US fondness for ratings continues

Last week, I blogged about the US being an outlier in terms of its excessive use of ratings in its regulations. This fondness for credit ratings (particularly the highest rating) continues. Yesterday, the US SEC announced proposals for reforms of money market mutual funds. Reforms are clearly needed here – among the most scary consequences of the Lehman bankruptcy last September were the problems at the Reserve Primary Fund which saw its Net Asset Value drop below par.

SEC is eliminating the ability of the money market funds to hold 5% of their assets in “Second Tier” securities that have the second highest credit rating instead of the highest rating. This was of course one of the recommendations of the industry body (ICI) in its report of March this year. But even that report admitted that investment in second tier securities had nothing to do with the post Lehman crisis. Lehman had a Prime-1/A-1/F-1 short term credit rating (making it a first tier security) right up to its bankruptcy.

To my mind, this reform is indicative of regulatory capture. This is the kind of tiny change that has propaganda value for the fund management industry (“money market funds are safer than ever before”) while changing nothing substantive. If the SEC genuinely wanted to use ratings to make funds safer, it could have said that the issuer must also have a AAA/AA long term rating – Lehman was rated A long before its bankruptcy.

Actually, having something like 5% in second tier securities is not entirely a bad thing in that it reduces the skewness of the distribution. A portfolio of top rated securities can only experience downgrades and this produces a skewness towards the left. A small proportion of securities that can experience upgrades could make the distribution more symmetric.

The weighted average credit rating of a portfolio is more important than the minimum rating as a measure of credit risk. The current SEC rule does not distinguish between gradations within the highest rating category. A money market fund with a small amount of second tier securities and a lot of A1+/F1+ securities in its portfolio can have a higher weighted average credit rating than a fund which has no second tier securities at all. In the run up to its bankruptcy, Lehman had an A1/F1 rating and not an A1+/F1+ rating.

Finally, the best reform (something that a regulator captured by the industry would never dream of doing) is simply to prohibit stable (amortized) value completely. All funds should be required to operate a proper net asset value (based on market prices) that would fluctuate up and down so that investors do not get a false sense of security.

Posted at 4:40 pm IST on Thu, 25 Jun 2009         permanent link

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