S&P, Moody’s and Fitch made a bold decision last week: they effectively banned the use of their ratings for new issues of asset-backed bonds. Since credit ratings are a legal requirement for bond registration statements in the US, this move has, in a single stroke, shut down the public market for asset-backed securities. (Although the SEC is doing its best to reopen it.) This is important because if companies cannot securitise their consumer debt, they will lend less to American borrowers – or at least charge them higher rates – for things like car loans and credit cards.
So why did the agencies do it? In a word: Dodd-Frank (or to give it its full name: the Dodd-Frank Wall Street Reform and Consumer Protection Act). Signed into law last week, the Dodd-Frank Act effectively renders agencies ‘experts’ – a label that makes them legally liable for the quality of their ratings. Fearing future liabilities, the agencies wasted no time in withdrawing their consent for their ratings to be used.
Are the agencies being justifiably cautious or, as one bond manager has suggested to me, exposing themselves to the accusation that they lack faith in their own work? They certainly have reason to be nervous. During the crisis billions of dollars of highly rated securities collapsed or suffered downgrades; disastrous failings which prompted furious investors to attempt to claim compensation from those they believed responsible. For their part, the agencies have kept claims at bay by arguing that their ratings are simply ‘opinions’ (i.e. free speech) and that investors should conduct their own due diligence. Dodd-Frank not only potentially exposes them to future liabilities; it also, presumably, opens them up to legacy lawsuits, too. Needless to say, that could prove extremely costly.
If, then, the crisis revealed ratings to be deeply flawed – and the agencies’ reaction to Dodd-Frank is a tacit admission that little has been done to improve them – the obvious question is: why? Guan Jianzhong, chairman of China’s largest rating agency, claimed last week that Western agencies – which he blames for the global financial crisis – are too politicised, and too eager to subjugate their principles in order to win new business. Agencies will doubtless argue that they are powerless to prevent companies shopping around for the best rating – a key argument behind Jianzhong’s claim – but surely businesses must have learnt that practice somewhere: after all, would they bother with the best-of-three approach if ratings were indisputably made on the basis of objective assessment?
For now, the agencies are hoping that Dodd-Frank will, in the course of its implementation, be substantially watered down. But if it is not – and at this stage there is little reason to believe it will be – there will be far-reaching consequences for credit rating agencies and the securitisation markets they serve. With the fall-out from the financial crisis still being keenly felt, few would argue that an overhaul of these industries is wholly without merit.