PO Box 2044
Durham, NC 27702
201 West Main St
Durham, NC 27701
Written by Joe Pimbley and Bill Harrington
May 20, 2020
In the rush to help struggling companies and prop up debt markets during the COVID crisis, the Federal Reserve has undermined a major reform Congress made in response to the Great Recession: don’t rely on credit ratings. Contradicting the 2010 Dodd-Frank Financial Reform Act, Federal Reserve lending programs for corporations, municipalities and asset-backed securities all use credit ratings to determine eligibility. This Fed use of commercially biased opinions from Moody’s, S&P, Fitch and other rating companies is a significant policy mistake.
Earlier this century, rating agencies made two sets of major blunders that put them in Congress’s crosshairs. During the 2001-2002 recession, the agencies incurred criticism for assigning inflated ratings to Enron and Worldcom until the eve of their respective bankruptcies. These errors led Congress to place the agencies under active SEC regulation, especially those few agencies that successfully applied for designation as nationally recognized statistical rating organizations (NRSROs).
But then a much larger debacle erupted in 2007-2008 when it became apparent that the raters had grossly understated the risk of bonds backed by subprime mortgages, of derivative instruments assembled from mortgage backed securities, and of institutions holding these bonds and derivatives.
These errant ratings helped inflate the housing bubble whose bursting triggered the Great Recession.
This time, Congress came down on rating agencies much more heavily. Dodd-Frank Section 939A required federal agencies, including the Federal Reserve, to remove all references to credit ratings in their regulations. No longer could credit ratings be used by the government to assess risk; other measurements would have to be used instead.
This decision was both sensible and necessary given the deep flaws of commercial credit ratings. First, because the ratings take the form of ordinal, alphanumeric symbols such as AA and BB rather than precise, numeric estimates of default probability or expected loss, their meaning is imprecise. A bond investor, the Treasury or the Federal Reserve has no idea of the likelihood, or amount, of principal and interest loss they may incur by buying $1 billion of AA or BB bonds.
Second, and more important, is the strong commercial bias affecting credit ratings. Because credit rating agencies are both paid by bond issuers and shielded by the NRSRO designation, they compete with one another to dumb down their credit standards in pursuit of rating fees. Indeed, this conflict of interest is the root cause of the horrendous rating agency failures that prompted Dodd-Frank. Yet this 2010 legislation did not rectify the business model’s conflict of interest, which was on full display just 15 months later when MF Global declared bankruptcy in October 2011. In fact, the competition among rating agencies for looser credit standards continues to the present day, the onset of the coronavirus crisis notwithstanding.
While many aspects of Dodd-Frank were controversial, its divorce of ratings from financial regulation received bipartisan support. Whether through forgetfulness or expediency, the Fed is now taking “rating agency reform” in precisely the wrong direction. Right now, the Fed is exposing the stricken economy to the mistakes that credit rating agencies have habitually made this century. Going forward, the Fed is embedding deeply flawed credit ratings in the arsenal of regulatory policy.
To limit losses on its new liquidity facilities, the Federal Reserve should develop, use, and be accountable for analytical measures to determine creditworthiness of prospective borrowers. Meanwhile, Congress should eliminate the concept of a government-sanctioned NRSRO, thereby removing once and for all the pretense that the opinions of conflicted commercial entities should impact public policy.
Joe Pimbley is the principal of Maxwell Consulting LLC, which he founded in 2010, an affiliate of PF2 Securities Evaluations, the Editor of the Journal of Derivatives, and a former Moody’s Investors Service Senior Analyst.
Bill Harrington is a senior fellow at Croatan Institute. Previously, Bill was a Moody’s Investors Service Senior Vice President and also a journalist who covered the credit ratings of complex finance at Debtwire ABS.