Capital Markets

A Rating-Agency Cure, or Mere Window Dressing?

The SEC is revamping its regulations for the raters, with a focus on making them more competitive. Will it make much difference?
Sarah JohnsonApril 22, 2008

The Securities and Exchange Commission has enough authority over the credit rating agencies to ease their pervasive problems, chairman Christopher Cox believes.

During a hearing of the Senate Committee on Banking, Housing, and Urban Affairs, Cox said the Credit Rating Agency Reform Act provides the SEC with enough leeway to impose an assortment of new regulations on the industry, and it has proposed some, though critics doubt that they will have a major impact. The new rules would be on top of those that the SEC adopted less than a year ago, when it officially accepted the oversight role that the 2006 law gave it.

The SEC may require the agencies to provide better disclosures about how their ratings stand up over time; publish annual reports that would describe how they come up with their ratings and manage conflicts of interest; and distinguish structured financial products, corporate securities, and municipal securities from one another. The commission will consider how better transparency in the industry could allow an agency point out the others’ flaws and show how its ratings are better. Cox said these rule proposals are still in the works and may change before the commissioners consider them “in the near future.”

For the past year, the SEC’s authority over the agencies has come into question as observers of the credit-market problems wondered what went wrong and who should be blamed. Critics of the agencies have partly faulted the raters for the widespread effects of the subprime-mortgage meltdown. Untimely ratings and inaccurate assessments of mortgage-backed securities have hurt the industry’s credibility, according to the critics, including legislators who have called the SEC into hearings several times in the past few months to explain the regulator’s authoritative limitations over the rating agencies.

“Who is rating the rating agencies?” Sen. Robert Menendez (D.-N.J.) asked rhetorically at Tuesday’s hearing. “The answer is clear: no one.”

While the Reform Act made the rating agencies subject to regulatory oversight for the first time, the SEC’s powers over them are limited and fairly new. The regulator can penalize rating agencies for wrongdoing but cannot second-guess their opinions. In effect, Cox acknowledged at the hearing, the SEC cannot sanction a rating agency for an inaccurate assessment.

What the SEC can do is withdraw the designation as national recognized statistical rating organization (which basically labels an agency legitimate in the eyes of the SEC and investors), but that would be the equivalent of handing out a death penalty in an industry that is already criticized for having too few players.

The law also gives the SEC responsibility for making sure rating agencies file proper disclosures and are consistent in their policies, procedures, and methodologies — all areas the SEC staff has been investigating for the past several months after adopting its Reform Act-related regulations last June, as required by Congress.

Cox wouldn’t specify what the commission has discovered during its inspections except to say it will publish a report this summer summarizing what its examiners have found. About 40 SEC staffers have been involved in the examinations, and Cox expects about 20 will be dedicated to working on the SEC’s new regulatory work over the rating agencies on a long-term basis.

The root of the broken industry may lie in the agencies’ inherent conflicts of interest and lack of competition — two factors that neither the regulators nor the agencies themselves deny exist. Cox suggested that a more competitive industry could lead to better-quality ratings. He also said the SEC has found instances where the larger firms have shown a failure to adequately manage their conflicts of interest, as recently as this year.

International regulators have recommended that the agencies should no longer be able to design structured products that they will later rate. The larger firms also face conflicts by their very business model; they receive fees from the companies they rate. As for competition, the SEC has designated only nine agencies as NRSROs, and three of them — Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s Ratings Services — control the bulk of the credit-rating business.

During a separate panel discussion at the hearing, John Coffee, a professor at Columbia University Law School, said Cox’s proposals could instill new confidence in the credit markets but recommended that they go further. He suggested the rating agencies should be held liable for inaccurate judgments and that they should use a third-party verification process to ensure the truthfulness of their assessments.

As it is, the agencies rely on the data provided by securities’ issuers, such as the mortgage loan originators, who have incentives to “game the system and get a higher rating,” according to Coffee. The rating agencies avoid doing the necessary due diligence because they have limited resources, he suggested.

Claire Robinson, senior managing director at Moody’s, defended the agencies’ practice of relying on others to do their own due diligence, including issuers, loan originators, and auditors. “I agree that the accuracy of the information is important, but there are others whose role it is to check and verify that information,” she said.

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