Two new developments in the recent rating agency drama could radically change the way pension funds manage their bond portfolios. One is the a court decision allowing the California Public Employees’ Retirement System (CalPERS), the largest state pension fund in the US, to go ahead with a lawsuit against Moody’s, S&P and Fitch, which it claims caused it to lose about $1bn (€809m) because of inaccurate ratings. The other development is the US Senate’s approval of an amendment to the financial reform proposed by Florida Republican George LeMieux and Washington Democrat Maria Cantwell to remove references to the raters from the laws governing securities and banking.
The latter is the most radical solution to the problems of the ratings system, says Lawrence J White, professor of Economics at the NYU Stern School of Business. In his paper ‘Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs is a Better Response’, he explains how US regulators in the 1970s required pension funds to rely on rating agencies to assess the riskiness of the bonds in their portfolios. That ‘prudent rule’ was crystallised by the SEC in 1975 when credit rating agencies had to register as a Nationally Recognised Statistical Rating Agency (NRSRO). “It immediately grandfathered Moody’s, S&P, and Fitch into the category,” without ever defining in a transparent way the criteria for becoming a NRSRO. So the oligopoly of Moody’s, S&P, and Fitch was born, with its inherent conflicts of interest - that is, the agencies are paid by the banks whose investments they rate, and the banks generally want higher ratings to make the securities they offer more attractive to investors. This flaw that was clearly exposed in April during the Senate hearings on the financial crisis.
The solution proposed by the LeMieux-Cantwell amendment is to remove the NRSRO special status: without it, insurance companies, mutual funds and pension funds will have to do their own financial homework about the creditworthiness of bonds. “Since the participants in the bond markets are primarily institutional investors, these sophisticated investors should be able to make sensible choices with respect to the sources of their information,” writes White.
Bill Gross, who manages the $220bn PIMCO Total Return Fund agrees. “Firms such as PIMCO with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense,” he wrote in his May investment outlook note. He concluded: “Those looking to profit at their expense will dismiss them. They no longer serve a valid purpose for investment companies free of regulatory mandates that can think with a teaspoon of IQ and a tablespoon of CQ [common sense quotient].”
If the LeMieux-Cantwell amendment becomes law, pension funds will be free to use their own judgment or buy the best independent advice on the market. Last November, the US National Association of Insurance Commissioners hired PIMCO to determine risk on 18,000 residential mortgage-backed securities held by the nation’s insurers, in a bid to improve on traditional bond ratings.
But the Senate also approved an amendment, proposed by Minnesota Democrat Al Franken, which suggests a different way ahead: it creates a new board, overseen by the SEC, which would decide which NRSRO got to rate which securities, thereby acting as a middleman between issuers and the rating agencies. A majority of the members will represent investors. But critics say this would even strengthen the NRSRO cartel and the contradiction must be solved in the final version of the financial reform.
S&P backs the LeMieux-Cantwell measure, saying it is ready to compete in the marketplace without the government forcing people to buy its services. It points out that Franken’s amendment could unintentionally give investors the idea that the ratings are government-sanctioned.
The financial reform has a long way to go, and in the meantime, CalPERS’ lawsuit goes on.
To date, the rating agencies are undefeated in court, successfully arguing that their ratings are essentially opinions about the future, and therefore subject to First Amendment protections identical to those of journalists. But that defence may prove useless after former S&P and Moody’s executives testified before senators that their management placed increasing pressure on analysts to award high ratings to risky investments in order to attract business from banks.