New Rating Regs Address Conflicts of Interest

The Accountability and Transparency of Rating Agency Act of 2010 provides investors with safeguards against potential conflicts of interest.  For example, the SEC requires rating agencies to structure payments in a manner designed to ensure accurate and reliable surveillance of credit ratings over time, and that incentives for reliable ratings are in place.

To be clear, the rating agencies have earned into revenue the rating fee at the time of new issue. The accounting theory was once the issuer borrows the money, the utility of the rating is finished.

What’s more, the new regulation addresses the shortfalls associated with “rating only upon request” and the old game of withdrawing ratings when issuers ran into trouble.  Yes, the rating agencies withdrew ratings just when investors need ratings the most because issuers simply stopped answering requests for additional, ongoing financial information.

My reading of the new regulation would require the rating agencies to earn the rating fee over the life of the underlying obligations/securities, which is consistent with Generally Accepted Accounting Principles (GAAP).

The impact on the rating agencies may be far reaching and dramatic.  However, the impact would vary by business line.  Sectors that issue longer-term obligations could be marginally less profitable than short-term counterparts.

Of course, the overall profitability of the rating agencies would take a huge whack.  But, over time, the balance sheets of the rating agencies might grow significantly as the retained rating fees accumulate.   And, the rating agencies may need to have strong balance sheets given the new “private action” rule that allows investors to sue rating agencies.

By earning the rating fee over the life of the obligation/security, the rating agency has an incentive to continue providing the rating, even if the issuer balks at providing additional disclosure.  Withdrawing the rating would require the agency to surrender the fee (or face lawsuits).

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