As the dust settles on the financial crisis, there is the inevitable move to create regulations to prevent a similar crisis in the future. One discussion we view as very positive is the effort to increase transparency.
We believe a strong framework of transparency should be developed for all groups in the financial sector that investors depend on for making decisions. This begins with the rating agencies.
Investors rely heavily on the credit ratings of securities. The ratings industry, dominated by three firms (Standard & Poors, Moody’s Investor Service, and Fitch ratings), is blamed by many for missing the subprime mortgage meltdown and resulting financial crisis. Specifically, AAA rated mortgage backed securities fell an astonishing 70 percent from January 2007 to January 2008.
This past fall, the Securities and Exchange Commission voted to increase oversight of credit ratings agencies by improving transparency and enhancing disclosure. Increasing the transparency of these organizations will ultimately improve the integrity of the ratings process, encourage more competition within the industry, and restore investor faith.
One of the SEC’s proposals would require companies to disclose whether they have received preliminary ratings from other agencies. The SEC’s intent is to prevent companies from “shopping” for favorable ratings. The commission also voted to provide greater information concerning ratings histories, with detailed information about how ratings were determined.
Further, the proposals would require the ratings agencies to disclose the name of the entity paying for the rating. They would also need to provide more information about income earned from the companies they rate, a measure intended to address the issue of conflicts of interest.
It’s unfortunate that regulating these agencies only occurred after the bubble burst, especially when the conflicts of interest within the ratings industry were so painfully obvious. But this is a pattern that unfortunately we seem destined to repeat. We can look at multiple financial crises such as the Madoff Ponzi scheme, Enron and the savings and loan crisis and identify how the culprits have benefited from the inefficiencies in the current system. A lack of greater transparency provides the opportunity for manipulators to benefit from an opaque system.
Similarly, allowing investment banks who currently develop fairness opinions on transactions they are involved in raises real questions of independence and potential conflicts of interest.
Actions should be taken to prevent these conflicts and assure that investors and boards of directors can trust the information they need to determine whether or not a transaction makes sense.
As we emerge from these challenging times, we’re clearly experiencing a natural tendency to place blame and identify what can be done to prevent a future crisis. We should utilize the current crisis to thoughtfully consider how to protect investors by making sure they have access to the quality information necessary to make informed decisions. Identifying conflicts of interest and improving transparency, especially within the ratings agencies, will go a long way toward ensuring a more secure future.
