Colorado fund stokes fire of Congressional grilling of ratings agencies

Premature efforts to eliminate the use of credit ratings agencies without an adequate alternative would increase risk to investors, warned Gregory Smith, the chief operating officer of the Public Employee’ Retirement Association of Colorado (PERA).

Smith made the comments when testifying recently to US Congressional hearings that have shone a spotlight on the performance of credit rating agencies and the effects of the 2010 Dodd-Frank reforms.

Dodd-Frank requires the removal of references to credit ratings in all federal statutes and regulations. The legislation also bolsters scrutiny of the agencies, including provisions for greater transparency and disclosure around ratings methodologies and practices.

Smith – who is a COO of Colorado PERA and a board member of the Council of Institutional Investors (CII) – urged caution in trying to untangle the complex role of ratings agencies in the financial system.

“We are concerned that hasty efforts to eliminate credit ratings prior to the development of effective substitute tools increases risk to investors, the regulatory environment of insurance companies, banking institutions and others whose capital and reserve requirements are dependent, in part, upon credit ratings, as well as counterparty risk,” Smith testified to a sub-committee of the Financial Services Committee.

“Therefore, we encourage regulators to take a careful, deliberate approach to eliminating references to ratings over time.”

Smith said both the $40.2 billion Colorado PERA and CII supported moves to reduce the reliance on credit ratings within the financial system.

CII focuses primarily on corporate governance issues and is a not-for-profit association of public, corporate and labour pension funds with combined assets of more than $3 trillion.

Colorado PERA is in the process of consulting with both internal fund managers and outside experts on identifying other alternative measures of risk to ratings, Smith said.

“The process is a challenging one in that to-date no single appropriate substitute for a robust, objective evaluation of credit risk has yet been discovered,” he told the Sub-committee on Oversight and Investigations.

The sub-committee heard from a range of witnesses at hearings investigating the role of credit agencies held last week. These included senior representatives from credit ratings agencies Moody’s Investors Services and Standard & Poor’s and from the SEC and the US Federal Reserve.

The Oversight and Investigations sub-committee is one of five sub-committees of the powerful Financial Services Committee that is tasked with wide-ranging reviews of regulators and the workings of financial markets in the wake of the financial crisis.

Smith said the fund was also looking to establish procedures for evaluating the different disclosures that rating agencies will be required to provide under SEC proposed rules mandated under the Dodd-Frank legislation.

“Colorado PERA intends to take full advantage of the increased disclosure requirements in order to better assess the soundness of individual credit ratings, the risks of the rated security itself, and the overall value of the rating agency’s work,” Smith said in testimony.

The role of the three main credit rating agencies has come under scrutiny after the global financial crisis due to their issuing of investment-grade ratings to mortgage-backed securities and collateralised debt obligations in the lead-up to market meltdown.

While some US pension funds have sought legal recourse against advisors for losses incurred investing in sub-prime mortgage vehicles, rating agencies were largely indemnified against similar action.

Dodd-Frank provisions allow for ratings agencies to be liable for material mis-statements on the ratings they provide for particular investments.

Smith said that, despite the changes in the regulatory framework and some operational improvements at ratings agencies, industry practices that had enabled the previous financial crisis remained.

“First, I would note that the three largest credit rating agencies, that issue about 98 per cent of the total credit ratings in the US continue to operate under a fundamentally conflicted system that was a significant factor responsible for the inaccurate credit ratings leading up to the financial crisis.”

Smith was referring primarily to the ongoing business model of the agencies.

The agencies have come under fire for having an “issuer pays” system, where those seeking and paying for the credit ratings are the same firms profiting from the sale of the products rated.

Critics have said this represents a conflict of interest, which previously led to weakened standards and more favourable ratings.

Smith also noted in his testimony that the senior management at both board and executive level ratings agencies were still in place despite serious questions about the performance of the organisations they are responsible for.

“Those individuals managed organisations that despite record revenues had serious operational problems that contributed to their inaccurate ratings,” Smith said.

Smith described these operational problems as including:

• Rating models that failed to include relevant mortgage performance data
• Unclear and subjective criteria used to produce ratings
• Inadequate staffing to perform rating and surveillance services

Smith said Colorado PERA did not rely solely on ratings either before the financial crisis or after the passage of Dodd-Frank.

“Relying exclusively on ratings would be a failure of their (pension funds) fiduciary duty,” he said.

But Smith said the use of ratings was still integral to the investment decision-making process at the fund.

Ratings were used at Colorado PERA as a “first cut” in identifying instruments eligible for further consideration and analysis, Smith said.

Ratings were also used as an aid in establishing initial risk parameters for Colorado PERA’s internal and outside portfolio managers. They also served as important factors in decisions to participate in short-term credit facilities, such as cash accounts and money markets.

Smith said the transparency provisions in the Dodd-Frank legislation were likely to be effective and both PERA and CII broadly supported the legal and regulatory changes.

He called for a full implementation of the proposed regulatory changes, saying better disclosure of methodology and the data used for ratings would promote more prudent use of ratings by investors.

Increased standardisation of ratings processes and release of more public information would also allow investors to better track ratings over time and compare the performance of ratings agencies.

Smith said he hoped this would promote competition and competence in the ratings industry.

Due to budgetary uncertainties the SEC has yet to form the new Office of Credit Ratings, and Smith said this was a vital oversight component of the Dodd-Frank reforms.