No more 10's from the American judges...

In the current Winter Olympics, viewers of the figure skating competition will see participants from each country perform their routines and receive numeric grades from ISU (International Skating Union) judges. The ISU, the ruling body in figure skating, is made up of member nations who elect members to the organization, which then operates independently to provide a neutral assessment.

Which begs the question why figure skating, and not United States credit rating judges, are funded in an independent manner. Since one of the causes of the financial crisis was undoubtedly inflated ratings accorded to toxic debt instruments, one remedy that deserves prioritized attention is the alteration of the corporate structure of the credit rating agencies.

             In the United States financial markets, debt obligations and debt instruments are given alphabet grades (AAA for the best, to D for the worst) by credit rating agencies (often termed “Nationally Recognized Statistical Rating Organizations” or “NRSROs”).  Unlike the judges in the ISU, the NRSROs are all separate companies that derive a significant portion of their revenue streams from the companies who create the debt instruments they rate.  Some of the largest NRSROs have parent companies/affiliates that issue public stock.

             Congress, the American economy, and the American public would be better served by passing a Bill which mandates that NRSROs: (1) take on the U.S. Government as a stakeholder; (2) earn a standard fee per rating; and (3) receive heavy fines when rated debt is not downgraded within a specified time of receiving relevant information.  Such legislation would greatly improve the independence and transparency of the credit rating agencies, and, through them, the debt market in general.

The economic crisis has proven that in the ratings game, the risk of conflicts of interest is simply too high.  By having each firm seeking a rating pay a standard fee, an NRSRO would be prevented from obtaining higher fees from repeat customers, thereby objectifying the process. Further, prohibiting the NRSROs from - directly or indirectly - issuing more stock to the public would have the effect of preventing both potential clients from becoming shareholders and profits from becoming the sole point of the business.  Finally, introducing the fear of regulatory fine would supplant and improve upon the current emphasis on ratings disclosure enforced by the SEC.   

One concern with such flattening of the fee scale cautions that some firms may still gain favored status because of the sheer volume of credit ratings they require.  However, in combination with the other provisions, the credit rating agencies should be in a position where their clients need them, and not vice versa.  Additionally, any concerns with government entanglements with private enterprise have surely been mooted by the events of 2008/2009, wherein nine of the largest banks took on the U.S. government as a shareholder (at approximately $25 billion of TARP money apiece); this month alone, a large financial services firm received approval to redeem its preferred shares owned by the government via the Bailout.   

The meltdown of the American economy has been well documented by the financial, legal, and academic communities. The general consensus is that some form of new legislation or regulation needs to be implemented in order to prevent such a calamity from recurring in the future. The consensus seems to stop there, and the range of proposed remedies has been diverse: create a consumer protection agency; regulate hedge funds; place limits on executive compensation; have the government become a shareholder in major domestic corporations; and provide additional more cash for those corporations.  Increasing regulation of the NRSROs is a straightforward and attainable solution that should appeal to both sides of the aisle.  It bears repeating that the dangers of impartial judging are with us still.  Indeed, the changes to money market fund regulation just announced by the SEC are intrinsically tied to NRSRO ratings.  Such targeted reforms might best be progressed through delay - specifically, until the underlying ratings model can be made more neutral through enhanced  regulation and partial ownership by the federal government. 

           

by Michael Capeci, Hofstra Law School Class of 2010,  and J. Scott Colesanti, 2/16/10