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Battleship and Rating Agencies

By Anonymous

Last summer, the SEC proposed new rules for credit rating agencies, and last week it published the final rules. The new rules are aimed at, among other things, conflicts of interests in the rating process. Specifically, the new rules prohibit rating agencies from issuing or maintaining a credit rating where the rating agency (or a person associated with the rating agency):

"made recommendations to the obligor or the issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the obligor or issuer of the security."

What constitutes a "recommendation"? Here's what the SEC, helpful as always, had to say:

[T]he Commission does not view an explanation by an NRSRO of the assumptions and rationales it uses to arrive at ratings decisions and how they apply to a given rating transaction as a recommendation.

Clear as mud. Thanks, guys.

Essentially, the new rules will turn the rating process into an elaborate game of Battleship. The sponsor of a structured security, which needs a top rating so it can be sold to real-money investors like pension funds, won't be permitted to ask the rating agency what changes it can make to the structure of a security to obtain the desired credit rating. Instead, the sponsor will have to guess what changes would lead the rating agency to issue the desired credit rating, and the rating agency can only tell the sponsor if its guess is right or wrong.

Presumably, every time the sponsor proposes a new change, the rating agency will say either "hit" or "miss." And when the sponsor finally makes enough changes to warrant a triple-A (or whatever the desired rating is), the rating agency will presumably yell, "you've sunk my battleship!"

Or at least that's what I hope will happen.

The new rules were primarily designed to prevent the issuers (or sponsors) from unduly influencing the rating agencies, not the other way around. But prohibiting the rating agencies from making "recommendations" to issuers actually diminishes the rating agencies' influence in the rating process. In other words, the SEC, in all its wisdom, has decided to diminish the influence of the party it believes is being unduly influenced!

Go figure.

Full post as published by Economics of Contempt on February 07, 2009 (boomark / email).