Risk & Compliance

How Will the SEC Rate the Rating Agencies?

Just as the subprime mortgage mess came to a head, the SEC received new regulatory powers over credit rating agencies. Will they do any good?
Sarah JohnsonSeptember 12, 2007

Last September, Congress gave the Securities and Exchange Commission 270 days to figure out how it would regulate credit rating agencies under a new law. Nine months later, with 21 days to spare, the SEC released final implementation rules for the Credit Rating Agency Reform Act.

But the SEC may have a lot less time this fall to prove that it’s up to the new regulatory challenge of overseeing credit rating agencies. With global securities regulators, Congressmen, and the Bush administration wondering what caused the subprime mortgage meltdown and pointing some fingers at rating agencies, the SEC will have to respond quickly, say observers. “There’s going to be a lot of pressure on the SEC and the rating agencies — not just in the U.S., but all around the world,” says James Kaitz, CEO of the Association for Financial Professionals (AFP), which lobbied hard for the law that brought rating agencies under the SEC’s regulatory oversight for the first time.

Kaitz believes the SEC should review the practices of the agencies over the next two to three months and provide some type of report to Congress. Otherwise, he theorizes, the SEC and the industry run the risk of opening themselves up to new rules from other countries’ regulators.

That, in turn, could disrupt the SEC’s fledgling efforts to rechristen the rating agencies as nationally recognized statistical rating organizations — or NRSROs. That designation was originally assigned almost accidentally by the SEC to certain rating agencies in the 1970s. However, the designation, which implied a government blessing as a credible provider, quickly became a de facto license to operate as a rating agency.

Over time, the SEC formalized its practice of doling out NRSRO status — but without published rules, the process was an unclear one that came under heavy criticism for its lack of transparency and its apparent role in promoting an oligarchy. By 2005, there were just five NRSROs: Moody’s Investor Service, Standard & Poor’s Rating Service, Fitch Inc., A.M. Best, and Dominion Bond Rating Service. The failure of those agencies to predict the collapse of Enron in a timely fashion just a few years earlier suggested to many critics that their regulatory regime ought to be changed.

The new law sought to take away the SEC’s unofficial NRSRO naming power and replace it with a more formal regulatory process. Under the law, each agency wanting NRSRO status must apply to the SEC and detail in their application how they manage conflicts of interest, list their procedures, and provide their financial statements. As of June, the SEC said that seven agencies had applied for NRSRO status. So far, however, the SEC has not officially designated any of them as NRSROs. It has 90 days from receiving the agencies’ applications to make that determination.

But almost as soon as those rating agencies submitted their applications, the subprime mortgage crisis thrust them under an all-to-familiar glaring spotlight. As in the aftermath of Enron, critics wondered why the rating agencies, with all their access to inside information, seemed to be the last to see the crisis coming. That, in turn, has many wondering if the new law passed on September 29 actually has teeth. Members of the House Financial Services Committee recently questioned whether the law did enough to address investors’ criticisms of the ratings agencies following Enron’s collapse. And more questions are sure to come when a House Financial Services subcommittee holds a planned hearing to address the responsibilities and independence issues of NRSROs. Similar reviews are reportedly underway in the Senate and at the International Organization of Securities Commissions, and President Bush has asked Treasury secretary Henry Paulson to look into the agencies’ role in the mortgage industry.

All this attention will probably reaffirm that Congress was right to think rating agencies needed SEC oversight, says SEC commissioner Annette Nazareth. But it won’t solve what most people really want from the rating agencies, particularly after a negative market event. “They wish government edict would make the credit rating agencies smarter and faster,” she says. “The Credit Rating Agency Reform Act does not address that nor should it.” Nevertheless, she admits, the number of ongoing bad calls by rating agencies “causes people to be frustrated.”

In fact, in giving the SEC more authority over the agencies, Congress did not allow the SEC to second-guess ratings themselves. “Congress did not intend for the SEC to get involved in the substance of ratings,” notes Dave Brey, compliance officer for A.M. Best Co. The SEC can inspect the agencies and use enforcement tools if their practices prove abusive to investors. But much of the oversight involves making sure the agencies have proper disclosures and behave consistently in their policies, procedures, and methodologies. The law was also intended to foster competition in the industry and curb abusive practices, such as sending companies bills for unsolicited ratings.

As it does for misbehaving broker/dealers and corporations, the SEC now has the authority to penalize rating agencies for wrongdoing. But short of yanking NRSRO status from an agency — the equivalent of a rating agency death penalty — it’s unclear how much enforcement power the SEC can actually wield. It’s also not clear how the SEC would prove that there were deficiencies in the ratings of subprime-related securities. But while it’s not exactly clear what the SEC would actually do in that case, it would not be constrained by the newness of the law. According to Nazareth, the SEC could take action against fraudulent behavior even if it occurred before the SEC implemented its rules.

For its part in responding to the subprime-loan mess, the SEC has started looking at the rating agencies’ polices and procedures, specifically in the area of mortgage-backed securities and CDOs. The SEC’s review will include “the advisory services they may have provided to underwriters and mortgage originators, their conflicts of interest, disclosures of their ratings processes, the agencies’ rating performance after issuance, and the meanings of assigned ratings,” said Eric Sirri, director of the SEC’s Division of Market Regulation, during last week’s House hearing.

Indeed, Moody’s recently received a documentation request from the SEC related to subprime matters, according to the agency’s general counsel John Goggins, who says Moody’s is in the process of complying with the request.

Beyond the Moody’s notice and some rather vague pronouncements, however, it’s not clear yet that much has changed in the relationship between the rating agencies and the SEC since the commission implemented its new rules in June. “But it will,” says A.M. Best’s Brey. For now, the agencies are waiting to find out how the SEC will flex its muscle, and have ramped up their record-keeping as required under the law. Goggins expects that when the SEC does start using its authority, the agencies will experience “inspections that are more frequent and more vigorous.” Since Goggins started working at Moody’s in 1999, the SEC has conducted only two inspections.

S&P spokesman Chris Atkins said he is unaware of whether the SEC has asked the ratings service for more documentation recently. Fitch spokesman James Jockle said his agency’s interaction with the SEC hasn’t changed since the law was passed. The firm has been reviewing its ratings in the subprime area and has been working on posting improved explanations of those ratings on its Website.

Nazareth contends that its too early to test the effectiveness of the Credit Rating Agency Reform Act. “It clarified our authority but I don’t think it resulted in a sea change in the rating agencies’ practices in any way,” she says.

Indeed, it could take years to realize the full effects of the law, according to AFP’s Kaitz. “It’s only been 60 days since the regulation has been in place,” he says. “You can’t expect miracles.” If history is any indicator, it also take time for rating agencies to see a regulatory response to a financial scandal. Despite a storm of criticism in the immediate aftermath of Enron’s collapse, it wasn’t until after a 2003 SEC report about the state of the rating agencies was submitted to Congress that the law began to take shape, and it took longer still before the new law was passed and implemented.

What’s more, critics such as Sean Egan, managing director of Egan-Jones Ratings Co., say the law still does not address conflicts of interest, which he considers a key problem among his competitors. Unlike most of the officially recognized NRSROs, Egan-Jones does not charge companies for their ratings, and thus “doesn’t have to worry about alienating issuers.” Egan-Jones in now the process of applying for NSRSO status with the SEC under the new rules — previous applications over the course of several years proved fruitless.

Critics of rating agencies that are paid by corporate issuers of debt wonder if they can be objective. But most rating agencies argue that proper disclosures and independence procedures keep those conflicts from interfering with trustworthy ratings. “We have a very good track record,” says Goggins of Moody’s. “We manage that conflict very successfully.”

Congress will likely take another look at the conflict-of-interest issues that were raised during the law’s writing as they look at the subprime mess, theorizes Mark Prysock, general counsel for Financial Executives International, which supported the law. That may mean more detailed rules on which types of activities the agencies can participate in when it comes to consulting services, such as giving companies assessments on how to achieve a good credit rating. Still, Prysock contends that with the rules just a few months old, “it’s premature to pass judgment on whether the regulations are actually being effective.”