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Standard Response: How Two Provisions in Dodd-Frank May Affect Credit Rating Agencies

  • By Deven Sharma
  • Published: 2011-01-06

This story was excerpted from the December 2010 issue of Exchange.

With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Law ("Dodd-Frank") the financial markets have entered a new era of transparency and accountability. We at Standard & Poor's supported many of the provisions of Dodd-Frank because we believe that legislation or regulation that helps to restore confidence through greater transparency, accountability and oversight in the capital markets is beneficial and desirable.

A number of provisions in Dodd-Frank, of course, applied to credit rating firms like Standard & Poor's, and in this article I will look at a couple that have received quite a bit of attention in the market place.

Elimination of the CRA Exemption to Reg FD
One such provision that is specifically of interest to issuers directed the SEC to eliminate the ratings agency exemption from Regulation Fair Disclosure ("Reg FD"). This exemption explicitly permitted issuers to share material, non-public information with rating agencies without triggering the broader disclosure requirements contained in Reg FD.

At Standard & Poor's, we do not believe that the elimination of the rating agency exemption in and unto itself should affect the manner in which issuers share confidential information with us as a part of the rating process. This is based on two important considerations.

First, Reg FD was originally enacted to prohibit selective disclosure of confidential information by issuers to certain designated outsiders, referred to in Reg FD as "enumerated persons." These included broker-dealers, invest-ment advisors, investment companies and other persons who may reasonably be expected to trade on the information.

We believe that Reg FD was never intended to apply to the sharing of confidential information with rating agencies such as Standard & Poor's as they are not within the list of enumerated persons and our policies prohibit trading on material, non-public information. In that regard, we have in place rigorous compliance and monitoring procedures that prohibit or significantly restrict S&P employees and their families from trading in any securities about which the employee may have access to confidential information.

Second, Standard & Poor's has confidentiality provisions in place as part of its engagement letters with issuers. This language is consistent with another exemption from the requirements of Reg FD which permits the sharing of confidential information (without triggering broader disclosure) with any person who expressly agrees to keep the information in confidence. We have long maintained a policy on the treatment of confidential information, and our employees are trained on this and other S&P policies.

Of course, issuers should seek advice from their own legal advisors regarding this issue.

Elimination of Ratings from Government Regulation
Another Dodd-Frank provision calls for the elimination of ratings from government regulation—something we have long supported. We do not believe that investors and issuers should be mandated to use any particular benchmark of risk—including credit ratings. But we also believe that they should have the ability to choose which benchmarks are most relevant to them.

Our goal is to ensure that our ratings will be sought by issuers because investors want to include ratings in their analysis. Of course, that requires that investors have confidence in the quality and performance of our ratings and analysis, not because they are mandated by regulation. This is the case in many other countries around the world, where government mandates on the use of ratings do not exist and Standard & Poor's ratings are widely used by investors.

We are dedicated to delivering tools, from our ratings to our indices, such as the S&P 500, that investors can use to better understand and gauge financial risk and opportunity. We take this mission very seriously—and I believe our role is more important today than ever before. We rate more than $32 trillion in debt securities and about $6 trillion of assets are benchmarked to our equity, commodity and real estate indices.

At this time two years ago, we were in the depths of the financial crisis. The vast majority of the securities S&P rates performed as anticipated during that time, including many sectors in structured finance. However, the performance of our ratings of U.S. residential mortgage-related securities was a major disappointment. This is something that we at S&P deeply regret, and we have learned and spent much of the past few years implementing significant measures to strengthen our credit ratings, not only in US mortgages but across all sectors globally, in order to better serve the capital markets. Certainly, the environment has improved since then. But risk has not been banished, it has simply shifted. Leverage remains high in many sectors and markets and the economic recovery is fragile. New trends are emerging in capital flows and there is the potential for new challenges ahead for investors. That means growing expectations on S&P to help market participants map and navigate the road ahead.

Why Ratings are Relevant
First, let us consider why credit ratings are relevant to investors today and, therefore, to issuers. Over the last two years, we have talked with hundreds of asset managers and pension funds here and around the world about what they want from our ratings of companies, financial institutions, municipalities, countries and asset-backed securities. We have also had frequent interaction and discussions with organizations like the Council of Institutional Investors and with a good many issuers, and the response we get back is relatively clear.

The vast majority of issuers and investors find ratings useful as a comparable and convenient benchmark for measuring and discussing credit risk. Credit ratings are intended to provide a long-term view of creditworthiness based on fundamental analysis. Market-based indicators such as bond spreads or credit default swap prices, on the other hand, reflect market sentiment and the dynamics of supply and demand. They are, in other words, a trader's view of credit risk.

In practice, most investors tell us they view fundamental research and market-based indicators as complementary and that they use both in their investment process. Market-based measures are, by definition, much more volatile than credit ratings. They may be useful indicators of possible concern about credit risk, but history shows they are prone to over and undershooting.

A classic example is the sovereign debt of Greece and other southern Eurozone countries. For many years, we rated these countries substantially lower than others in the Eurozone at a time when the market consistently valued their debt on a par with AAA-rated countries such as Germany. Now the market has swung to the opposite side and is more pessimistic than we are about medium-term default risk for Greece.

Ratings may change over the course of a cycle as conditions change but they are intended to be relatively stable and cover a much broader universe of credits than the CDS market, for example. S&P has over 1,300 credit analysts...worldwide who cover 126 countries, nearly 10,000 companies and thousands of states and municipalities. By comparison, the global credit default swap market covers a few thousand names. Therefore, pension funds may find ratings a more useful tool for their investment guidelines and, we expect, will continue to look to issuers to seek credit ratings in the future.

Our future success depends entirely on serving the investment community effectively. If they have confidence in our ratings, they will look to issuers to seek them. Increased regulatory oversight is an important way of bolstering confidence, and we welcome it.

That is why we are intent on improving the quality of our credit ratings and taking steps to make our other benchmarks clear and comparable, no matter where or when or by whom they are used.

Deven Sharma is president of Standard & Poor's.

Copyright © 2014 Association for Financial Professionals, Inc.
All rights reserved.

Copyright © 2014 Association for Financial Professionals, Inc. - All rights reserved.
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