AFR Comment Letter to the SEC on Credit Ratings

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April 25, 2011
Ms. Elizabeth Murphy
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090
Re: RIN 3235-AL02: “Proposed Amendments to Remove References to Credit Ratings in Rule
2a-7 Under The Investment Company Act of 1940”
Dear Ms. Murphy:
American for Financial Reform (“AFR”) appreciates this opportunity to comment on the
Commission’s “Proposed Amendments to Remove References to Credit Ratings in Rule 2a-7
Under the Investment Company Act of 1940”. AFR is a coalition of over 250 national, state,
local groups who have come together to advocate for reform of the financial industry. Members
of AFR include consumer, civil rights, investor, retiree, community, labor, religious and business
groups along with prominent economists and other experts.
This letter is in response to the Commission’s request for comments on its recent proposal to
remove credit rating references in Rule 2a-7 under the Investment Company Act, the rule
governing the operations of money market funds.
Section 939A of Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) requires
that the Commission remove references to Nationally Registered Statistical Rating Organizations
(NRSROs) in regulations promulgated pursuant to the Investment Company Act of 1940. This
step by Congress was a reaction to the over-reliance on credit ratings as a risk management tool,
which played a key role in enabling the financial crisis.
However, we are concerned that eliminating the reference to NRSRO ratings from Rule 2a-7
without offering more concrete guidance on alternative means to assess risk could seriously
weaken protections for investors in money market funds without truly addressing the systemic
problem of institutional over-reliance on the rating agencies who failed during the financial
crisis. We are also concerned that this rule does not satisfy the intent of Section 939A, which
requires not only that regulatory agencies remove references to credit ratings but that they
substitute an alternative “standard of credit-worthiness”. The guidance offered in this rule does
not rise to the level of specificity necessary to be an objective standard of credit-worthiness, and
leaves fund investors completely dependent on the subjective and opaque judgments of the fund
The Commission is not the only agency facing the difficult question of how to provide guidance
on credit-worthiness without the use of NRSRO ratings. Recent proposed rules by the prudential
regulators have also requested public input on this issue.1 In light of the complexity of this
problem and the need for assistance across the financial regulatory community, AFR suggests
that the Commission and other regulators convene a group of experts to provide advice and
recommendations on ways to provide guidance to financial entities regarding objective standards
of credit-worthiness that do not incorporate credit ratings Convening such a group in concert
with other regulators would also help the Commission to implement the statutory mandate in
Section 939A to work toward uniform standards of credit-worthiness across the financial
regulatory agencies (to the extent that this is feasible). The proposal currently does not address
this statutory requirement.
Overreliance on Unreliable Ratings Was A Central Contributor to The Financial Crisis
Recent reports by the Financial Crisis Inquiry Commission (FCIC) and the Senate Permanent
Subcommittee on Investigations have laid out in extensive detail the absolutely central role
played by credit rating agencies as enablers of the financial crisis.2 The FCIC summarized the
case well in its Conclusions:
“ …credit rating agencies were essential cogs in the wheel of financial destruction. The
three credit rating agencies were key enablers of the financial meltdown. The mortgagerelated
securities at the heart of the crisis could not have been marketed and sold without
their seal of approval. Investors relied on them, often blindly. In some cases, they were
obligated to use them, or regulatory capital standards were hinged on them. This crisis
could not have happened without the rating agencies. Their ratings helped the market soar
and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”
The “big three” rating agencies were paid by securities issuers and faced a fundamental conflict
of interest. This conflict was perhaps especially salient in rating novel, complex asset-backed
securities. The ratings for such securities were dependent on complex mathematical models that
were not well understood by investors, and rested on numerous assumptions that could easily be
1 See discussion on p. 1903 of the proposed rule, “Risk Based Capital Guidelines: Market Risk”. Federal Register
Vol. 76, No. 7, January 11, 2011.
changed to give ratings the issuer desired. The FCIC report summarizes some statistics
concerning the almost incredible breakdown of professionalism and reliability of NRSRO ratings
prior to the crisis:
“From 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-
A. This compares with six private-sector companies in the United States that carried this
coveted rating in early 2010. In 2006 alone, Moody’s put its triple-A stamp of approval
on 30 mortgage-related securities every working day. The results were disastrous: 83% of
the mortgage securities rated triple-A that year ultimately were downgraded.”
The ‘blind reliance’ on untrustworthy credit ratings is addressed in two ways in the Dodd-Frank
Act. The first is through increased supervision of NRSROs, including more mandated
disclosures. Hopefully these steps will make NRSRO ratings more reliable and help investors
better understand the ratings process. The second is by mandating the removal of references to
credit ratings in laws and regulation. This will hopefully lessen blind or uncritical reliance on
ratings by the investor community.
Improving ratings quality and reducing uncritical overreliance on ratings are crucial parts of
financial reform. However, the proposed rule seems unlikely to accomplish this goal.
Eliminating Ratings References Without Providing Sufficient Guidance on Objective Standards
of Credit Worthiness Is Risky and Does Not Accomplish Statutory Goals
Currently, Rule 2a-7 requires a money market fund to hold top-quality securities in its portfolio.
The board of directors of a mutual fund is charged with determining that portfolio investments
present “minimal credit risk” based on factors pertaining to credit quality, in addition to any
credit ratings on a security. In other words, securities must satisfy a two-tiered test: 1) they must
be highly rated—an objective determination; and 2) they must pass the scrutiny of the board of
directors—a subjective determination.
Under the current proposal, an NRSRO rating would no longer be a required element for
determining which securities are permissible investments for a money market fund. Instead, a
security would be an eligible investment for a money market fund if the fund’s board or its
delegate determines that the security presents minimal credit risks. The Commission does not
introduce new guidelines or objective standards to guide the board in determining asset risk.
2 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, January, 2011; Permanent
Subcommittee on Investigations, Wall Street And The Financial Crisis: Anatomy of a Financial Crisis, United States
Senate Committee on Homeland Security and Government Affairs, April 13, 2011.
Instead, the rule simply restates the existing obligations of the money market fund Directors to
ensure that the fund invests only in securities with minimal credit risk.
Thus, the current proposal effectively eliminates the objective standard, credit ratings, and
expands the subjective standard– the board of directors’ internal determination. A rule that
increases reliance on subjective determinations of risk is not likely to increase investor protection
and market stability in a sector such as money market funds, where investors place an extremely
high priority on the ability to retrieve all of their funds on short notice.
As several commentators have suggested, the elimination of credit ratings without the
substitution of some other external measure of risk will seriously undermine the Commission’s
ability to determine whether mutual funds are in compliance with Rule 2a-7 due to the difficulty
of policing subjective standards. This is especially true since requirements to document board
decisions are limited, and this proposed rule does not increase them. If the Commission chooses
to move forward with this proposal, it is absolutely essential to take steps to ensure that fund
boards can clearly document, and regulators can review, the basis for their determination that a
security poses “minimal credit risk.”
An inability to police consistent standards of credit-worthiness at money market funds raises the
risk of a dangerous ‘race to the bottom’ among fund managers, where a few funds certify higheryielding
securities as minimally risky in order to pay higher returns and attract investors away
from more conservative funds. Without clearer yardsticks of asset quality it is unclear how
investors will know how to avoid such risky behaviors.
The proposed rule also does not satisfy the statutory requirement that the Commission shall
“substitute…such standard of credit-worthiness as each respective agency shall determine as
appropriate for such regulations.” Instead, the rule simply maintains in place the internal due
diligence standard and eliminates the external standard based on credit ratings without replacing
it with any alternative standards.
We also generally share the concern, recently expressed by Commissioner Aguilar, that the
current proposal creates uncertainty regarding the extent to which market participants will
continue to rely on credit ratings.3 While this current proposal is designed to reduce reliance on
ratings, it explicitly permits the board of directors of a mutual fund to continue to rely on credit
ratings in making its own subjective determinations of risk.4 Indeed, the Commission several
times appears to state its expectation that money market funds will continue to do “business as
usual” and unofficially rely on credit ratings:
4 “In making these credit quality determinations, money market funds would continue to be able to use analyses
provided by third party parties, including ratings provided by ratings agencies, that the funds conclude are reliable
for such purposes.” References to Credit Ratings in Certain Investment company Act Rules and Forms, Investment
Company Act Release, March 2, 2011.
“We do not anticipate that the proposed amendments would significantly change
collection of information requirements under rule 2a-7 because we believe funds would
likely rely on their current policies and procedures to comply with the proposed
amendments. Under current rule 2a-7, money market fund boards, or their delegates, are
required to perform a minimal credit risk evaluation with respect to each of the fund’s
portfolio securities…. As we have noted above, with respect to each of the amendments
we propose today, money market funds could continue to consider evaluations of outside
sources, including credit ratings, in making credit quality determinations, monitoring and
stress testing. Moreover, we anticipate that funds would likely continue to rely on their
current policies and procedures with respect to credit quality determinations, monitoring
for credit events and stress testing because that is likely to be less costly than revising
policies.” [p. 33 of proposed rule]
Thus, there is some risk that this proposal could create the “worst of both worlds” by exposing
investors to new risks without solving the serious problem of overreliance on credit ratings.
The Commission And Other Regulators Should Devote More Effort To Developing Objective
Guidance for Credit Risk Assessment
The current proposal relating to Rule 2a-7 is only the beginning of the Commission’s arduous
task of reducing regulatory reliance on credit rating agencies. This task is now being faced by
other financial regulatory agencies as well. The SEC and other regulators will be repeatedly
confronted with similar concerns about how to replace references to NRSROs in federal rules. It
would benefit both regulators and the markets for the Commission to give more thought to
identifying externally-verifiable measures of risk other than credit ratings.
Such metrics could serve as the basis for guidance on best practices to be offered to fund
managers in performing their required due diligence, and could restrain the risk referred to above
of a ‘race to the bottom’ among money market fund managers. There are a variety of approaches
this guidance could take. One would be to identify a range of “plain vanilla” securities as
permissible for investment, whose risks and liquidity are well understood and can be assessed.
Should the Commission wish to be less prescriptive, it could identify the range of data that
should be considered in assessing securities risk and the minimal tests that should be performed
on this data. Fund managers could then be required to document their examination of this data in
the purchase and monitoring of their investments.
The Commission’s task in providing 2a-7 guidance to money market funds could be one of the
better areas to begin this effort to provide guidance and standards for asset evaluation. That is
because fund directors are not required to determine fine gradations of risk, but only to designate
the safest possible assets (“minimally risky”) for investment. This task is complex, but it is still
much simpler than assessing all possible gradations of risk. In addition, guidelines for risk
assessment in this area could avoid the need to analyze the most novel and complex types of
structured finance on the grounds that such new innovations are unlikely to be well understood
enough to be ‘minimally risky’.
Since the NPRM requests input from commenters on standards for risk assessment, it is clear that
the Commission desires more assistance in this area. But it seems unlikely that regulatory
comments are the best setting to do the technical work that needs to be brought to bear on these
questions. There is considerable effort already being devoted to risk assessment in academia and
in the private sector. This work will be given additional impetus by the new disclosure
requirements established by the Dodd-Frank Act for asset-backed securities offerings, which will
make much more information publicly available for assessing securities risk. The Commission
would benefit from convening a range of experts from academia and the financial industry to
develop more objective guidelines for asset evaluation for money market funds.
Such a group of experts could also be convened as a part of a broader effort by financial
regulators to develop uniform guidance for standards of credit-worthiness that do not directly
reference credit ratings. An effort to develop uniform standards to the extent feasible is required
by Section 939A of the Dodd Frank Act.
Thank you again for this opportunity to comment on this NPR. If you have the further questions,
please contact Marcus Stanley, the Policy Director of Americans for Financial Reform at (202)
Americans for Financial Reform