Honorable Paul E. Kanjorski

Ranking Member

Subcommittee on Capital Markets

2129 Rayburn HOB

Washington, DC    20515                                 via email

 

Dear Representative Kanjorski,

 

I write to respond to your request for comments on HR 2990 and the proposed SEC Exchange Rule 3b-10. Although the initiatives take different paths they converge in support of enhancing competition among rating agencies, making the ratings process more transparent, reducing the cost and improving the quality of ratings. I commend the Subcommittee for its efforts on this important issue.

 

I am forwarding comments about rating agency regulation as it specifically relates to retail investors.  I have provided comments to the SEC as part of their two rounds of information gathering in July, 2003 and June, 2005. I have restated some of my comments here.

 

Proportionally fixed income securities are held by a small number of American households relative to other financial assets. Compared to the institutional fixed income market the retail market has limited access to information flow, market data and sophisticated analytics. Rather the retail market has come to rely in a significant way on the ratings systems maintained by Nationally Recognized Statistical Ratings Organizations (NRSROs) as signals of the relative creditworthiness of individual securities.

 

Although none of the current statutory framework surrounding NRSROs explicitly requires the protection of the individual investor, the longstanding effect of the rules has been to ensure limited but high quality analysis. Unfortunately the current designation process has also reduced transparency and restricted competition.

 

I call on the Committee to balance the continued protection of individual investors with the move to expand competition for rating agencies. I present several possible approaches to encourage competition in the ratings business later in this brief.

 

To provide a quantitative framework I have included data from the “Survey of Consumer Finance” (Excel spreadsheet table 5A) published triennially by the Federal Reserve. This data, from 2001, outlines retail ownership of fixed income and equity securities.

 

Household income percentile

Owning bonds

Owning equities

 

40-60 %

4 %

12 %

 

60-80 %

6 %

19 %

 

80-90 %

7 %

29 %

 

90-100 %

26 %

55 %

 

 

Retail ownership of equity securities is generally 2 to 4 times higher than ownership of fixed income securities. Information availability in the equities market is broad, free or low cost and plentiful to retail investors. Equities have the advantage of being traded on exchanges which aggregate and publish pricing for the securities.

 

The NASD’s corporate bond TRACE system and the Municipal Securities Rules Board’s Transaction Reporting system have begun to assist retail investors discover municipal and corporate fixed income prices. These systems will serve as the foundation of more evolved markets for retail investors in fixed income.

 

Like bond investors, equity owners suffered from the collapse of Enron, WorldCom and many other firms. Equity analysts had been compensated to “tout” stocks through the sharing of underwriting fees. Analysts were giving their negative views of a company to their institutional clients while publicly maintaining positive ratings intended for retail investors.

 

The regulation of equity analysts has been strengthened to include a NASD licensing requirement, the 86 and 87 licenses, which covers fundamental analysis and valuation of equities and knowledge of federal and industry rules and regulations. Conflicts of interests are now being disclosed and real walls between research, trading and investment banking have been built.

 

It is within this context that we make the following comments about some of the provisions of HR 2990 and its possible effects on retail investors.

 

HR 2990 Section 3 –

 

` (60) STATISTICAL RATING ORGANIZATION- `(A) DEFINITION- The term `statistical rating organization' means an entity--

 

`(ii) that employs either a quantitative or qualitative model, or both, to determine its publicly available ratings.

 

The use of quantitative models by NRSROs would be a significant change from the fundamental methods of the current NRSROs. The use of quantitative analysis for rating systems raises several issues for retail investors. Many quantitative methods are built on   an analysis of the entire capital structure of a firm and rely heavily on pricing from the equity markets. This method can be relatively volatile in its ability to signal risk. These systems, derived from the Merton model, tend to respond to short-term fluctuations in the equity markets.

 

The “signal volatility” of quantitative models poses particular hurdles for the retail investing community as they generally do not have a liquid market with which they can trade fixed income securities. If a quantitative model signals a big spike in default probability due to a sell off in the equity of the issuer, the retail investor interpreting that signal as a “sell” might not find any liquidity for the security and be faced with selling at a significant discount.

 

Qualitative or traditional, fundamental analysis gives relatively steady signals to retail investors about the long-term default probability of the rated security. These qualitative ratings are intended to represent the likelihood of default for a security through the entire credit cycle. This steadiness is very beneficial for retail which tends to buy and hold securities.

 

Quantitatively derived models are used by institutional investors most often blended with other ratings information typically fundamental analysis. Additionally, quantitatively derived models are not useful for rating financial firms because of their high levels of leverage. Approximately 25% of corporate fixed income outstanding is from financial companies.

 

 

`(B) PUBLICLY AVAILABLE RATINGS- For purposes of subparagraph (A), the term `publicly available ratings' means ratings on public companies or specific debt securities or both disseminated on the Internet for free or a fee.

 

This provision goes to the heart of one of the differences in the approach of the staff of the Commission and the proposed legislation. Although the intent of “publicly available ratings” which can be acquired “through subscription” seems intended to help newly designated rating agencies create a revenue base it potentially has a very negative unintended consequence for retail investors. The designation of firms who charge a fee for their ratings generally advantages institutional investors over retail investors.

 

The clearest example of this would be contained in the June 29th, 2005 testimony of Sean Egan of Egan-Jones Ratings Company. Mr. Egan uses price charts from a Bloomberg machine to illustrate the “early warnings” that he was able to provide his subscribers for Enron and WorldCom.  Unfortunately only those investors capable of paying for a subscription would have access to that information. This clearly disadvantages retail investors who would have suffered severe price declines in the value of their securities without knowing that a SEC designated rating agency had downgraded the security. And would have allowed institutional investors to sell their holdings first and possibly to retail investors who did not know of the ratings downgrades.

 

The SEC Proposed Rule for NRSROs requires only the rating symbol be “publicly available”. It does not require the credit rating agency to disclose the background analysis and rationalization for a rating or rating change.  This requirement is similar to the how equity ratings are handled. Firms publicly disclose the equity designation (buy, hold, outperform, etc) but share the background analysis only with clients of the firm.

 

Additionally the language of HR 2990 incorporates designation for ratings firms that issue ratings on “public companies or specific debt securities or both”. This could prove very misleading to retail investors who could have difficulty distinguishing the relative creditworthiness of the securities of a firm that issued various tranches of subordinated securities. By granting designation status to firms that rate companies, in addition to individual securities, retail investors could unknowingly believe that certain securities were more highly rated because they were issued by a more highly rated firm although the specific security was subordinated in the capital structure.

 

Increasing competition among rating agencies

 

The goal of creating more designated rating agencies will have a far reaching and long term effect on financial markets. The role played by ratings firms is as important a role as underwriters or exchanges or clearing firms. Rating agencies are part of the infrastructure of the markets.

 

            Segmented designations

 

The fixed income markets are segmented by particular types of securities. The trading floors of large investment firms have separate trading desks for Treasuries, corporate debt, municipals, asset-backed securities, mortgage backed securities, etc. Mutual funds for bonds are also generally delineated into specific categories of bonds and the expertise of the fund manager reflects that segment. The numerous electronic trading platforms that are utilized by the markets are also categorized by bond types.

 

One of the most useful methods of advancing competition among rating agencies would be to create a designation process that divides the fixed income markets into segments and then allow designation of rating agencies as NRSROs for a specific segment. For example, a ratings firm would be designated as a NRSRO for asset backed securities.

 

It would be much more achievable for firms to be qualified within narrow niches of the market then to attempt to provide the full array of analysis that the current dominant firms provide. The narrow designation would encourage specialization and advanced expertise for segments of the fixed income markets. It would be much more plausible for a firm to raise the capital necessary to build a franchise and sustain a business model as a NRSRO designated firm covering a portion of the fixed income markets.

 

 

 

 

EDGAR for NRSROs

 

Within our comments to the SEC in 2003 we recommended the creation of an online disclosure system for the NRSROs similar to the EDGAR system. The purpose of this system would be to have the NRSROs annually submit required disclosures about their ratings methodologies, conflicts or interest, firm resources and default statistics in a standardized form that would be published on the SEC site and available to all investors. This system would create enhanced transparency for NRSROs and allow direct comparison between firms about important metrics. Transparency is fundamental to competition.

 

Underwriter requirements

 

The choice of rating agencies for new debt issues is often influenced by the investment banks underwriting the securities. The underwriters have deep and longstanding ties with the dominant rating firms. The Committee could consider some requirement that underwriters that do a large number of deals annually use all the rating firms that are designated for the types of securities that they are bringing to market. This would have the effect of broadening the pool of analysis and assist new NRSROs to become established through revenue derived from rating new issues.

 

Summary

 

The need to increase the number of rating agencies that are designated as NRSROs is matched by the need to maintain high standards and to protect individual investors. There are many alternatives available to the Committee and the SEC as they review this issue. We hope that the information flow to the retail investment community is enhanced in this process and look forward to supplying any additional information.

 

                       

Very truly yours,

 

Cate Long

Founder, Multiple-Markets

 

888-752-0900

 

August 17, 2005