Hearing on Examing Proposals to Enhance the Regulation of Credit Agnecies(Jui Kai Li)

On Aug 5th, the US Senate Committee on Banking, Housing, and Urban Affairs held a hearing on Proposals to enhance the Regulation of Credit Rating Agencies.

Testifying were Michael S. Barr-U.S. Department of the Treasury, Professor John C. Coffee, Jr.-Columbia University Law School, Dr. Lawrence J. White-New York University ,Mr. Stephen W. Joynt-Fitch Ratings, Mr. James Gellert-Rapid Ratings, Mr. Mark Froeba-PF2 Securities Evaluations, Inc.

The testimony is summarized below and copies of the written statements are available at;
http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=89e91cf4-71e2-406d-a416-0e391f4f52b0

Credit Rating Agency blamed for Financial Stress

In credit markets, borrowers often know more than lenders. While lenders may buy a portion of debt issued, borrowers often issue debt to many borrowers. Thus, rating agencies are traditionally assumed to address this information asymmetry. They help lenders evaluate the credit worthiness of borrowers. However, many researches show that investors’ over reliance on these rating agencies causes financial stress. These researchers believe that a severe conflict of interest and lack of transparency in the rating process led to overly optimistic ratings. A wave of sudden CDO downgrades in July 2007 not only led investors to lose confidence in rating agencies but also led to an increase in risk aversion and to low liquidity afterwards.

Conflicts of interest and a lack of transparency have led to increased Corporate Governance risk, a key factor socially responsible investors examine. Due diligence issues, accountability and liability factors aroused a lot of debate at the hearing. In highlights from the testimony, we will see how the administration proposes to regulate credit rating agency and gain different perspectives on the proposal.

Highlights from Testimony:
Senators’ Support for the Proposal

Most Senators think reform is necessary. “I strongly believe that the credit rating agencies played a pivotal role in the collapse of our financial markets. Any regulatory reform effort must take that into consideration,” said Senator Shelby.

The Senators agree to give SEC more authority to regulate disclosures and conflicts of interest, as well as unfair and abusive practices. However, the agreement between the Senators and the Administration is not a coincidence. Before the Administration’s proposal was submitted, the Banking Committee proposed and helped passed the Credit Rating Agency Reform Act of 2006. The act gives the SEC more authority to regulate credit rating agencies. According to the Assistant Secretary’s testimony, “This Committee, under the leadership of Senator Shelby, Senator Dodd and others, took strong steps to improve regulation of rating agencies in 2006. That legislation succeeded in increasing competition in the industry, in giving much more explicit authority to the SEC to require agencies to manage and disclose conflicts of interest, and helping ensure the existence and compliance with internal controls by the agencies.”

Industry’s Perspective on the Proposal
On the other hand, from an industry perspective, many disagree with key points in the proposal. They do not believe that due diligence and greater liability should be the responsibility of credit rating agencies.

“In that regard, we support the concept that issuers and underwriters ought to be required to conduct rigorous due diligence on the underlying assets that comprise asset backed and mortgage backed securities….. Congress ought not to hold rating agencies responsible for such due diligence or for requiring that others do it,” said Stephen W. Joynt, President and Chief Executive Officer, Fitch Ratings. “Unlike other gatekeepers, the credit rating agencies do not perform due diligence or make its performance a precondition of their ratings. In contrast, accountants are, quite literally, bean counters who do conduct audits,” said Professor John C. Coffee, Jr.
,Professor of Law Columbia University Law School.

Both industry and academic perspectives point out that rating agency should not be held to a standard that might lead to greater credit rating agency liability. “A credit rating is an opinion about future events – the likelihood that an issue or issuer will meet its credit obligations as they come due. Imposing a specific liability standard for failing to accurately predict the future in every case strikes us as an unwise approach,” said Mr. Joynt. “Also, Professor Coffee maintained that”We have to face the simple reality that the rating agencies have a built-in bias: they are a watchdog paid by the entities they are expected to watch. “