that are offering up ratings that are unrealistic?

    An improved situation would be no ratings agencies rather than ratings agencies that apply lipstick to a pig. No ratings agencies = ‘let the buyer beware’…

    1. Richard Smith Post author

      Thanks. Here’s the relevant piece, and yes, it’s the House words.

      SEC. 939G. EFFECT OF RULE 436(G).

      Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933, shall have no force or effect.

  6. Mikhail Kropotkin

    So… the big boys will now, supposedly, know what they are doing, courtesy of, now, realistic appraisals by their mates. For a change. *Snort*
    Meanwhile, as kneejerk behaviour by every other capitalist continues in it’s enormously well informed manner, along with the “austerity we all had to have”, work becomes harder to find. Even harder. Don’t expect the rest of us to start buying right now. Trickledown does not work and we are still not happy. Time for a change?

  7. Doug Terpstra

    Surely this is a mistake. Accountability for the masters of the universe? It violates the natural world odor, akin to suspending gravity or appointing someone “controversial” (unapproved by the WSJ) to head consumer protection. If true, Dodd and Frank have just jeopardized their future ‘consulting’ propsects.

    A more careful reading may reveal this to be a bizarre typo, or one of 3,000 pages stuck in the printer. Otherwise, the lobbyists that wrote this travesty of a ‘reform’ bill should be fired immediately and charged with malpractice. In any case, there is not yet cause for such panic: a loophole will be forthcoming in short order.

  8. Richard

    Suppose the bill had contained the following:

    “Liability: Investors can bring private rights of action against bloggers for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. Bloggers will now be subject to “expert liability” with the nullification of any Rule which provides an exemption for bloggers for ratings by bloggers.”

    Would publish tomorrow?


    1. Richard Smith Post author

      Well I wouldn’t, not with my research record. Yves is a bit feistier.

      But no-one’s paying me money to do this; it is sheer vanity. Nor are they investing based on the accuracy and integrity of my commentary. AFAIK.

    2. RagingDebate

      That is a good point Richard, but free markets that don’t self regulate and cheat are supposed to be a responsibility of the public, government. That collusion of government and Wall St. over the last four decades led to this calamity.

      The Internet self-regulates. Bloggers that put forward unsubstantiated facts or falsehood are blasted from either site owners or other bloggers. Yves has been corrected on occasion and if the facts were off, she revises. Also, she responds to criticism as a form of a public square or town hall. Greenspan in 2004 stated that debate on Central Banking had no place.

      In my world of Internet marketing business, the Internet Service Providers worked conjointly with business and proposed regulation to Washington. If the rules requested as law are broken, at some point I would expect the public to step in forcefully.

      Greenspan spoke often of free markets being self-regulating but finance was only providing lip service.

    3. Doug Terpstra

      It’s materially different when when one is paid to value and/or certify a product, similar at some level to a warranty. Resonable liability ensures independent due diligence. The same should apply to appraisers.

      Liability for commentary or opinion is entirely different, though SCOTUS could find grounds to make individuals liable and grant corporations immunity from almost anything. Oh wait, they already have.

      But IMO, there are cases where bloggers should be held liable, such as the recent case of Shirley Sherrod fired from USDA for “racist comments”. Blogger Andrew Breitbart maliciously edited her speech in order to publicly slander her as a racist, resulting in her immediate firing by knee jerk disgrace Democrat Tom Vilsack. It’s an echo of ACORN’s assassination, in which feckless Democrats characteristically bowed and groveled before the “superior” force of mad tea-potters and villainous wing nuts.

  9. scraping_by

    No unintended consequences here. It’s a feature, not a bug.

    Outsiders find it bizarre that people get huffy about being expected to do what they’re paid to do.

    This one’s probably going to drift away in the mumble of bombast and private understandings that is the way financial markets work these days. It’s hard for an outsider to tell which insider information is legal and which insider information is illegal. The crime is less a definition than an atmosphere. When firms such as GS talk about a “Chinese Wall”, most people roll on the floor laughing while the courts take it quite seriously.

    Similarly, there’s going to be a “You didn’t believe us, did you?” ethic arise around ratings. A healthy dose of “sophisticated investors” and a little dash of “not one of us, you know” with a whole lot of money for lawyers and judges and this can be put back right where it was.

    1. RagingDebate

      Where is the Roman Republic than? It died. Either the public wins or Uncle Sam dies. So much for that sovereign protection for multinational corporations. At that point they had best hope that the Chinese and Russian Communists truly had a “come to Jesus” moment on capitalism and don’t consider themselves sovereign entities like the U.S. elite did. Something about a rope and Karl Marx. Hmmmm…

  10. shrivti1

    I’m writing my thesis about credit agency reform, specifically on implications of increased liability for credit ratings.

    This is not a recent change to the bill at all. In fact, this provision was in the original language of the house bill. A weaker provision was contained in the senate bill which merely took safe harbor exemption away from ratings agencies, but the stronger language of the house prevailed (as was expected. I suspect the weaker senate language was merely an oversight, as most Senators expressed support for rescinding rule 436(g).

    The intent of the rule is to incentivize the ratings agencies to provide accurate ratings specifically for SF products while allowing more straightforward corporate and sovereign ratings to proceed without much problem.

    My guess is that ratings and their methodologies will become more widely available to investors through published and distributed materials (whereas many SF ratings had only been released to issuers and a specific set of investors who had access to the prospectus of the SF deal). This way, MOST ratings decisions will still be covered by 1st Amendment provisions and the resulting reform will be relatively weak.

    Right now, though, it is uncertain how courts will interpret the new provision, and if they will apply a different legal standard to the credit rating in its function as information on the SEC filing under Section 7 and 11 of the Securities Act (liable for negligence as an expert opinion) than its function as an opinion given to investors (protected by the 1st Amendment).

    So right now, agencies are backing off from allowing issuers to use their ratings for ANYTHING (because it is practically impossible to use ratings in prospectuses or advertising materials without using it in the registration statement) until their liability is more clearly understood and defined by the courts.

    1. Richard Smith Post author

      Spectacularly appropriate credentials there shrivti1.

      I knew this was the House formulation of the rule but cynically assumed the soft Senate version would make it into law, particularly since I didn’t pick up any strong lobbying noise. Leaving me mighty underresearched for prompt commentary on the outcome…a short cut too far…hey ho.

  11. Ginger Yellow

    As shrivti1 says, this only covers structured finance offerings, not other debt issuance, so whatever the impact is it will be limited to that sector.

    From what people have told me, the likely consequence will be a slowdown in issuance in the near term, with everything that is issued being done on a 144a basis (where a registration statement is not needed and hence the specific 436g liability issue doesn’t arise). In the medium term, there will likely be some sort of arrangement worked out – for instance including in the registration statment something along the lines of “this deal has been rated by an NRSRO” without naming the agency, or removing the conditioning of sale on achieving a given rating, which is what requires the inclusion of specific ratings in a prospectus. Alternatively, the agencies may just accept expert liability, perhaps in return for higher fees. In the longer term, it potentially becomes irrelevant, as the SEC’s changes to Reg AB remove all rating requirements for public offerings. There still remains a possible problem in terms of material omission, though.

  12. Richard Smith Post author

    Thanks v. much GY.

    “Alternatively, the agencies may just accept expert liability, perhaps in return for higher fees.” It will be very interesting to see if they decide that there’s a subset of structured finance deals for which they could take this sort of risk on. They would end up with a sort of monolinish business model (the losses materializing via litigation).

    I will do a more measured follow up post on this when I am prepped better.

  13. Ginger Yellow

    The thing is, while I’m absolutely not an expert on this subject (if you’ll pardon the unfortunate choice of words), I’m not sure that it will increase their liability all that much. After all, the first amendment defence doesn’t apply to private placements, which makes up much of the structured finance market, nor does it apply to deliberate or recklessly negligent misstatements. It may well be that expert liability opens up new causes of action for a bad rating, but I’m not sure that it will change all that much in practice. But it’s obviously something the agencies haven’t had to consider before, so it may take them time to get comfortable with it.

    1. Richard Smith Post author

      Agree. I wonder if they actually do have a workaround plan already (shrivti1 followed this closely enough to be confident this would be the legislative outcome, which sort of implies the RAs have actually had about 6 months to think it through), and this is just a spot of grandstanding, or a negotiation.

      Time will tell fairly soon – there must be some sort of issuance pipeline backing up, even in quiet times. Somewhere I saw a mention of $3Bn of pending ABS from last week.

      1. Ginger Yellow

        Well, Ford have apparently pulled an auto loan deal, which is the first concrete impact I’ve seen.

        If I had to guess, I’d say this was mainly brinksmanship by the agencies – in other words they’re using this as leverage to whack up their fees as much as possible.

    2. shrivti1

      Actually, Ginger Yellow, I both agree and disagree with you.

      Credit ratings have proved in court to have incredibly strong 1st Amendment protection up to now, including private issues and structured finance deals. There has been one case in which the free speech defense did not work because the rating was not considered public information, but the case was ultimately thrown out because of 436(g).

      And ratings agencies are given an enumerated exemption from a standard of negligence, so they can make all the negligent statements they want and not be held legally liable. That was the beauty of 436(g) for the ratings agencies.

      The new legal uncertainty manifests in a couple of ways:

      1. Every case that dealt specifically with cases of credit rating negligence (as opposed to fraud) had been thrown out by the courts to this point because ratings agencies are not held to a standard of negligence due to 436(g). Fraud is a considerably higher legal standard, and one which is notoriously difficult to prove in court. Now, ratings agencies are also liable for negligence as an “expert” under the Securities Act, so the extent of first amendment protection in these cases is a big unknown.

      2. There is some legal question as to whether the first amendment defense will cover ratings in their function as regulatory statements in the registration document of the security considered separately from their function as opinions given to the investment community. This legal strategy was not possible before the rescission of 436(g).

      There will be increased amounts of 144a issuance, to be sure, and there will also be a backup in issuance until the legal uncertainties are more known.

      The ideal solution, in my opinion, is for liability to price bad or economically shaky deals off the market, which is good for the investor. The unfortunate trade-off may be that transaction costs are increased as ratings agencies price in liability. Well worth it, though, considering what the market went through in the crisis.

  14. Engineer

    My heart does not bleed for the ratings agencies. I am a professional engineer. When I render an opinion or produce a design, I need to put my signature and seal on the document. I am subject to the tort of negligence for any of my work as well as the potential punishment of losing my professional license.

    I have sent recommendations to my legislators in the past to require the ratings agencies to employ licensed raters who need to put their personal signature and seal on ratings. This would elevate the attention paid to these ratings greatly since somebody’s career is on the line every time, just the way it is with engineers.

    To date the ratings agencies have been paid handsomely for shoddy work of high importance with little or no consequence. The recent system has been virtually guaranteed to lead to failure since there were few incentives to do the right thing. Putting liability into play will surely be a necessary mechanism. It would be reasonable to put some statutory limitations on liability that are serious enough to warrant good behavior but not so serious that nobody will provide an opinion for a rating.

    1. Konstantin

      2 Engineer
      The problem is, securities’ rating (and economic forecasting in general) includes much more uncertainty than engineering calculations. Laws of physics are pretty well understood and working steadily, while laws of economics are at best vague and subject to multiple equilibria. When an investment grade security goes junk, it’s not always rating agency oversight.

      Yes, it’s good to have more accountablility for those guys, but the dosage should be balanced given the inherent uncertainty in subject matter

      1. shrivti1

        You have a point, however, credit ratings agencies were assigning ratings to products like CDO^2 and CDO^3, which had a very short performance history, and risks which were *impossible* to accurately model–on top of that, the agencies knew full well how sensitive these structures were to even minute changes in PD or correlation assumptions. But they rated them anyway, and AAA no less. Most of this was due to 1. pressure from the issuer and 2. the opaque nature of the instrument made it easy to justify a high rating w/o fear of contradiction. Most investors (even the most sophisticated) just didn’t have the access or ability to do due diligence on such a complicated offering.

        Add to this that the ratings agencies were shielded from negligence laws because of 436(g), and ratings agencies are incentivized to turn out crap ratings en masse for the structured finance market.

  15. Ginger Yellow

    “When an investment grade security goes junk, it’s not always rating agency oversight.”

    Indeed. It’s something that’s got lost amid the (much deserved) critisicm over subprime and structured credit ratings. We’ve just been through the worst financial crisis for over 50 years, with massive house price declines, credit contraction, unemployment and so on. It would be a miracle if a large number of investment grade bonds didn’t default or get downgraded in those circumstances. Of course there’s a twist in that inappropriately giving top grade ratings played a large part in causing the crisis in the first place, but the point still stands.

  16. Erich Riesenberg

    I think this is a phony issue.

    GM today announced it is buying AmeriCredit for $3.5 billion.

    AmeriCredit issues billions, a majority of its debt, in asset backed securities, to finance auto loans.

    The cost of issuing this stuff may go up to reflect the real risk, but auto loans and home loans can be rated if the effort is made.

  17. Gerard Pierce

    It’s been a while since the publicity around the Gaussian Copula. (The Formula that killed Wall Street.) If I interpreted this mess properly, it meant that the mathematics that the rating agencies used to justify those AAA ratings was used “inappropriately”.

    Unless they have changed the rules one more time, it means that there is once again no economical way of evaluating the risk involved in certain investment pools. That was the whole point of the Gaussian Copula – Wall street used it to come up with a cheap number that supposedly allowed the rating agencies to label crap as AAA.

    This seems to further mean that there is no economical way of fudging the numbers so that pension funds and other fiduciaries can legally buy these investments – and the law says they cannot invest in anything less than AAA.

    Of course if you have no liability, you can always just lie about it, but if you can’t lie about it, you have to do just what they have now done.

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