Speech by SEC Commissioner:
Statement at Open Meeting to Consider Proposed Rules under the Rating Agency Act
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
June 11, 2008
Thank you, Mr. Chairman. I appreciate the hard work of the staff in getting this proposal to us today, especially the Trading and Markets team including Erik Sirri, Mike Macchiaroli, Tom McGowan, Randall Roy, Joseph Levinson, Carrie O'Brien, Sheila Swartz, and Rose Wells. They were ably assisted by the Division of Corporation Finance, the Office of General Counsel, and the Office of Economic Analysis. Even after today's meeting, you will not get much of a respite since the work will continue over the next couple weeks as you finalize a related recommendation that would set in motion the elimination of ratings references from Commission rules. Thank you for all your work.
I generally support the proposal before us. If adopted, the amendments, most importantly, should provide more information to investors so that they can judge the opinions that credit rating firms provide, especially on investments such as structured products. This enhanced transparency also could lead to increased competition in credit ratings. Transparency and competition make for healthy markets, because investors have a better view of what is going on in the market and can make better decisions. Towards this end, the proposal would require disclosure of information that NRSROs use in the development and surveillance of their ratings, enhanced disclosures of NRSROs' rating methods, and more comprehensive information about changes in ratings. The focus of the amendments on ratings of structured finance products is warranted given recent events. I hope that our efforts in this area will help to restore confidence in the market for structured finance products, through providing a basis for investors to have a better understanding of those products.
We are clearly charged by Congress in overseeing credit rating agencies under the Credit Agency Reform Act. However, we must keep in mind our own authority under this Act, which is to police for conflicts of interest and improve competition. We must remember the explicit intent of Congress that we not substitute the Commission's judgment for that of the rating agencies. Ultimately, a rating is an expression of opinion — one that, barring self-dealing or lack of integrity, enjoys the protection of the First Amendment. More importantly, we must remember that a triple-A opinion issued by a credit rating agency — no matter how much expertise it may have — is no substitute for an investor's making an informed decision and undertaking careful due diligence. We should not create a regulatory regime that creates a moral hazard for investors by encouraging them to rely on credit ratings.
Some investors were not caught off-guard by the recent problems with structured products. One comment by a large mutual fund portfolio manager is indicative that some understood the limitations of credit ratings: "We never rely solely on a credit-rating service. We look at what they have to say, but for us it's just a starting point. Our investments are based on our own independent credit analysis."
Now, I turn to the part of the release and rule that I cannot support. I have to part company with the majority on this issue. I appreciate the Chairman's bifurcating this question so that all of us might express our reservations.
I oppose proposed rule 17g-7 and Section III of the release, which describes the new rule. Rule 17g-7 would require NRSROs, in connection with any structured finance rating, either to issue a report along with that rating that describes any unique aspects of the rating methods and risk characteristics of structured finance products. As an alternative, the rule would permit the NRSRO to use a special structured finance ratings symbol. An NRSRO could, for example, append a "dot SF" to its structured finance product ratings.
This proposed change is a shiny, but costly, veneer on an otherwise good set of proposals. I give the staff credit for not pushing this idea — it comes from our side of the table. Likewise, I did not agree with the inclusion of a recommendation for different symbols in the IOSCO credit rating agency code of conduct. Given that investors in the market for these structured finance products are institutional and other sophisticated investors, the fact that a structured finance product is different from other types of securities ought not to come as much of a revelation to investors. Certainly it will serve as a warning of sorts — will it become "Beware the dreaded "SF" rating"? That scarlet letter might quickly fade away, though, as people learn to ignore it and focus only on the rating to which it is appended. In addition, how much information can a "dot SF" provide an investor about the underlying investment?
It is a question whether investors would pay attention anyway, since the requirement that certain products bear the warning is somewhat arbitrary. After all, what is a structured finance product? Can a rule properly define the universe of such products, especially in an area that is marked by innovation and creativity over the past twenty years? If the "dot SF" becomes a scarlet letter, how long will it take for smart lawyers, accountants, and investment bankers to design products around it? Will that further skew the marketplace and confuse investors? A distinctive rating for certain products could give investors negative assurance about other products; investors might take comfort in the absence of a "dot SF" and unduly rely on the rating without considering other relevant information. On the other hand, will the "dot SF" moniker one day become the fashionable thing to have appended to a rating, so that everyone will strive to have one?
The tenuous benefits offered by the proposals could come at quite a cost. First, there are the costs associated with updating settlement, clearance, trade confirmation, trading, reporting, processing, and risk management systems, to name a few. Second, pension funds and other institutional investors such as insurance companies might be precluded, by state law and their own investment guidelines, from purchasing these products with a "dot SF" rating. Should a rating with an extension be considered of a different category as a "normal" rating? After all, that is the rationale for the differentiation in the first place — to point out the differences.
What about our own rule 2a-7, which governs money-market mutual funds? Will money market funds be able to invest in these instruments, or will we have to change our rules to accommodate the differentiated symbols? Presumably, we can relatively quickly change our own rule 2a-7. Institutional investors certainly can change their investment guidelines, but that also takes time. To change all of the state laws is likely to take even more time. What about in the meantime? Would these firms be able to continue to hold this kind of investment, or would they have to sell what they have into a market with limited demand? What will that do to the already depressed prices? This, in turn, could further depress liquidity in the market for structured products, which plays a very important role in today's economy. Home owners, companies, and college students enjoy lower rates and more access to capital through securitized markets.
Another major underlying question is whether the SEC has the authority to do this. We have constructed a books-and-records bootstrap, but it seems a tenuous hook to me, especially when we have clear Congressional intent under the Credit Rating Agency Act that we not micro-manage the rating process. Indeed, some ratings firms see symbols as a proprietary matter.
Undoubtedly, as the SEC removes ratings from its rules, systems changes and changes in investment guidelines will be necessary. The difference is that removing ratings from our rules promises the real benefit of removing the government imprimatur that has facilitated the development of a ratings industry characterized by a dangerously low level of competition.
Accordingly, I cannot vote in favor of proposed Rule 17g-7 and Section III of the release.