SEC panel: ‘Disruptions’ come with credit rating assignment system

WASHINGTON, May 15 -- The proposed credit rating assignment system could slow markets and disrupt capital flows while creating new conflicts of interest for credit rating agencies, agency executives told the Securities and Exchange Commission Tuesday.

Standard & Poor’s Ratings Services President Douglas Peterson said the government assignment system proposed in an amendment to the Dodd-Frank law could create uncertainty, set back markets and “disrupt capital flows at a time that we can least afford it.”

The Franken-Wicker proposal calls for the creation of a board that assigns agencies to provide initial credit ratings for those issuing mortgage-backed securities and other debt obligations in order to eliminate conflicts of interest. The current “pay to play” model in which credit agencies are paid by the bond issuers that they rate has been criticized as having an inherent conflict of interest for the agencies.

S&P is the largest of the big three ratings firms that currently hold more than 90 percent of the ratings market. Changes to the current “issuer pays” model would dramatically impact the ways these firms do business.

“It would allow smaller agencies to ultimately to break up the oligarchy,” said Sen. Al Franken, D-Minn., who co-authored the amendment more than three years ago in the wake of the financial crisis. “It's a common sense idea that will restore Americans’ trust in the market.”

But many panelists at Tuesday’s SEC roundtable -- especially those representing larger credit rating agencies that have the most to lose -- pointed out what they considered faults of the proposed assignment system.

Several representatives argued that random assignments would overlook the specific level of expertise required for certain projects.

“It would require a level of expertise, of knowledge, of detail and precision about understanding all these different asset classes,” said Peterson, who said the quality of ratings would suffer by overlooking expertise.

“It could be the situation that investors aren’t getting a valuable report,” said Martin Hughes, CEO of Redwood Trust, which relies on agencies like S&P for its rating specialties.

Small agencies like Kroll Bond Rating Agency instead favor a simplified rotation system by which bond issuers would be forced to rotate their use of credit rating agencies.

The agency’s chief executive, Jules Kroll, said the rotational structure would reduce conflict of interest and help open the market to smaller agencies.

“We need to take the power out of the S&P’s, the Moody’s, and Fitch’s,” Kroll said.

But Kermit Roosevelt of the University of Pennsylvania Law School said the credit rating assignment system is more in compliance with the First Amendment guarantees of the Constitution than the rotational structure.

According to Roosevelt, First Amendment issues are more likely to arise when speech rights are actually removed. “We’re adding some speech to the mix, not taking anything away,” Roosevelt said. “Here the proposal says selected ratings agency can decline to provide rating if they want to.”

A “forced” rotation could potentially infringe on the rights of agencies to express their own ratings agency preferences. The rotational structure is therefore “prohibiting” instead of “supplementing” the decisions of bond issuers and ratings agencies.

Roosevelt said the rotational structure is more “constitutionally vulnerable,” should credit rating agencies resort to legal action against current pay model reform.