The credit rating industry

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Richard Cantor, Frank Packer

The achievement of an investment grade rating eases the burden of disclosure for the issuer of the securities. In 1982, the SEC started to require less detailed disclosure at issuance for investment grade securities. In 1993, the SEC adopted Rule 3a-7, which made the investment grade rating a criterion for easing the public issuance of certain asset-backed securities (Cantor and Demsetz 1993).

Embedding the investment grade distinction in regulations has simplified prudential oversight of financial institutions. Some of these regulations have, as a by-product, adversely affected the availability and cost of funds to below-investment-grade borrowers. West (1973) and Carey et al. (1993) show that spreads rose for borrowers rated BB following the adoption of regulations affecting bank and insurance company investments in below-investment-grade securities.

THE EMERGENCE OF NEW CUTOFF RATINGS

Regulators are increasingly using ratings other than BBB as thresholds in their rules. Each new regulatory use appears to have encouraged other regulators to expand their reliance on ratings. Some of these new rules have greatly influenced the development of capital markets.

In 1984, to promote the development of a mortgage-backed securities market without the support of government-related agencies (Government National Mortgage Association, Federal National Mortgage Association, and Federal Home Loan Mortgage Corporation), Congress passed the Secondary Mortgage Market Enhancement Act (SMMEA). This act eased issuance and enhanced the marketability of mortgage-backed securities rated AAA or AA. In particular, it allowed these securities to be marketed up to six months in advance of the delivery of their underlying collateral and exempted them from most states' blue sky laws. In addition to essentially creating the nonagency mortgage-backed securities market, SNMEA established a new regulatory cutoff rating. The higher AA rating was chosen because mortgage-backed securities with full or partial government backing--the reference securities to which the new securities were compared--were virtually all rated AAA or AA at the time.

A few years later, the Federal Reserve Board, which had previously refrained from expanding its use of ratings beyond the basic investment grade requirement for bank portfolio investments, also began to incorporate an AA cutoff in certain of its prudential rules affecting bank supervision. In recognition of the expanded role given to ratings by the Congress, the Board began to use AA as a cutoff in rules for determining the eligibility of mortgage-related securities (1987) and foreign bonds (1989) as collateral for margin lending.(6)

The single A rating has also served as a cutoff. The Labor Department, in its role as overseer of the private pension industry, adopted a regulation in 1988 permitting pension fund investments in asset-backed securities rated single-A or better (Baron and Murch 1993). The A rating gained further regulatory importance in 1990 when the NAIC adopted new capital rules that applied the least burdensome capital charge to bonds with the NAIC quality designation corresponding to a public rating of A or above.