Don’t Just Blame the Rating Agencies

The Financial Stability Act of 2010 includes various provisions relating to Nationally Recognized Statistical Rating Organizations (NRSRO) — Rating Agencies — ranging from Senators LeMieux and Cantwell’s laissez faire elimination of NRSROS to Senator Franken’s governmental assignment of NRSRO’s to specific bond offerings. While the extremes are covered, a middle of the road approach is missing.

Fortunately, we have been through this dance with the role of Rating Agencies once before, and the SEC came out with a prudent solution.

Every mutual fund lawyer knows that advisors to money market funds cannot blindly rely upon the the Ratings Agencies’ assessment of a debt instrument. Instead, money market fund advisors must do their own credit homework in analyzing debt instruments.  They may take into account a Rating Agency’s rating as one factor in their own analysis, but the rating can not be a substitute for their own analysis.

This issue was firmly put to bed in the early 1990’s.

A little background.  Money Market Funds are allowed to keep their share prices valued at $1.00 per share (irrespective of slight movements of net asset value of the fund) provided they abide by certain credit and diversification rules. (Set forth in Rule 2a-7).  In other words, money market funds are exempt from the basic rule that the share price of a mutual fund must fluctuate and reflect the net asset value of the assets held by the fund.

One of the core provisions of Rule 2a-7, is that a money market fund must “limit its portfolio investments … to instruments which … present minimal credit risks”. After a series of commercial paper defaults in the late 1980’s, the SEC substantially modified Rule 2a-7 in 1991.  Among other changes, the SEC, for the first time amended the “minimal credit risk” requirement, by adding the following parenthetical; “(which determination must be based on factors pertaining to credit quality in addition to the rating assigned to such instruments by a NRSRO)”.  The Commission explained that the language was designed to emphasize that:

Possession of a certain rating by a NRSRO is not a “safe harbor.” Where the security is rated, having the requisite NRSRO rating is a necessary but not sufficient condition for investing in the security and cannot be the sole factor in determining whether a security has minimal credit risks.

This simple amendment transformed the management of money market funds. For over 15 years, money market fund advisers have had to undertake their own credit analysis.  Rather than relying on the Rating Agencies, investment firms had to develop their own staff of credit analysts.

Investors burned by investments in mortgage-backed-securities and CDO’s cannot place all of the blame on the Rating Agencies for the investment losses that they incurred.  I am hardly an apologist for the Rating Agencies given the various allegations of collusion between the Rating Agencies and Wall Street firms, as well as the conflict of interest inherent in their business model in which the issuers of securities pay the fees of the Rating Agencies.  Nonetheless, investors must take some responsibility for their investment decisions.

The unanswered question in the subprime financial crisis is whether investors did their own credit analysis with respect to the various mortgage-related instruements.  Those who did, not only likely sidestepped the crashing market for these instruments, but  some made fortunes on their bets against these instruments.

Michael Burry, Steve Eisman and Robert Rodriguez, profiled in Michael Lewis’s, The Big Short and Roger Lowenstein’s, The End of Wall Street, are examples of investment professionals who did their homework and did not blindly rely upon the pronouncement or ratings of Wall Street’s standard bearers.

In my mind, the lesson is simple, particularly for investing fiduciaries.  Do your homework.  In the constellation of jobs within the financial services industry, credit analysis is neither glamorous nor high paying.  Everyone would rather be a deal-maker or a hedge fund maestro.  But with complicated investment products and volatile global markets, I want to stick with the guy who does his credit homework.  Rigorous credit analysis can never be a bad thing.  Whereas as blaming the other guy — such as the Rating Agencies — seems, shall we say … a bit unfiduciary-like.  Instead, we need fiduciaries who will raise their hands and say, “I did my homework and I take responsibility for my decisions.”

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