Risk & Compliance

Does the SEC Have the Clout to Rule the Rating Agencies?

Securities and Exchange Commission chairman Christopher Cox testified that the SEC has enough leeway to keep the agencies in line.
Sarah JohnsonSeptember 27, 2007

During a Wednesday hearing, Securities and Exchange Commission chairman Christopher Cox deflected senators’ concerns that the SEC may not have the authority to intervene if a credit rating agency continually issues false assessments.

He reminded the members of the U.S. Senate Committee on Banking, Housing, and Urban Affairs that the SEC has only just put Credit Rating Reform Act rules into place and started the examinations of the agencies that the one-year-old law allows it to conduct.

Still, when pressed by committee chairman Christopher Dodd, a Connecticut Democrat and presidential candidate, Cox conceded that the SEC could “theoretically” give one of the agencies registered with the commission its approval even if that agency’s ratings were wrong. That would be true if the agency has provided proper disclosures and has been consistent in following its policies, he acknowledged.

Indeed, under the law that gave the SEC broader oversight of the rating organizations last September, the commission has no say on the ratings themselves. Under the law, the commission is limited to assessing whether the agency is financially stable, shares information about its conflicts of interest, and follows its own procedures. The SEC also held on to its power to designate the agencies as “nationally recognized statistical rating organizations.”

For his part, Cox believes that if an agency were providing inadequate ratings, investors would surely notice. “One wonders if we are providing [enough] transparency, how long that [false ratings] would last in the marketplace,” he said.

But some senators mused about the prospect of passing added legislation to rein in the conflicts of interest they say are inherent in the agencies’ business models. The agencies’ rapid downgrades of mortgage-backed securities following the subprime-loan meltdown brought the matter squarely into the spotlight. Does the SEC have the ability under the law to, as Alabama Republican Richard Shelby put it, “conduct vigorous oversight of the rating agencies?” Added Robert Casey (D-Pa.), “We shouldn’t be precipitous in our judgment, but I think when an act is in place even for a year, it bears scrutiny and examination, especially in light of a crisis.”

For his part, Cox said the SEC does indeed have enough oversight of the agencies. Any more regulatory control could interfere with the agencies’ methods and ability to be innovative in their statistical models, he contended. Still, the senators kept asking what penalty an agency would pay if it did something wrong. The SEC has the power to revoke an agency’s NRSRO status, a surefire death penalty for a rater.

It’s unclear, however, whether the commission could prove why an agency deserved such treatment, according to John Coffee, a Columbia Law School professor. Coffee suggested that the SEC develop a definition of a maximum default rate for each type of rating and use that standard to determine whether the agency’s ratings for corporate bonds and structured finance products fall within that set range. Those with poor default rates should have their NRSRO status forfeited, he said.

Amid the intensified congressional scrutiny trained on the commission, the SEC privately looked into the agencies’ behavior when they rated subprime residential mortgage-backed securities over the past year. The SEC is probing whether they “were unduly influenced by issuers to publish a higher rating,” Cox said.

The SEC will focus on whether the NRSROs followed their own procedures for addressing their conflicts of interest. “The examination will seek to determine whether the rating agencies’ role in the process of bringing RMBS to market compromised their impartiality,” he added.

On Monday, the commission announced that it had formally recognized seven major credit rating agencies as NRSROs. And in the past month, it has taken a “leading role” in a study for one of President Bush’s working groups aimed at probing the role of the rating agencies and how securitization has affected the mortgage industry.

The regulator has also recently met with the International Organization of Securities Commissions, which is also looking into NRSROs’ responsibilities. Further, the topic will be discussed during a hearing at the House Committee on Financial Services on Thursday.

The SEC eventually became the overseer of the NRSROs almost by accident when it informally gave some of the agencies that status in the 1970s. Following Enron’s collapse in 2001 and the congressional scrutiny that followed, the NRSROs were sharply criticized for not adjusting their investment-grade ratings of the company until just days before it fell apart. Congressmen are lobbing similar barbs at the agencies for again not being able to predict that a crisis was looming. “Some specific ratings were wrong and the subsequent downgrading actions by rating agencies have had a serious impact on a significant sector of our financial system,” said Shelby.

For their part, representatives from Moody’s Investors Service and Standard & Poor’s said they have made many changes to their polices and procedures in the past five years and have added sections on their websites explaining their methodologies.