Changing the role of the rating agencies

As expected, yesterday the SEC voted to change the requirements for certain investors to use credit ratings in their investment decisions. As SEC Chairman Christopher Cox explained in his Statement on Proposal to Increase Investor Protection by Reducing Reliance on Credit Ratings:

In preparing the staff recommendations to the Commission today, the Division of Trading and Markets, the Division of Corporation Finance, and the Division of Investment Management all have conducted thorough evaluations of the way credit ratings are used in the rules and forms within their areas of expertise. What those evaluations have found is that in some rules and forms, the reference to credit ratings isn’t really necessary at all. In those cases, the proposed new rules would simply eliminate the reference.
. . .
All told, the three Divisions have examined the references to credit ratings in 44 of our rules and forms. The staff is recommending changes to 38 of them. Specifically, they are recommending the complete elimination of any reference to credit ratings in 11 rules and forms. They are recommending the substitution of a standard based on a more clearly stated regulatory purpose or other concept in 27 rules and forms. And they are recommending leaving the reference unchanged in 6 rules and forms.

The major impact of the rule changes appears to be on money market funds – which would now be required to make their own determination of the default risk and liquidity of their holdings. However, another change involves structured finance vehicles – with implications for the monetization of intangibles. As Andrew J. Donohue, Director of the Division of Investment Management, explained to the Commission in his remarks:

With respect to Rule 3a-7 [under the Investment Company Act], as part of this rulemaking initiative, we have reevaluated the use of credit ratings as a factor for excluding structured finance vehicles from the Investment Company Act and are recommending that you amend the rule to limit the type of investors that may participate in offerings of the securities of those vehicles to accredited investors and qualified institutional buyers to make the rule consistent with marketing practices relating to those vehicles. We also recommend that you substitute for the references to credit ratings in the rule certain procedures that are designed to protect the full and timely payment of outstanding fixed income securities and to require that cash flows from a structured finance vehicle’s asset pool are deposited in a segregated account.

Structure finance vehicles are a standard mechanism for the securitization of intangibles (see our working paper – Intangible Asset Monetization: The Promise and the Reality). As the details of the proposed rules are made public, someone needs to take a close look at this to make sure that intangibles don’t get caught up in and damaged by the needed tightening of other financial engineering abuses.

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