Treasury Official Sees Reform of Credit Rating Process and Enhanced Disclosure

Echoing a recent UK Treasury Committee finding that securitization is here to stay, a US Treasury senior official called for broad reform of the securitization process, including reliable ratings of complex securities, better disclosure, and improved risk management Assistant Secretary Anthony Ryan told the Exchequer Club that securitization is a financial innovation that has expanded the availability of credit and reduced the cost of capital. After diagnosing the weaknesses of the securitization process, the Treasury, the SEC and the Fed have embarked on reform.

As part of that reform, the President’s Working Group on Financial Markets recently proposed broad and substantial changes to US financial regulation. The comprehensive reforms are nothing less than a complete overhaul of the securitization process and the concomitant mortgage origination process that relied on the sale of asset-backed securities.

The working group recommendations, when implemented, will strengthen markets through risk awareness, enhance disclosure and risk management, reform credit rating agencies processes, and promote transparency. The PWG put forth a series of recommendations regarding ratings practices that focused on improving the quality and integrity of underlying data and models, independence of the ratings process, and limits in utilizing ratings.

The weaknesses of the rating agencies were compounded by investor over reliance on the rating agencies' assessments and by the practices of other market participants, including originators and securitizers. He emphasized, as others have, that investors have a responsibility to conduct independent analysis and not simply rely solely on ratings.
It is axiomatic, said the official, that rating assessments are dependent on the quality and integrity of the underlying data received from both the originator of credit and the packager of securitized products. As a result, the PWG has called for rating agencies to disclose what qualitative reviews they perform on originators. Rating agencies should also require securitizers to represent the level and scope of due diligence performed on the underlying assets

In addition, the use of the same rating categories for both securitized products and corporate bonds must end, noted the official; since this facilitated investor complacency. Investors acted as if they did not appreciate that risk characteristics differed. But they most certainly do differ, declared the official, and there needs to be a clearer distinction made by the rating agencies, investors, and regulators. The Treasury official suggested the use of a separate nomenclature or identifying suffix highlighting the unique risk characteristics of structured credit products.

Noting that many securitized products are opaque, the official called for additional disclosure by originators, underwriters, and credit rating agencies so that investors have information available to better assess risk. Securitizers need to enhance disclosure regarding the originators of assets, including, for example, assessing the originator's experience, quality of management, underwriting standards, process by which loans are sourced, and track record of providing accurate information on originated assets. They should also publicly disclose whether they engage in ratings shopping, and if they do, disclose the reason for not publishing preliminary ratings.

The PWG also called on financial institutions to make more detailed and comprehensive disclosure of off-balance sheet commitments, including commitments to support conduits and other off-balance sheet vehicles. To facilitate better disclosure, the PWG will ask a private sector committee made up of investors, rating agencies, and issuers to develop best practices.

Much of this comes back to risk management, said the Treasury official. Market participants and regulators must both be part of curing weaknesses in risk management. He related that U.S. banking regulators and the SEC are developing common guidance to address risk management weaknesses, including improving stress testing, the governance of the risk management and control framework, and internal risk reporting and measurement.