Risk & Compliance

How to Fix the Rating Agencies, Part II

Regulators will recommend ways the credit rating agencies can avoid missteps — less than two years after a law to do just that was passed.
Sarah JohnsonFebruary 7, 2008

In 2007, lawmakers waggled their fingers at the credit rating agencies for missing the mark in assessing the risks of mortgage-backed securities, a factor congressmen and senators claim partly led to the subprime-mortgage crisis. Now, nearly a year after the mortgage market meltdown, national and global regulators plan to come up with ways to avoid credit rating mistakes of the past.

The International Organization of Securities Commissions, whose members regulate more than 90 percent of the world’s securities markets, will propose changes to its code of conduct for agencies in March. Meanwhile, the U.S. Securities and Exchange Commission, which is an IOSCO member, is set to come out this year with preliminary findings based on investigations into the agencies’ policies and procedures.

Investment managers will also weigh in. The CFA Institute Centre for Financial Market Integrity, a research and policy organization representing investment professionals, provided IOSCO with a slew of suggestions to help shore-up ratings agencies procedures. One of the proposals calls on agencies to better distinguish their ratings for structured products from their ratings of corporations. For example, collateralized debt obligations could be rated CD-AA rather than be given the same AA assigned to high-quality corporate bonds.

Agencies are already out in front of that suggestion. This week, Standard and Poor’s Ratings Services announced plans to develop an identifier for its ratings of securitized products, and Moody’s began seeking public comment on whether it should differentiate between its structured ratings and those of companies.

The moves seem to indicate that ratings agencies are anxious to avoid further regulatory scrutiny by demonstrating their commitment to fixing what’s broken. In fact, on Thursday, S&P officials said that the agency is in the process of making several changes, such as hiring an external firm to independently review its governance compliance; creating a new committee to assess risks associated with S&P processes; and conducting retrospective reviews of ratings when an analyst resigns. In addition, S&P plans to work with other agencies and IOSCO to develop best practices.

The ideas for tweaking agency business models come less than two years after the Credit Rating Agency Reform Act was signed into law. The act, which gave the SEC broader oversight responsibilities, was a response to the agencies’ missteps in identifying Enron a good credit risk just days before the scandal-ridden energy giant filed for bankruptcy.

Under the law, the SEC gained power to designate rating companies as nationally recognized statistical rating organizations (NRSROs), and penalize them for wrongdoing. The commission was also charged with making sure that agencies file proper disclosures and are consistent in their policies, procedures, and methodologies. However, the SEC’s authority stops there, as the regulator does have the power to second-guess agencies’ opinions.

But the law didn’t seem to head-off any of the current problems, as the agencies landed in hot water again when the subprime mortgage industry collapsed. Similar to criticism lobbed against them following Enron’s demise, critics of the agencies said that they should have seen the subprime mortgage crisis coming, and issued appropriate ratings warnings. That criticism may be played out in court. To be sure, some plaintiffs’ law firms are looking at rating agencies as potential targets in shareholder class-action suits, John P. Coffey, a plaintiffs’ lawyer himself with Bernstein, Litowitz, Berger, & Grossman in New York, said during a session of the Professional Liability Underwriting Society’s directors’ and officers’ conference in New York on Wednesday.

The specter of another Enron debacle may have pushed the SEC into action. In September, Erik Sirri, director of the SEC’s Division of Market Regulation, said the regulator was looking into the business relationships between credit rating agencies and underwriters and mortgage originators. Specifically, the SEC was examining the advisory services agencies provided to mortgage companies, examining conflicts of interests, disclosures of agency processes, and the performance of companies after they were awarded ratings. According to SEC spokesman John Nester, the investigation is ongoing and eventually will result in a public statement from the commission.

Questions about potential conflicts of interest also caught the attention of President Bush. Last fall, the President asked the Treasury Department to examine the role the agencies played in the mortgage crisis. What’s more, House and Senate committee hearings were held on the subject, and SEC officials were queried on their expanded oversight responsibilities.

Meanwhile, global regulators also began scrutinizing whether the relationship between mortgage companies and rating agencies was too cozy. Before subprime woes became a full-blown crisis, IOSCO started reviewing whether credit rating agencies adhered to the group’s three-year-old code of conduct. While agencies are not legally required to follow the code, the CFA Institute would like to make compliance with the code mandatory.

For its part, IOSCO reviewed several firms around the world, including those designated as NRSROs by the U.S., including Fitch Ratings, Moody’s, and S&P, which largely follow the code. The guidelines call for the agencies to be transparent about ratings and create safeguards against conflicts of interest.

The proposed IOSCO changes also would make it mandatory for agencies to break out how they rate structured products, and follow new disclosure requirements regarding the agencies’ underlying assumptions of such transactions. Committee members also would like to ban agencies from getting involved in the design of structured products that they intend to rate, and to prove they have relied on quality information to support ratings.

The CFA Institute is also hoping that IOSCO recommendations will include a list of process changes for rating agencies, such as eliminating the term “investment grade” from ratings, and putting a stop to rating new structured products before statistical data supporting those ratings have matured.

While the CFA’s recommendations are aimed at reforming the rating agencies’ policies, they’re also a call for investors to educate themselves. “People take shortcuts instead of doing due diligence,” says James Allen, director of the capital markets policy group for the CFA Institute Centre.

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