How many of us would knowingly step onboard a new airplane that has a known flaw with a high probability of catastrophic failure? Unless you are an extreme risk-taker, this scenario is highly unlikely. And yet, this is exactly what faces the mortgage secondary market unless meaningful reform of the credit rating process occurs ahead of GSE reform.
Over the last few weeks, the buzz over GSE reform has intensified among legislators. There is a glimmer of hope that private capital may be willing to dip a toe into the secondary market without government support as evidenced by the recent mortgage securities sale by JPMorgan Chase and EverBank. On top of that, the Federal Housing Finance Agency is moving forward with its mandate requiring the GSEs to each pilot a variety of credit enhancement structures on billions of dollars of their credit risk exposure. While these events herald the beginning of a much-awaited focus on reducing the government's role in the mortgage market, overhauling the credit ratings process that contributed to the mortgage crisis must be a priority.
Inherent conflicts of interest in the issuer-pay model underlying the credit ratings process as described in the Securities and Exchange Commission's study of assigned credit ratings were exposed after the mortgage crisis began. Is it any wonder an issuer desiring lower financing costs associated with high credit ratings will select the rating company able to provide it with that result? By facilitating ratings shopping, it was just a matter of time before the weaknesses of the issuer-pay model would adversely affect a secondary mortgage market already suffering from a number of major process and control weaknesses. But, in the aftermath of the crisis, any meaningful reform of the credit ratings process has remained elusive, even though the Dodd-Frank Act forces regulators to drop requirements relying on external ratings by banks. A number of alternatives to the current credit rating structure have been identified, but the one that holds the most promise may be where ratings are assigned to a nationally recognized statistical ratings organization by an independent public utility.
The basic idea behind this ratings assignment model is to place an independent public utility between the issuer and NRSRO as a way of avoiding the conflicts of interest in the issuer-pay model. The SEC would establish a board that would designate qualified NRSROs and would select an NRSRO to conduct a ratings assessment requested by an issuer through the board. Credit rating fees under this model could be established by the board. This assignment process for credit ratings is not unlike processes designed to prevent conflicts of interest arising out of property appraisals.
During the housing boom, inherent conflicts of interest arose in many cases where mortgage production staff directly assigned appraisals. Not surprising, repeat business for an appraiser would be dependent on the appraisal coming in at a value that would get the loan completed. Such arrangements were in violation of appraisal industry and regulatory standards. An effective way to address potential appraisal conflicts has been the use of a randomized list that eliminates the possibility of a specific appraiser being contacted by the production unit. In similar fashion, a credit ratings assignment board would have the same effect on the credit ratings process and should be adopted.
Other advantages to a credit ratings assignment process include a performance monitoring structure that incents NRSROs to maintain a high level of accuracy in their ratings, and a broadening of the market base across NRSROs by allowing smaller, but higher quality ratings companies to be assigned a greater share of ratings. Some arguments have been levied over the possibility that issuers could still directly solicit other NRSROs to provide supplemental ratings to the initial rating assigned by the board to an NRSRO. However, this concern could easily be mitigated by investing the board with the authority to assign initial and supplemental ratings based on accuracy and expertise of the NRSRO for that particular structured product.
GSE reform without reform of the credit ratings process is incomplete and exposes the secondary mortgage market to another eventual crisis. With the FHFA signaling their intent to evaluate senior subordinated structures, credit default swaps and other complex structured products, the accuracy and objectivity of credit ratings must be of paramount interest to regulators, investors and the public for the same reason that faulty batteries must be fixed before allowing unproven technologies to take to the skies.
Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.