Risk & Compliance

SEC Relies on Rating Agencies, Too

The commission may revise rules that require investors to depend on the raters.
Sarah JohnsonFebruary 14, 2008

The Securities and Exchange Commission is looking at ways to pull back its reliance on credit ratings. The SEC and federal regulators, as well as state and local lawmakers, have the ratings embedded in many of their rules — effectively requiring investors to trust the ratings.

For the past 30 years, regulators “have increasingly used credit ratings as a proxy for objective standards for monitoring the risk of investment held by regulated entities,” SEC Chairman Christopher Cox said on Thursday. The commission’s own rules use the ratings to make distinctions among investment grades and to pick out securities that could be put through a faster registration process than those with a lower grade.

Cox revealed that he has directed his staff to look at that issue, as well as many other aspects of the ratings agency industry. During his second Congressional testimony about the raters since the subprime meltdown started last year, he reported that the SEC also plans to revise year-old rules governing the agencies.

Cox was joined by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke at a hearing before the Senate Committee on Banking, Housing, and Urban Affairs. The three government officials talked about the state of the U.S. economy, which Bernanke said will experience “sluggish growth” in the near term.

All three agency heads placed much of the blame for the economic downturn on the broken housing market and its ripple effect on the credit markets. Members of Congress hold the credit rating agencies responsibile for not acting quickly enough to downgrade mortgage-backed securities that in retrospect were, according to Sen. Richard Shelby, “grossly underestimated.”

For its part, the SEC has spent the past year looking into whether the rating agencies have followed their own methodologies and procedures consistently, as mandated by the commission’s fairly new purview as the agencies’ overseer. The SEC got that power from the enactment of the Credit Rating Agency Reform Act of 2006.

More important, the SEC is looking into whether the agencies that the commission designated as nationally recognized statistical rating organizations have properly managed the conflicts of interest “inherent” in its business of rating mortgage-backed securities, Cox said.

The conflicts arise when agencies help their clients design structured products that they will later rate. The International Organization of Securities Commissions, which includes the SEC, plans to propose banning that practice in its revised code-of-conduct manual for rating agencies later this year.

In early spring, the SEC may propose that agencies disclose information about past ratings so their users can judge the accuracy of each agency’s determinations over time. The commission will also consider whether it should require the agencies to make a distinction between ratings for corporate debt and structured debt. Standard and Poor’s Ratings Services and Moody’s are already considering that change.

Cox didn’t give any details about what the SEC’s inspections of the agencies have revealed. But he promised to share with the Senate any of the commission’s preliminary findings. The regulator will issue a formal report in the early summer.

Amid the criticism lobbed at the rating agencies for inaccurate ratings that seem to have led investors to unknowingly make shaky investment decisions, members of congress have also wondered if the SEC is doing enough to fix the industry. To be fair, the SEC had to adopt new regulations last May based on the Credit Rating Agency Reform Act before it could assume authority over the agencies. Soon after, questions have arisen about the agencies’ business, and the SEC was called to testify before both the House Financial Services Committee and the Senate Banking Committee last fall.

Christopher Dodd, chairman of the Senate committee, will likely invite Cox to another hearing about the agencies later this year after the SEC provides more information about its inspections.