Capital Markets

Rating Agency Reform: Band-Aids or Overhauls?

The SEC will consider a laundry list of ways to fix the credibility-tainted raters. Ideas range from new disclosures to new business models.
Sarah JohnsonApril 14, 2009

The Securities and Exchange Commission will be back at the reform drawing board on Wednesday, mulling the regulator’s oversight of the credit-rating agencies.

It’s been a familiar place for the SEC, which became the raters’ overseer in 2006 under the Credit Rating Agency Reform Act. Enacted after some agencies misidentified Enron as a good credit risk just days before the scandal-ridden energy giant filed for bankruptcy, the law gave the SEC the power to designate rating companies as nationally recognized statistical organizations (NRSROs). It also authorized the commission to review the agencies’ disclosures and the consistency of their policies and penalize them for wrongdoing.

But the SEC can’t second-guess the agencies’ opinions. Thus, the regulator doesn’t have the power to sanction agencies whose ratings, in retrospect, did not accurately depict the riskiness of the underlying loans of some structured financial products before the subprime-mortgage market imploded. For the past two years, critics of the agencies have questioned whether the SEC has done enough to keep the raters accountable, particularly in their ratings of mortgage-backed securities and collateralized debt obligations.

Indeed, the SEC has had to play catch-up with its new authority ever since the CRA act was signed. To be sure, the commission’s adoption of new regulations for the agencies ran parallel to the burgeoning problems in the mortgage market and the veiled risk embedded in the structured financial products tied to those loans. It’s only under fairly new SEC rules, for example, that agencies are now barred from helping to structure the financial products they rate and some have to publicly post a random sample of their ratings histories.

Critics of the industry, including lawmakers, have questioned how the agencies’ credibility can be repaired and whether more should be done to require them to better manage the ill effects of their conflicts of interests. Critics believe it’s hard to rid the agencies of conflicts when they collect fees from the issuers they review — in contrast to the agencies that use a subscriber-based model. With a new chairman at the helm, the SEC is again considering whether more reforms are needed for this niche business, which is dominated by three players: Standard & Poor’s, Moody’s Investor Service, and Fitch Ratings.

Representatives of those agencies, as well as those other NRSROs and trade groups, issuers, professors, and investor advocates will consider those issues during a daylong roundtable on Wednesday. They are scheduled to discuss the raters’ actions since the financial crisis hit, lack of competition in the industry, users’ perspectives, and ideas for improving the oversight of the SEC. SEC chairman Mary Schapiro said the insight received at the meeting will help the commission “as it continues to pursue aggressive oversight of the industry.” Earlier this year, Schapiro promised congressmen she would consider ways to fix the industry.

Longtime critics of the agencies are hoping Schapiro has significant reforms in mind. “We’re at a point where incremental changes aren’t going to be effective,” James Kaitz, president of the Association for Financial Professionals and a speaker at Wednesday’s hearing, told “We’ve got to make dramatic changes in the areas of transparency, how rating agencies are paid, and also really making sure that absolutely no conflicts of interest exist between the part of the company that’s rating and the other part that’s providing consulting services. I don’t think those issues have effectively been addressed yet.”

At the same time, Kaitz notes in his prepared remarks for the roundtable, financial professionals need credit rating agencies for help with making investment decisions. However, he notes, “if investors do not or cannot rely on credit ratings, then rating agencies serve no purpose in our economic system.”

Indeed, investors’ trust of the agencies is shaky. Sixty percent of investors believe the major agencies’ ratings are not valid, according to the CFA Centre for Financial Market Integrity, which conducted a survey of 1,186 members earlier this month. The same amount said they do not use the ratings for their investment decisions.

To be sure, a company’s credit ratings remain a key determinant of its cost of capital and ability to raise financing. Alan Fohrer, CEO of Southern California Edison Co., plans to tell the commissioners that they should tread carefully before reforming the industry. “Any changes imposed on the credit rating agencies must not foster confusion or uncertainty in the capital markets to the detriment of businesses seeking financing,” he wrote in his prepared remarks.

In the past two years, the SEC has adopted two new sets of regulations, proposed new ones, and spent 10 months looking over the Big Three agencies’ internal records mostly relating to subprime residential mortgage-backed securities and CDOs. The SEC found significant deficiencies in the agencies’ policies and procedures concerning the high-risk instruments. But it issued no enforcement action against the raters. Exchanges among agency employees showed they felt pressured to keep ratings high and had trouble keeping up their workload between 2002 and 2006 when the CDO market was growing in volume and complexity.

The major agencies have since made changes to their polices and procedures. For instance, recent measures at S&P include putting a new system in place for rotating its analysts, reviews of ratings every time an analyst leaves the agency, and more analyst training.

In their defense, the rating agencies have said they could have predicted neither the subprime-mortgage meltdown nor its widespread effect on the credit markets. Still, “we believe that we should be the leading edge for predictive opinions about future credit risks, and we have learned important lessons from that experience,” wrote Raymond McDaniel, Moody’s chief executive officer, in his prepared remarks. Moody’s and other agencies say they’re in favor of making their business more transparent.

Among the ideas to be floated at Wednesday’s meeting: creation of a new overseer for the raters, similar to the Public Company Accounting Oversight Board’s role over the audit firms; requiring the agencies to charge flat fees so they’re not emboldened by certain issuers that pay more; development of a new category of agency that would be owned and controlled by investors; and mandating agencies to be more up-front about their methodologies and ratings track record.

Many of these issues have been discussed at length previously. But another concept could gain new life if one of the speakers, New York University professor Lawrence White, has his way. White wants the SEC to revisit a proposal it dropped last year that would have wiped out the nearly 40 references to NRSROs in the SEC’s own rules — references effectively requiring investors to trust the ratings of those hand-picked firms. Similarly, he opposes such blessing of guidelines by other federal and state regulators that require banks, mutual funds, pension funds, and insurance companies to limit their bond portfolios to only those rated investment grade by an NRSRO.

“These rating judgments should no longer have the force of law,” White told By delegating or, in White’s words, “outsourcing” decisions on the safety of investments, regulators have limited the source pool of opinions available to investors and reduced the scrutiny the agencies receive.