Risk & Compliance

Are Rating Agencies Forever Broken?

The group that helped lawmakers write the Credit Rating Agency Reform Act says the law isn't being enforced — and worries that even better enforcem...
Tim Reason and Sarah JohnsonMarch 27, 2008

Credit rating agencies could be one of the few organizations blamed for the recent credit crisis that will escape the heavy-handed treatment now being threatened by federal regulators.

The most recent report of the President’s Working Group, chaired by Treasury Secretary Henry Paulson, obliquely threatened new or stricter regulation for many financial institutions, but side-stepped the question of rating-agency regulation. The report suggested rating agencies may be doing enough on their own by making voluntary fixes to the way they rate structured financial products.

It wasn’t long ago that the government tried a fix of its own, passing the Credit Rating Agency Reform Act of 2006. But that law has basically sat dormant, says the Association for Financial Professionals, which helped draft the legislation. And the regulator tapped to enforce the law — the Securities and Exchange Commission — has done little to use its new regulatory powers, the AFP charges.

In letters to Securities and Exchange Commission Chairman Christopher Cox, the AFP has pleaded with the commission to “aggressively exercise its regulatory authority.”

Since the creditworthiness of mortgage-backed securities began to crumble last year, lawmakers have criticized the rating agencies for miscalculating the risks of the structured products and for being too slow in updating their assessments. The criticism echoes the response to the agencies’ missteps when they identified Enron as a good credit risk just days before the scandal-ridden energy giant filed for bankruptcy nearly seven years ago.

As a longtime advocate for reforming the rating agencies, AFP President and CEO James Kaitz says he is at his wit’s end to see a repeat of those problems. “What more can be done? It’s frustrating, very frustrating,” he said to CFO.com.

Kaitz hopes the SEC will enforce the powers it was given under the Reform Act. Yet even Kaitz admits he’s not sure how to fix the rating agencies. “This has kind of left us scratching our heads, looking for alternatives,” he says. “If there were 50 players in this marketplace, we wouldn’t be having this discussion.”

In fact, the number of players is in the single digits. The SEC has designated nine agencies as national recognized statistical rating organizations (NRSROs); and three of them — Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s Ratings Services — control the bulk of the credit-rating business.

“You don’t need any more regulation,” Kaitz says. “The Reform Act of 2006 gave sweeping authority to the SEC.”

Yet, under the Reform Act, the SEC has relatively few obvious tools at its disposal. The regulator can penalize rating agencies for wrongdoing but cannot second-guess their opinions. It can also withdraw their NRSRO ratings, but that would be the equivalent of handing out a rating-agency death penalty in an industry that is already criticized for having too few players. The law does give the SEC responsibility for making sure that rating agencies file proper disclosures and are consistent in their policies, procedures, and methodologies — all areas the SEC staff has been investigating for the past several months.

So far, however, the SEC has been mum about its findings. To be fair, the SEC has had little time to act, notes spokesman John Nester. The SEC adopted its own Reform Act-related regulations last June, as required by Congress, and then had a few months to designate the NRSROs, which it did by the fall.

Still, full enforcement of the law will likely not satisfy all the raters’ critics. “They wish government edict would make the credit rating agencies smarter and faster,” former SEC commissioner Annette Nazareth told CFO.com last fall before she resigned. “The Credit Rating Agency Reform Act does not address that nor should it.”

At the time, she said the SEC was in the process of building its resources to be able to handle its new authority. SEC spokesman Nester said he could not specify how many SEC staffers are dedicated to inspections of the agencies.

Cox has said the SEC plans to issue a formal report about the inspections in early summer. The commission may also propose this spring 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, and may revise its own rules that require investors to rely on NRSROs.

But for now, any changes in response to the criticism lobbed against the agencies have been voluntary. For example, S&P and Moody’s are considering whether to distinguish between corporate ratings and ratings of structured securities.

At the same time, international regulators are asking the agencies to make changes to their code of conduct. Among the most significant recommendation to come from overseas is the idea that agencies should refuse to design structured products that they will later rate. Critics including Kaitz have pointed to this practice as one of the main conflicts of interest when it comes to ratings of structured products. In a similar vein, it has long been considered an inherent conflict that credit rating agencies make most of their revenue from the organizations they rate.

The International Organization of Securities Commissions — of which the SEC is a member — noted these conflicts in a report issued Wednesday that proposes revisions to its code of conduct for the agencies, which is voluntary. “While some observers believe the structured finance rating process does not necessarily pose an inherent conflict of interest vis-à-vis the CRA’s rating business more generally, the further question is whether a CRA has sufficient controls in place to minimize the likelihood that conflicts of interest will arise,” the report said. The contributors to the report included two SEC staffers who work in the Office of International Affairs.

If the SEC doesn’t quickly move forward with reforms, what’s left of the ratings’ credibility will continue to fall apart, Kaitz predicts. That credibility, he adds, is crucial for keeping the global capital markets in a healthy condition. “We’re clearly in a quandary here,” he says. “I don’t think the reputational risk of the rating agencies is going to just miraculously change overnight.”