New financial rulebook tangles loan bundlers, ratings agencies

By Jia Lynn Yang
Washington Post Staff Writer
Friday, July 23, 2010

Merely days old, the financial regulatory law has already generated its first real-world hiccup.

A minor rule change in the law unexpectedly shut down the market for selling new bundles of car loans and consumer loans after bond issuers, ratings agencies and the Securities and Exchange Commission found themselves caught in a tangle of old and new regulations.

The SEC intervened Thursday afternoon, but traders viewed the incident as a warning that more dust-ups could come as the gargantuan law makes the leap from paper to reality.

The confusion stemmed from a provision in the law that removes legal protection for ratings firms when they lend their opinions to bond issuers introducing new products. If the ratings turn out to be wrong -- for instance, if an agency gives the debt product a top rating but then the debt defaults -- the ratings companies can be sued.

In response, the three major ratings agencies -- Moody's, Fitch and Standard & Poor's -- started telling clients that they weren't allowed to use the agencies' opinions in documents used to register new bond products.

This put the bond issuers in an impossible position. The SEC requires them to include these ratings anytime they register new asset-backed securities to sell to investors. Without permission to use the agencies' opinions, bond issuers couldn't offer new products. And so, earlier this week, the public market for asset-backed securities came to a full stop.

"It's a disaster," said Joseph Lorusso, founder of Structured Finance Advisors, an investment management firm, on Thursday morning. "Everybody's trying to figure out how to get around it."

The SEC stepped in Thursday afternoon, with a statement saying that for the next six months it would suspend the rules requiring issuers to use ratings when they register new asset-backed securities.

"This action will provide issuers, rating agencies and other market participants with a transition period in order to implement changes to comply with the new statutory requirement while still conducting registered ABS [asset-backed securities] offerings," said Meredith Cross, director of the SEC's division of corporate finance, in a statement.

Market watchers were instantly relieved.

"This should effectively provide short-term relief for issuers, allowing the public new-issue market to re-open," wrote Paul Jablansky and Brian Lancaster at the Royal Bank of Scotland. But, they added, at the end of six months, the market could be faced with the same worries.

The SEC's move won't affect the availability of ratings. Bond issuers and potential investors can still look at how products are rated. The underwriters just won't have to use those ratings in their prospectus documents for the time being.

But the glitch worried analysts who are waiting to see how the overhaul works in real life.

"It's still kind of murky," said Jeffery Elswick of Frost Investment Advisors. "I've been involved in the asset-backed markets for 18 years, and I don't understand [the legislation] at this point. If I don't understand it, a lot of people don't."

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