I know I return to this theme a lot in this column, but the Unintended Consequences Watch needs to be manned day and night. Today let’s talk about 17g-5. This esoteric sounding SEC rule is intended to diminish the perceived failings of the rating agency culture which has been fingered as one of the principal causes of the “Late Unpleasantness”. The notion was that the rating agencies, hired by the issuers, were mired in conflicts of interest and there were few, if any, structural safeguards to protect investors from bad ratings.
17g-5 provides that rating agencies must require a party retaining the agency to rate an asset backed security (including CMBS) to establish and maintain a password-protected website for all other rating agencies. The website must contain all information provided to the rating agency in connection with the rating. This pertains whether information is provided in writing or orally and to information provided by the issuer or by anyone on behalf of the issuer. The information must be loaded into the website simultaneous with its delivery to the retained rating agency. This was purported to provide a structural counterpoint to the pressure for continuously lower levels by issuer procured ratings.
This has some superficial appeal. To the extent that investors were concerned about conflicts of interest, unsolicited ratings seems an antidote to these perceived concerns. Indeed, on first blush, it’s hard to see an argument that unsolicited ratings are bad.
But on first blush I thought the financial crisis that began about three years ago last month, would be over by Thanksgiving. The story of 17g-5 is yet another reminder that financial systems are much more complex than rule makers perceive them and wish them to be. Welcome back, yet again, to the wonderful world of unintended consequences.
In this case, what has flowed from the desire to do good by providing multiple opinions of value to the investors is a system which is likely to degrade the quality of information and analysis available to investors.
The heart of Rule 17g-5 is the simultaneous sharing of information. Again, sounds good but here’s what’s happening. Bankers legitimately concerned with liability are insisting that there be only one conduit of information from the issuer’s side to the rating agency. So no lawyers and no third parties are having direct contact with the rating agencies and, more importantly, the rating agencies can’t have contact with them. Moreover, the rule treats oral and written communication alike and requires all to be simultaneously transmitted to all rating agencies through the website. No one is quite sure how to deliver oral communication to all the rating agencies simultaneously through the web-based delivery system. Are transcripts needed? Can summaries be provided? How simultaneous is simultaneous? Bottom line: oral communication is being suppressed.
The consequence? The rating agencies have a much poorer picture of what they’re rating than they had before. Just think of conducting a business transaction in mime. Documents are never entirely clear. Documents describing highly complex structured finance transactions are REALLY not clear. How often do you call up someone in a transaction and say, I don’t get it, what are you trying to do here? So rating agencies have been left to try to discern what’s going on from the bare documentation and take a view without the benefit of the normal give and take of the conference call. Rating by charades!
Rating agencies are going to get it wrong. They may get it wrong in ways that results in lower subordination levels or higher. It’s inevitable, and not their fault. If you actually had to do a deal, any deal, without talking to the other side, can you imagine how wrong that deal might come out? So that’s what we’ve got. In an effort to level the playing field and create competition, we are degrading the quality of ratings. At a time when it’s clearly vital that the marketplace gain renewed confidence in the rating exercise, we’re creating reasons for lack of confidence. Explain to me exactly how that’s a good thing.
By Rick Jones.
