“Government agencies like the SEC force institutional investors (banks, insurers, pension plans, and others) to follow the credit raters’ advice. In 2010 Dodd-Frank required the SEC to remove credit raters from its rules, but much of this work remains undone…
…Instead the SEC has completed a new rule intended to ensure the virtue of credit analysts who work for the cartel.”, “The SEC’s New ‘Thought Crime’”, Wall Street Journal
“As I have described on this blog before, the simple free market solution is to discard these highly arbitrary (and often incorrect) credit ratings from investment, and bank and insurance company capital requirements and tie the investment limit and capital required to the current market spread above “riskless” U.S. Treasuries. The spread widens when the market perceives the bond’s risk has increased. So, as the spread widens and risk increases, the capital required to hold a bond should rise (maybe within some floor and ceiling or with step floors and ceilings over time). This is a simple market solution and also prevents banks and others from arbitraging the rating agencies’ ratings and banks’ risk-based capital requirements tied to these ratings. No amount of regulation is going to “fix” the National Statistical Rating Agencies, because they don’t work in a free market. Scrap them, in favor of a simple, market-based solution.”, Mike Perry, former Chairman and CEO, IndyMac Bank
The SEC’s New ‘Thought Crime’
Trying to purge the profit motive from the minds of credit analysts.
As if catching real crooks isn’t hard enough, the Securities and Exchange Commission will now seek to punish credit raters who harbor impure thoughts of financial gain. This really is as bizarre as it sounds.
The industry at issue is the oligopoly of credit-rating agencies including Standard & Poor’s, Moody’s and Fitch. The Big Three helped create the financial crisis by slapping triple-A ratings on pools of mortgages—without inspecting the individual loans. One reason the raters could wreak such havoc in 2008 is the same reason they are still rolling in profits six years later: Government agencies like the SEC force institutional investors to follow the credit raters’ advice. In 2010 Dodd-Frank required the SEC to remove credit raters from its rules, but much of this work remains undone.
Instead the SEC has completed a new rule intended to ensure the virtue of credit analysts who work for the cartel. The big agencies get paid by the issuers of the bonds they rate, so the commission wants to insulate the people who determine the ratings from the issuers who pay for them. Late last month the SEC voted to ban the raters from issuing a rating if anyone involved “is influenced by sales or marketing considerations.”
Imagine the billable hours securities lawyers will generate as they explore the influences at play deep in the heart of a credit analyst. Commissioner Daniel Gallagher, who joined fellow Republican Michael Piwowar on the losing side of a 3-2 vote, said the new rule amounts to a “thought crime.”
Mr. Gallagher added, “This new prohibition is solely based on state of mind—there is no requirement that any action be taken. Even if the rating process is effectuated without any abuse, we could theoretically still pursue the analyst unfortunate enough to display evidence that a stray thought related to sales and marketing considerations crossed his or her mind.”
To prevent impure thoughts, the SEC will limit contact between analysts and securities issuers whenever issuers are considering hiring a ratings firm. The theory seems to be that analysts cannot even talk to potential clients about the process of measuring creditworthiness without going in the tank.
A better approach would be to recognize that potential conflicts exist in every industry. The challenge is to manage them, not to make it illegal to desire profits. If the government prosecuted every journalist who thought a story might find favor with potential sources or advertisers, law enforcers would have little time for anything else.
The real remedy is to allow consumers to decide whether they think they’re getting the straight story. But the SEC still won’t let them decide. Endorsements of the cartel are still included in SEC rules, such as the one governing money-market mutual funds. Fund managers must invest in securities rated highly by the racket.
The SEC justifies its new thought-crime rule by pointing to hastily drafted Dodd-Frank language calling for analysts to certify that their ratings aren’t influenced by commercial considerations. But for better or worse, Dodd-Frank gave regulators broad discretion in implementing mandates. The SEC should reconsider its new rule while moving quickly to rescind earlier endorsements of the ratings racket.