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SEC Will Get Rid Of Ratings Rules But SEC Doesn't Have To Like It

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Last week Bloomberg reported on the SEC's efforts to comply with Dodd-Frank's requirement that it remove references to credit rating agencies from its regulations. How's that going?

Screw you, that's how. The SEC has made pretty clear its displeasure with having to eliminate references to ratings, saying in an April release:

As noted above, in each of these concept releases and rule proposals, commenters generally did not support the removal of references to NRSRO ratings from Commission rules and provided few possible regulatory alternatives. The
Commission recognizes the concerns raised by commenters that replacing credit ratings – which provide an objective benchmark – with more subjective approaches could increase costs to broker-dealers and the Commission. ... The Commission, in proposing alternatives to credit ratings, is seeking generally to neither narrow nor broaden the scope of financial instruments that would qualify for the benefits conferred in the existing rules while, at the same time, fulfilling the statutory mandate in Section 939A of the Dodd-Frank Act.

So: we're going to eliminate references to ratings because Congress told us to, but we think it's dumb and want to change as little as possible. Bloomberg describes what they've come up with:

In the absence of a good substitute, the Securities and Exchange Commission has handed the problem back to the market: in two rules issued last spring, the agency has suggested that money-market funds, which invest in top-quality bonds and other securities, evaluate credit risk themselves and that broker-dealers figure out their own measures for creditworthiness when tallying their required reserves.

The proposed new rules on broker-dealer capital requirements, for example, would allow brokers to use the favorable capital treatment currently given to rated investment-grade debt if they determine that a security has a "minimal amount of credit risk" based on their own written policies. Those policies can refer to a list of non-required factors including credit spreads, third-party research, "internal or external credit risk assessments" (including ratings), default statistics, inclusion in an index, credit enhancements, price, and "asset class-specific factors" (i.e. if a structured product was actually structured by cows or whether primates were involved in some capacity).

Better Markets thinks this doesn't go far enough, and in their comment letter ask the SEC to set specific mandatory factors for broker-dealers to follow - factors that exclude any reliance on credit ratings, which Better Markets thinks are wholly evil.

Industry group SIFMA, on the other hand, wants to make it as easy as possible for brokers to continue doing what they've been doing, and say in their comment letter:

We believe policies and procedures reasonably designed for determining whether a fixed income security has only a minimal credit risk could base the determination solely on a small number of objectively determinable factors (e.g., internal or external credit ratings and yield spreads) under circumstances where (i) the position in the security is acquired on a short term basis (e.g., as part of an underwriting or market-making business) and is not held for a long period or (ii) the firm‘s position in securities of the relevant issuer is immaterial in relation to the firm's capital. Such policies and procedures would represent a reasonable allocation of the limited resources of the broker-dealer‘s credit review function, and they could also be implemented by small and medium-sized broker-dealers that lack the resources necessary to conduct a sophisticated credit review.

Which would mean that, for most of their regular trading inventory, brokers could be allowed to continue relying on ratings in determining capital.

These rules are a consequence of some half-baked thinking that went into Dodd-Frank. Yes, investors relied too much on ratings and didn't do enough of their own credit work in evaluating bonds and the balance sheets of banks that held them. But that's hard to fix by just regulating that everyone should do better credit work. The SEC's proposed rules are a clever compromise, paying pages of lip service to the idea that everyone should think deeply about the creditworthiness of all of their assets while in practice giving brokers a fair amount of leeway to rely on easy-to-read external indicators like ratings and spreads. Particularly with the addition of SIFMA's friendly amendment, the SEC may be able to follow Congress's instructions without doing much to change how brokers calculate capital. Which, y'know, will be great until the next crisis in highly rated debt instruments.

SEC Trying to Gauge Risk Without Credit Raters [Bloomberg]

Removal of Certain References to Credit Ratings Under the Securities Exchange Act of 1934 [SEC]