Risk & Compliance

New SEC Rules Being Drawn Up for the Ratings Game

Proposals would improve independence, disclosure and would highlight the risks of structured products.
Alan RappeportJune 11, 2008

The Securities and Exchange Commission moved on two fronts to reform the embattled credit rating agencies — aiming to fix conflicts of interest in the industry, and to distinguish between different types of asset-backed securities.

Twin proposed new rules come as the rating companies have taken major blame for the magnitude of the subprime mortgage crisis and resulting credit crunch. Critics contend that the agencies overrated securities backed by bad loans, leading investors to take on more risk than they could handle.

“The complexity of the structured products themselves, combined with the lack of quality information about the underlying assets, make it exceptionally difficult for anyone to determine a credit rating at all,” SEC chairman Christopher Cox said at an open meeting Wednesday.

If given final approval after a comment period, one rule would prohibit ratings agencies from issuing ratings on structured products unless they have sufficient information about the underlying assets. It would also prevent them from structuring the same products that they rate. In the future the agencies would not be able to negotiate the fee of a rating with an issuer and also determine the rating. The practice of issuers “shopping around” for quality ratings or asking agencies how to structure a product to ensure a good rating has been blamed for inflated ratings. Moreover, the raters would not be allowed to receive gifts of more than $25 from those they rate.

Disclosure will also be improved. The SEC is proposing that credit rating agencies make all their ratings publicly available to keep them from being overly optimistic. They will have to disclose the information that they use to make a rating, publish regular performance statistics. And the ratings agencies will have to publish an annual report of all the ratings action that they took and maintain that information in an ‘interactive data” database.

In a nod to how tricky it can be to rate structured financial products the SEC offered a second proposal that would create labels to differentiate between complex asset-backed securities and more traditional corporate bonds.

“Structured finance ratings in fact differ from traditional corporate debt ratings in important ways,” Cox said.

Structured products are more vulnerable to the changing winds of the broader economy, they are more heavily reliant on complex models that have proven to be imperfect, and they are driven by assumptions and are therefore riskier, according to Cox. Although the proposal on independence passed unanimously, this one received a nay vote from commissioner Paul Atkins.

“This proposed change is a shiny but potentially costly veneer on an otherwise good set of proposals,” Atkins said.

Atkins said that investors are sophisticated enough to tell the difference between ratings of financial products and was wary of the impact of such a change. Cox acknowledged that changing symbols could force changes to investment guidelines and might lead to “forced liquidation” of products that don’t meet those guidelines.

The SEC’s renewed focus on the ratings agencies comes a week after the top three credit rating agencies signed an agreement with New York Attorney General Andrew Cuomo intended to create better independence and more accurate results. The agreement will change the way Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings are paid by investment banks for evaluations of loan pools, and will require banks to share the due diligence they perform on the pools before ratings are issued.