US legislators have proposed several reforms of the US credit rating system. Yet, incentives for credit agencies remain misaligned, while a new subprime market begins to grow.
Financial regulation in the US today would have been unrecognizable six years ago, when Lehman Brothers had just been liquidated and AIG was bailed out. The Dodd-Frank Act, along with the Basel Accords, has fundamentally changed how financial institutions treat risk – or perhaps, more cynically, how financial institutions report it.
Many of these regulations only indirectly address the diseases that caused the crisis, however, and it took nearly six years for the SEC, under direction of the Dodd-Frank Act, to issue new rules to address one of those causes: how credit rating agencies rate asset-backed securities (ABS). The problem is, the SEC’s rules perpetuate the misaligned incentives and underestimation of systematic risk that spurred the Dodd-Frank Act in the first place.
Pay to play
The role of the major credit rating agencies (Standard & Poor’s, Moody’s and Fitch), which account for more than 95% of the industry, in the financial crisis has been clear for some time: investment banks selling mortgage-backed securities (MBS) chose the rating agency that would give their products the best rating. The agencies responded to the incentives before them, and risky securities retained AAA ratings. This is more than just a popular narrative at this point: a handful of distressed debt hedge funds have successfully sued investment banks over securities they issued with deceptive ratings.
Proposals to realign the credit rating agencies’ incentives have varied greatly, and their strength is largely determined by the proposers’ proximity to the industry. Perhaps the most prominent is Minnesota Senator Al Franken’s proposal, which creates a board overseen by the SEC that administers credit ratings. It would select a rating agency without disclosing that information to the seller of the asset and serve as the intermediary throughout the process.
This provision passed the House and Senate during the Dodd-Frank debates, but was later removed in reconciliation negotiations. Proponents argue that this independent board would remove agencies’ incentive to inflate ratings, while opponents worry that it would not have the expertise to delegate to the correct agencies and that it would create an implicit government sanction of resulting ratings.
Return of subprime
Worries among financial observers have recently turned to the rise of subprime auto loans, which surged by 18% in 2013 and continue to grow. Parallels between the rise of subprime mortgages and auto loans can certainly be drawn, but it is unlikely that subprime auto loans will pose a similar systematic threat.
First and foremost, car prices are not accelerating into a bubble. Also important is the differing size of the markets: about $25bn of subprime auto loans will be issued in 2014, while $600bn of subprime mortgages were issued in 2006. Simply put, cars are a lot less expensive than homes.
Concerns that rating agencies are up to their old deeds in this market are rising nonetheless. The Financial Times reports that Fitch has refused to give several of these subprime securities AAA ratings and issuers have quickly found other, more accommodating agencies. As a result, Fitch has only been the official rating agency of four of this year’s 29 issuances.
Reforms come up short
While the reforms proposed by Sen. Franken could be improved by addressing some of the more legitimate concerns brought up by its opponents, they take aim at the main flaw in the current system: the incentive to inflate ratings of securities. However, they have been watered down or pushed aside. The SEC’s rules fall far short of proposals like Franken’s.
The major provisions of the rules that were implemented by the SEC leave loopholes that undermine the system. Under one rule, sellers of ABS are required to give potential buyers information about the underlying assets in the security, but are exempt if the buyer is a hedge fund, pension fund or insurance company – which are three of the largest buyers of these securities.
The other major rule forces rating agencies to separate their sales divisions from their credit analysis divisions, as well as disclose the accuracy of previous ratings and any downgrades on assets they rated. This second rule puts in place penalties for bad behavior, but still does not proactively change rating agencies’ incentives to accurately rate assets.
Additional action on reducing the risk posed by subprime auto loans is also being proposed, although it has been met with firm resistance from auto dealers. The Consumer Financial Protection Board’s plan includes limiting the marketing of these loans and allowing lenders to purchase and refinance up to 10,000 of them each year.
These actions target the loans long before they are securitized and rated by the agencies, which should limit the supply of low quality loans for the agencies to improperly rate. On the other hand, it is still just an additional piece in an unsystematic set of regulations.
Even though subprime auto loans will not cause another financial crisis, the weakness of credit rating reform has not mitigated a prime risk-driver in this niche but growing securities market. More broadly, it is representative of a broader theme in financial regulation since the financial crisis: too late, piecemeal, watered-down and not focused enough on mitigating systematic risk.
