Non-use of ratings in SEC regulations

I am not fully satisfied with the 222 page proposal that the US SEC has put forward for eliminating the use of credit ratings in various regulations. It is certainly commendable that the SEC has done a comprehensive job of identifying all regulations that refer to ratings and then systematically eliminated every one of them. Moreover, in many cases, the SEC has also identified meaningful alternatives to the use of ratings. My disappointment is in relation to the two or three truly critical uses of rating in the SEC regulations.

The first is in capital requirements for broker dealers where the existing regulations specify different levels of haircuts for their proprietary positions in debt securities with different levels of credit rating. A good solution to this problem could have provided the template for eliminating the use of ratings in Basle 2 as well. Instead what the SEC proposes is:

We are proposing the substitution of two new subjective standards for the NRSRO ratings currently relied upon under the Net Capital Rule. For the purposes of determining the haircut on commercial paper, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the three highest rating categories by at least two NRSROs -- with a requirement that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately. For the purposes of determining haircuts on nonconvertible debt securities as well as on preferred stock, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the four highest rating categories by at least two NRSROs with a requirement that the instrument be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time.

We further believe that broker-dealers have the financial sophistication and the resources necessary to make the basic determinations of whether or not a security meets the requirements in the proposed amendments and to distinguish between securities subject to minimal credit risk and those subject to moderate credit risk. The broker-dealer would have to be able to explain how the securities it used for net capital purposes meet the standards set forth in the proposed amendments.

Notwithstanding our belief that broker-dealers have the financial sophistication and the resources to make these determinations, we believe it would be appropriate, as one means of complying with the proposed amendments, for broker-dealers to refer to NRSRO ratings for the purposes of determining haircuts under the Net Capital Rule.

The last paragraph above means that while technically the SEC gets ratings out of its rule book, for all practical purposes nothing really changes. Broker dealers would use ratings exactly as before with the full blessings of the SEC.

The SEC has a similar non solution in the second place where ratings play a critical role. Money market funds are allowed to value their holdings at amortized cost rather than fair value on the ground that regulations restrict their investments to short term debt securities in the two highest short-term rating categories. The proposal is to rely on a determination of “minimal credit risk” by the board of directors of the fund. In the context of the large losses that many money mutual funds have taken during the sub prime crisis, I would have thought that the logical thing to do would have been to mandate fair value accounting for money market funds and treat them like any other mutual fund.

The third critical use of rating and rating agencies is in the field of disclosure. Rating agencies are exempted from the prohibition of selective disclosure under Regulation FD. The SEC proposes to maintain this exemption. I think this exemption is inconsistent with the stand of the ratings agencies that their ratings are “editorials”. Similarly, the SEC permits but does not require issuers to disclose credit ratings in their offer documents. The SEC’s proposal leaves this substantially unchanged. My problem here is that if ratings are editorials, then they should be permitted to be disclosed in offer documents only in the same way and to the same extent that other editorials, research reports or expert opinions are permitted to be disclosed.

Posted at 5:09 pm IST on Wed, 2 Jul 2008         permanent link

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