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Yves Smith - Caught napping, sorry folks…
A surprise for the ratings agencies, the bond market, and me, too – this has to be a late change in the Financial Reform bill, and it’s a corker. From the WSJ:
Monster update: I can’t find the final text of the Bill, and nothing but broken links to older versions, so it will have to be the House press release. The big sticking point for the ratings agencies is evidently the liability clause here:
So it’s the liability clause that really matters; the Reg FD part is just griping. What happens next? Well, Partnoy wouldn’t like the way adding this liability clause has panned out:
Possibilities, half-baked and possibly hyperventilating wildly:
“Informed reader input is most welcome”. I note that there’s very little newsflow on this so far, which does suggest that the more lurid outcomes above may be on the fantastical side.
I’ll do some archaeology on how this change got under my radar, for my own peace of mind, in slower time.
Final update:
Well, I’ll be damned, something got watered up in the final version! Here’s the timeline:
The nation’s three dominant credit-ratings providers have made an urgent new request of their clients: Please don’t use our credit ratings.
The odd plea is emerging as the first consequence of the financial overhaul that is to be signed into law by President Obama on Wednesday. And it already is creating havoc in the bond markets, parts of which are shutting down in response to the request.
Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days.
Update: a few more details here and here.The odd plea is emerging as the first consequence of the financial overhaul that is to be signed into law by President Obama on Wednesday. And it already is creating havoc in the bond markets, parts of which are shutting down in response to the request.
Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days.
Monster update: I can’t find the final text of the Bill, and nothing but broken links to older versions, so it will have to be the House press release. The big sticking point for the ratings agencies is evidently the liability clause here:
Liability: Investors can bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. NRSROs will now be subject to “expert liability” with the nullification of Rule 436(g) which provides an exemption for credit ratings provided by NRSROs from being considered a part of the registration statement.
So yeah, June 29th at the latest. Missed it. Liability was always part of Partnoy’s script for Ratings Agency reform, which is a source for the changes that went into the bill:Historically, the threat of liability has been an effective tool in encouraging gatekeeper accountability. In general, gatekeepers are less likely to engage in negligent, reckless, or fraudulent behavior if they are subject to a risk of liability.
Although most financial market gatekeepers have been subject to serious threats of civil liability, credit rating agencies have not. Some market observers believe that, with appropriate changes in policy, litigation could become a viable tool for ensuring NRSRO accountability.
Rating agencies have been sued relatively infrequently, and rarely have been held liable. As rational economic actors, rating agencies factor in the expected costs of litigation, including the cost of defending lawsuits as well as any damage awards or settlements. Given the litigation track record, the fact that the rating agencies have published unreasonably high ratings should not be surprising.
Litigation against the credit rating agencies often is deterred by statutory provisions and judicial precedent that limit the liability of NRSROs. NRSROs are immune from liability for misstatements in a registration statement under Section 11 of the Securities Act of 1933. Securities Act Rule 436 explicitly provides that NRSRO are exempt from liability as an expert under Section 11.
The demise of Ratings Agencies’ exemption from Reg FD, which these chaps mentioned as another issue, is also addressed by Partnoy:Although most financial market gatekeepers have been subject to serious threats of civil liability, credit rating agencies have not. Some market observers believe that, with appropriate changes in policy, litigation could become a viable tool for ensuring NRSRO accountability.
Rating agencies have been sued relatively infrequently, and rarely have been held liable. As rational economic actors, rating agencies factor in the expected costs of litigation, including the cost of defending lawsuits as well as any damage awards or settlements. Given the litigation track record, the fact that the rating agencies have published unreasonably high ratings should not be surprising.
Litigation against the credit rating agencies often is deterred by statutory provisions and judicial precedent that limit the liability of NRSROs. NRSROs are immune from liability for misstatements in a registration statement under Section 11 of the Securities Act of 1933. Securities Act Rule 436 explicitly provides that NRSRO are exempt from liability as an expert under Section 11.
For years rating agencies have enjoyed an exemption from Regulation Full Disclosure, or Regulation FD, which allows the rating agencies to receive inside information from issuers that is not shared with the market. The agencies contend that the exemption is needed in order to fully evaluate credit risk. NRSROs say the Regulation FD exemption allows them to alert the public to any substantial changes in the status of a security more quickly and clearly through rating upgrades, downgrades, and watches. Moreover, some argue that credit rating agencies should be able to receive material non-public information from arrangers for the purpose of developing unsolicited credit ratings.
But a strong case can be made for removing this exemption. Rating actions, without a substantial increase in transparency, can cause confusion and speculation. And unsolicited credit ratings are rare. Unless that practice becomes common, there is scant justification for giving credit rating agencies access to inside information through a Regulation FD exemption. Moreover, it is far from apparent that credit rating agencies have incorporated inside information in their ratings. Most notoriously, even though Enron made non-public credit rating agency presentations, information about the risks described in those presentations was not reflected in Enron’s credit ratings. The same has been true of structured finance ratings. For these reasons, the board should have the power to limit the subsidy given to credit rating agencies to obtain, and act upon, material non-public information.
So – this part of the change is the demise of a subsidy (in the form of insider information) that the agencies often didn’t exploit anyway. I bet they wish they had used more insider info in their ratings process now…But a strong case can be made for removing this exemption. Rating actions, without a substantial increase in transparency, can cause confusion and speculation. And unsolicited credit ratings are rare. Unless that practice becomes common, there is scant justification for giving credit rating agencies access to inside information through a Regulation FD exemption. Moreover, it is far from apparent that credit rating agencies have incorporated inside information in their ratings. Most notoriously, even though Enron made non-public credit rating agency presentations, information about the risks described in those presentations was not reflected in Enron’s credit ratings. The same has been true of structured finance ratings. For these reasons, the board should have the power to limit the subsidy given to credit rating agencies to obtain, and act upon, material non-public information.
So it’s the liability clause that really matters; the Reg FD part is just griping. What happens next? Well, Partnoy wouldn’t like the way adding this liability clause has panned out:
…it is not feasible or practical for regulators and investors simply to stop using ratings. Mandates to use ratings have become part of the fabric of financial markets, and cannot be unwoven instantaneously.
Let’s see if the pleas by ratings agencies have that instantaneous unweaving effect, shall we? Remembering that ratings are embedded both in investment mandates round the globe, and in Basel II definitions of bank capital, what will their declarations do to investor appetite for new corporate bonds, new ABS, and new sovereign debt?Possibilities, half-baked and possibly hyperventilating wildly:
- Total logjam of all classes of new debt issuance everywhere.
- Ratings agencies’ pleas quietly ignored, because you can’t rewrite Basel II and tens of thousand of investment mandates in a day; and we all carry on in some sort of la-la land where officialdom pretends to think the agencies are now liable, but everyone knows they still aren’t really.
- Someone gets the Tipp-Ex out before the Bill lands on Obama’s desk (later today).
- Someone tells the ratings agencies to stop fooling around.
I’ll do some archaeology on how this change got under my radar, for my own peace of mind, in slower time.
Final update:
Well, I’ll be damned, something got watered up in the final version! Here’s the timeline:
Konczal in May bemoans the absence of the stiff 436(g) language (present in the House Bill), from the Senate Bill.
Ritholtz spots some late tightening fiddling with this part of the Bill in mid-June.
And some time after that, the stiff House language (or something like it, because I still can’t find the final version of the words) gets reinstated: and here we are with the sulking RAs.
That’s a reminder of the perils of jaded cynicism…not enough to make me discard the “la-la land” option, above, though.
Ritholtz spots some late tightening fiddling with this part of the Bill in mid-June.
And some time after that, the stiff House language (or something like it, because I still can’t find the final version of the words) gets reinstated: and here we are with the sulking RAs.