Risk & Compliance

Rating-agency Reforms Are Hammered Out

Moody's, S&P, and Fitch announce agreement with New York Attorney General Cuomo, boosting independence and transparency.
Alan RappeportJune 5, 2008

The top three credit rating agencies, as expected,
signed an agreement with New York Attorney General Andrew Cuomo that reforms their business by instilling greater independence from the entities they rate — and, it is hoped, introduces greater accuracy.

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. Loan pools refer to the home mortgages that backed residential mortgage-backed securities (RMBS), a market that collapsed with falling home values.

“The mortgage crisis currently facing this nation was caused in part by misrepresentations and misunderstanding of the true value of mortgage securities,” said Cuomo, who remains deep in an investigation of the mortgage industry. “The tremendous reach of this crisis cannot be understated — our entire economy continues to feel aftershocks from the collapse of the mortgage industry.”

The investigation by the attorney general’s office had found conflicts of interest between banks and rating agencies that contributed to the crisis. The agencies were typically only paid by an investment bank if that bank ultimately selected it to perform the rating. Since banks could get a “free preview” from all the agencies and pick the most favorable, the ratings firms had an incentive to produce optimistic results. Further, the agencies did not have access to the due diligence information that banks had on the mortgages they were pooling.

“By increasing the independence of the rating agencies, ensuring they get adequate information to make their ratings, and increasing industry-wide transparency, these reforms will address one of the central causes of that collapse,” Cuomo said.

Under the agreement, rating agencies will now establish a fee-for-service structure, where they will be compensated regardless of whether the investment bank ultimately selects them to rate a RMBS. Rating agencies will now have to disclose information about all securitizations submitted for their initial review so that investors can see if issuers tried to shop around.

Credit rating agencies will also review loan originators and publish the results on their Web sites. They will have access to due diligence results and review them before issuing ratings, and they will have to annually review themselves to look for cracks in their independence.

After months of bearing intense criticism as a culprit for credit crisis, the agencies expressed relief that some changes will occur.

“S&P remains steadfast in our commitment to transparency, openness, and strengthening the governance of the ratings process, and we are pleased these principles lie at the heart of today’s agreement,” said S&P President Deven Sharma. P. Stephen Joynt, of Fitch; and Michel Madelain, of Moody’s, also said they were pleased that the agreement will improve the agencies’ transparency and independence.

Thursday’s agreement comes as the Securities and Exchange Commission also has set its sights on reforming the rating agencies. Earlier this week, the SEC’s three new nominees
agreed with Senator Christopher Dodd (D-Conn.) who said that it was time to “engage in some serious rule-making” due to recent missteps by the agencies.

“The attorney general’s actions, as well as the comprehensive new rules for all nationally registered credit rating agencies that the Commission will consider next week, are motivated by our mutual desire to promote ratings with integrity and curb the questionable practices that contributed to the credit market turmoil,” said SEC Chairman Christopher Cox.