BLOG VIEW: Breaking Up The Old Boys’ Club

Written by Jessica Lillian
on May 28, 2009 No Comments
Categories : Blog View

has Standard & Poor's (S&P) done a good job of rating commercial mortgage-backed securities[/b] (CMBS) over the past couple of years? The agency recently [link=http://www.mortgageorb.com/e107_plugins/content/content.php?content.3579][u] invited industry participants [/u][/link] to provide feedback on its methodologies and assumptions. While S&P most likely was not encouraging anyone to write in and urge the people in charge to throw out the entire existing rating system, its request-for-comment article comes at a time when rating-agency backlash among lawmakers and market players alike has once again surged. Last October, [link=http://www.mortgageorb.com/e107_plugins/content/content.php?content.2460][u]MortgageOrb examined[/u][/link] what role the Big Three rating agencies (S&P, Moody's and Fitch) allegedly played in either contributing to or failing to prevent the credit crisis. Now, with the focus firmly set on moving the economy forward and strengthening regulatory oversight to stop future economic traumas, it seems more appropriate to identify specific opportunities for making changes – i.e., rolling out a new and improved rating agency model. One window of opportunity for at least symbolically starting to revise this deeply flawed system – which, lest we forget, is charged with assessing investment risk – is the continued implementation of the Term Asset-Backed Securities Loan Facility (TALF). (Criticized [link=http://www.mortgageorb.com/e107_plugins/content/content_lt.php?content.3539][u]just last week[/u] [/link] for failing include CMBS issued before Jan. 1 of this year as eligible collateral, the TALF was subsequently expanded to include certain legacy CMBS. This new inclusion is a victory in itself, of course, but for now, let's focus the other major news in the Federal Reserve's announcement.) Interestingly, the Fed added DBRS and Realpoint to the list of companies able to provide official CMBS ratings to determine TALF eligibility. What's the significance here? Following the early-May, pre-expansion CMBS TALF announcement, Connecticut Attorney General Richard Blumenthal [link=http://www.ct.gov/ag/cwp/view.asp?A=2341&Q=440006][u]wrote[/u][/link] to both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner urging the government to look beyond what he called the ‘Old Boys' Club’ of rating agencies in its TALF dealings. At the time, only ratings from S&P, Fitch and Moody's would suffice to prove that legacy CMBS would make suitable TALF collateral. ‘The Federal Reserve's stated reason for favoring the Big Three that it has 'customarily employed' perpetuates the Old Boys' Club mentality that has been condoned for too long,’ Blumenthal said in a press release recounting his exchanges with Bernanke and Geithner – which may or may not have played a role in the Fed's subsequent reversal of its decision on rating agency eligibility. ‘The policy seems hardly likely to instill the sort of confidence in the due diligence undertaken by the Federal Reserve that U.S. taxpayers deserve and the markets merit.’ As Realpoint President and CEO Robert G. Dobilas [link=http://www.house.gov/apps/list/hearing/financialsvcs_dem/dobilas.pdf][u]noted in his testimony [/u] [/link]to the House Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises (yes, there was recently another hearing devoted to fixing the rating agencies), his firm's basic model of operation differs from that of the Big Three rating agencies. ‘Realpoint operates as an independent, subscriber-based model, which, incidentally, is how Moody's, S&P and Fitch operated for the first 75 years they were in business,’ Dobilas noted. Now, as issuer-paid companies, the latter three ‘are paid substantial, up-front fees on the sales event by the corporations which are issuing the securities or by investment banking companies which are underwriting the transaction,’ and focus nearly exclusively on pre-sale situations. Consequently, according to Dobilas' testimony and Securities and Exchange Commission data, Moody's has downgraded 94.2% the subprime residential mortgage-backed securities (RMBS) it rated in 2006. Realpoint – which, incidentally, claims to specialize in CMBS ratings – boasts a sub-30% RMBS downgrade rate and tends to downgrade six to 12 months sooner than the Big Three agencies. ‘If we do not produce accurate ratings at Realpoint, we lose our subscribers,’ Dobilas pointed out. ‘But under the issuer-paid model, the record shows that there are no adverse consequences for being wrong.’ Based on this information, it would appear that the Realpoint model, with its subscriber-based revenue, is inherently superior to the issuer-paid model – for both pure accuracy and removal of potential conflicts of interest. Then again, the overarching goal of nearly any form of financial reform right now is increased transparency. Wouldn't limiting crucial rating information to those who have paid for it, rather than publishing it openly as the Big Three agencies do, severely restrict transparency instead of enhancing it? Moreover, perhaps that conflict-of-interest issue with the subscriber-pays model can be successfully mitigated or avoided altogether. [link=http://www.house.gov/apps/list/hearing/financialsvcs_dem/joynt.pdf][u]In his testimony[/u][/link], Fitch President and CEO Stephen W. Joynt stated that the credit analysis group and the business development group at Fitch are kept strictly separated, and an employee issuing a rating would never be involved in issuer fee transactions. This separation is not so difficult to believe or achieve. After all, many other businesses operate successfully under a similar separation model. Here in the magazine industry, for instance, our company includes an editorial unit that provides unbiased information to an audience alongside a separate sales unit that collects payment from advertisers. Overall business integrity remains intact by steering clear of any dangerous crossover. Perhaps the Big Three rating agencies have been – or, at least, are capable of – operating under the guidance of such principles as well. Nevertheless, does the introduction of two new voices to the TALF rating process reflect a response to the alleged misbehaviors of the Big Three rating agencies? Does it improve rating legitimacy? How important was Blumenthal's crusade to shatter this so-called Old Boys' Club? [b]- Jessica Lillian[/b], [i]Commercial Mortgage Insi

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