Capital Markets

Raters Cry Foul over SEC Changes

Agencies claim the regulator's proposals for reforming the industry will instead cripple it.
Sarah JohnsonAugust 6, 2008

As blame has been heaped on the rating agencies for their role in the mortgage-market mudslide, they’ve given many reasons for issuing what proved to be overstated ratings.

Among their defenses: that much of their judgment is based on trust in what securities issuers tell them. Unlike auditors, the agencies rely on others to do their own due diligence. However, in the Securities and Exchange Commission’s attempt at fixing the industry, the regulator wants full disclosure of what the rating agencies are being told — which could have a “chilling effect” on the market, according to critics of the SEC’s proposals.

In June, the SEC proposed rules that attempt to solve the industry’s conflict-of-interest issues, along with investors’ apparent ignorance over the different risks involved among various types of asset-backed securities. If approved, the changes would require all rating agencies to publicly release all their ratings, and share the information on which they are based. In addition, the agencies could no longer structure the same products they rate.

The changes are meant to restore confidence in an industry that has faltered in its ability to keep up with the true risks inherent in residential mortgage-backed securities and collateralized debt obligations. “While credit rating agencies did not create the credit crisis, their practices contributed to the debacle,” wrote the Council of Institutional Investors in a letter to the SEC in general support of its proposed rules.

These rules also could help reinvigorate the SEC’s enforcement powers over the rating agencies — powers granted under the Credit Rating Agency Reform Act of 2006. The law handed the SEC limited rights over the agencies that it designates as national recognized statistical rating organizations (NRSROs). While the agencies can be penalized for wrongdoing, the regulator is not entitled to second-guess their opinions.

In its latest proposal, the SEC plans to require that ratings-related information shared with, and used by, NRSROs be made public. However, the commission acknowledges that it will refrain from saying who is responsible for making that data public; it could be NRSROs, or could be the arrangers or trustees that created the financial products.

Not surprisingly, that ambiguity over responsibility doesn’t sit well with the rating agencies, which are concerned about newfound liability. For instance, in one letter critical of the SEC’s proposals, Standard & Poor’s Rating Services posits that the regulator could be overstepping its bounds, and is unnecessarily calling for a “radical reordering of the roles and responsibilities of the parties involved in a securities offering.”

S&P further claims that the SEC is threatening the agencies’ First Amendment protections by suggesting that NRSROs can’t publish ratings until they’ve ensured that the data behind those opinions has been disclosed.

Another NRSRO, Toronto-based DBRS, worries that the changes would discourage the groups that put together structured products from sharing relevant information with the more conservative raters, which could lead to more competitive issues in an industry dominated by three agencies — S&P, Moody’s Investor Service, and Fitch Ratings.

While investors may want more information from the rating agencies, to reassure the market that conflicts of interest are being managed, investors don’t want a so-called data dump. In its letter opining on the SEC proposals, the CFA Institute Centre for Financial Market Integrity calls on the regulator to refine what type of information is to be shared publicly.

Critics of the SEC also are trying to poke holes in its other proposals meant to bring more transparency to the rating agencies’ proposals. One provision — which would make all ratings publicly available after six months — would surely kill the subscriber-based model used by some of the smaller NRSROs that do not have the same conflicts-of-interest issues that have hurt the larger raters’ reputations.

In addition, most of the 50-plus letters sent to the SEC during the 30-day public comment period on its rule proposals — which ended July 25 — agree with former SEC commissioner Paul Atkins that the ratings don’t need new labels. The SEC suggests that complex asset-backed securities could be distinguished from more traditional corporate bonds by using new symbols (such as AAA.sf), a prospect that Atkins voted against. Many of the respondents believe the labels would cause confusion and place a costly, technological burden on both the agencies and the users of the ratings.