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Credit-rating-agency reforms: as an outgrowth of the meltdown in the mortgage-backed securities (MBS) markets, the Securities and Exchange Commission has adopted new rules to tighten oversight of the credit-rating agencies.

The story of the credit-rating agencies is a story is a story of colossal failure. The credit-rating agencies occupy a special place in our financial markets. Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public."--Statement of Rep. Henry Waxman (D-California), chairman of the House Committee on Oversight and Government Reform, during the Oct. 22, 2008, Hearing on Credit Rating Agencies and the Financial Crisis. * "Since all opinions [about future events] are liable to error, and opinions based on models are liable to systemic error of vast proportion, why should the U.S. government want to enshrine the opinions [of certain preferred rating agencies] as having preferred, preferential--indeed mandatory--status? It shouldn't."--Testimony of Alex J. Pollock, resident fellow at the American Enterprise Institute, Washington, D.C., to the Joint Economic Committee of the U.S. Congress, May 14, 2008. * "[Analysts and managing directors] are continually 'pitched' by bankers, issuers, investors. [At times,] we drink the Kool-Aid."--Internal board presentation delivered by Raymond W. McDaniel Jr., chief executive officer, chairman of the board and director of New York--based Moody's Corporation, to Moody's directors in October 2007 and discussed as part of his testimony before the House Committee on Oversight and Government Reform's Oct. 22, 2008 hearing.


On Feb. 2, 2009, the Securities and Exchange Commission (SEC) published the last of a series of final rules to reform federal regulatory oversight and registration of nationally recognized statistical rating organizations (NRSROs) to expand the list of prohibited conflict-of-interest activities. The rules' broader goals include maintaining separation of core functions from consulting services, minimizing conflicts inherent in issuer-based compensation, and enhancing record-keeping and disclosure requirements to better educate investors on methodologies used to initially rate a security class and ongoing monitoring processes used to ensure the integrity of the credit rating into the future.

Conflict-of-interest and NRSRO registration rules take effect on April 10, 2009; new record-keeping and disclosure rules take effect on Aug. 10, 2009.

The official name--nationally recognized statistical rating organization (NRSRO)--was adopted by the SEC in 1975. It was established solely for determining capital charges on different grades of debt securities under the Net Capital Rule--a rule requiring broker-dealers, when computing net capital, to deduct from their net worth certain percentages of the market value of their proprietary securities positions.

Over time, as marketplace and regulatory reliance on credit ratings increased, the use of the NRSRO concept became more widespread. Between 1975 and 2002, the SEC used the NRSRO designation as its "seal of approval" to select on an informal no action letter basis only a few national credit-rating agencies--Moody's Investors Service, Standard & Poors (S&P) and Fitch Ratings, all based in New York (collectively referred to as the Big Three); plus four other credit rating agencies that ultimately merged into the Big Three.

The 2009 SEC rules are designed to fully implement the Credit Rating Agency Reform Act of 2006 (the Reform Act), signed into law by President George W. Bush on Sept. 29, 2006. That's right--2006. The Reform Act came about as a result of the collapse of Enron Corporation in November 2001, and was to serve as a supplement to the Sarbanes-Oxley Act of 2002.

Well before the U.S. subprime mortgage collapse and collapse of financial markets worldwide, the Senate Committee on Governmental Affairs held hearings and issued a staff report in October 2002. The Senate committee was investigating how credit-rating agencies could have rated Enron a good credit risk right up until four days prior to the company declaring bankruptcy.

The staff report found that, "because CRAs are subject to little formal regulation or oversight, and their liability traditionally has been limited by regulatory exemptions and First Amendment protections, there is little to hold them accountable for future poor performance." (Financial Oversight of Enron: The SEC and Private-Sector Watchdogs, S. Prt. 107-75 [Oct. 7, 2002].)

The Reform Act creates a new Section 15E of the Securities Exchange Act of 1934 (Exchange Act), requiring all current and future NRSROs to file a detailed registration application with the SEC. Portions of the application are to be made publicly available on each NRSRO's Web site and are to be updated whenever the information becomes "materially inaccurate" (a term undefined in the Reform Act).

NRSROs must also re-certify their registration annually. To qualify for NRSRO registration, a CRA must have been issuing ratings on bonds issued by the financial services industry, broker-dealers, corporate issuers, slate and local governments, and issuers of asset-backed securities (ABS) for at least three years.

NRSROs are required to maintain and enforce written policies and procedures designed to address conflicts of interest identified through SEC rulemaking. In addition, NRSROs are prohibited from engaging in any act or practice identified through SEC rulemaking as being unfair, coercive or abusive. Section 15E also requires NRSROs to employ a compliance officer to administer the policies and procedures, and to ensure the NRSRO is operating in compliance with securities laws and SEC rules.

The Reform Act also amended Section 17(a) of the Exchange Act, giving the SEC regulatory authority to impose annual reporting and record-keeping requirements, as well as agency authority to conduct periodic examinations of NRSROs. However, The Reform Act does not give secondary agency examination authority to federal banking agencies to verify the integrity of credit ratings assigned to investment-grade securities purchased by depository institutions. This is a significant regulatory gap.

The Reform Act did not take effect until June 2007. The SEC issued its first, round of final implementing rules on June 26, 2007. By that time, delinquency and foreclosure rates for subprime mortgage loans in the United States had dramatically increased, creating turmoil in the residential mortgage-backed security (RMBS) markets and for collateralized debt obligations (CDOs) linked to such securities.

Moody's, Standard & Poor's and Fitch downgraded a significant number of their ratings, raising questions about the accuracy of their initial credit ratings and the lack of monitoring or surveillance of ratings assigned over time, as well as the integrity of the ratings process as a whole. The Big Three became formally registered NRSROs in September 2007.

Congressional action and SEC regulatory oversight did not come soon enough to avoid catastrophe when the global financial markets collapsed on Sept. 18, 2007, according to the Summary Report of Issues Identified in the SEC Staff's Examinations of Select Credit Rating Agencies, July 2008 (Examination Report).

2009 reform measures

The SEC's 2009 final rules are a result of a formal, 10-month examination of Moody's, Standard & Poor's and Fitch that began in August 2007 and culminated with the release of the Examination Report in July 2008. All of the following elements of the 2009 final rules are designed by the SEC to address examination findings raising concerns about the integrity of the Big Three's credit-rating procedures and methodologies.

Increased competition among registered NRSROs

Acknowledging the Reform Act's stated purpose is to "improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency and competition in the credit-rating industry," the SEC designed its final NRSRO registration rules to dilute the highly concentrated credit-rating industry and increase the number of NRSROs ultimately to 30.

Since June 2007, the SEC has formally registered 10 NRSROs, including the Big Three; A.M. Best Co. Inc.; DBRS Ltd.; Japan Credit Rating Agency Ltd.; Rating and Investment Information Inc.; LACE Financial Corporation; Egan-Jones Rating Co.; and Realpoint LLC.

Transparency of NRSRO registrations

Each of the NRSROs' registration applications and supplemental reports are to be made publicly available on their respective Web sites, pursuant to Rule 249b. The registration application form and supplemental reports disclose the following publicly available information: 1) credit ratings performance measurement statistics for each class of credit rating over one-, three- and 10-year periods through the most recent calendar year-end, including historical ratings transition and default rates; 2) the procedures and methodologies used to determine credit ratings and how they are revised, where necessary, through ongoing monitoring processes (surveillance); 3) written policies and procedures adopted and implemented by the NRSRO to prevent the misuse of material, nonpublic information; 4) the NRSRO's organizational structure; 5) whether the NRSRO has a code of ethics in effect and enforced by a compliance officer; 6) any conflict of interest related to the issuance of credit ratings; and 7) what categories of debt it intends to rate.

Verification of RMBS loan-level data received

The 2008 Examination Report noted that the Big Three failed to adequately, if at all, perform due diligence on RMBS loan-tape information supplied by issuers and others, or to otherwise verify the accuracy or quality of the loan data. Congress and the SEC found the same procedural lapses during the 2002 investigations of the Big Three.

There was no federal law or regulation requiring NRSROs to do this due diligence until a May 2008 settlement agreement among the Big Three and New York State Attorney General Andrew Cuomo. The settlement agreement required the rating agencies to develop and publicly disclose due-diligence criteria to be performed by underwriters on all mortgages comprising RMBS, and to review those results prior to issuing ratings.

The SEC's 2009 Rule 294b will require NRSROs to include a description in their registration application and at least annually thereafter of how they will verify the accuracy of loan-tape information before determining credit ratings.

Enhanced record-keeping requirements; SEC examination authority

The 2008 Examination Report noted that while the Big Three all had written policies and procedures generally requiring documentation of the ratings committee process and its key deliberations, none of them acted in compliance with those requirements. As a result, that had the effect of thwarting SEC examination staff and internal auditors' tasks of determining how credit ratings were derived and whether exceptions were made to established methodologies that occurred in their subprime RMBS and CDO ratings processes.

Starting on April 10, 2009, SEC Rule 240.17g-2(a) will require that if a quantitative model is a substantial component of the credit-rating process, an NRSRO is required to keep a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued. Rule 24.17g-2 already requires an NRSRO to keep records that identify any credit analyst(s) who participated in determining the credit rating; identify the person(s) who approved the credit rating before it was issued; identify whether the credit rating was solicited or unsolicited; and identify the date the credit-rating action was taken.

Monitoring the accuracy of ratings on an ongoing basis (surveillance)

The 2008 Examination Report noted that while the Big Three were not required by law to perform surveillance, they did receive either upfront or annual ratings surveillance fees to monitor the accuracy of their ratings on an ongoing basis and to adjust those ratings up or down when circumstances or events so warranted. But examiners found that none of the Big Three demonstrated having sufficient resources to conduct surveillance in a timely manner.

Starting on April 10, 2009, NRSROs are to include in their registration application a description of procedures for monitoring, reviewing and updating credit ratings. This description will include how frequently credit ratings are reviewed; whether different models or criteria are used for ratings surveillance than for determining initial ratings; whether changes made to models and criteria for determining initial ratings are applied retroactively to existing ratings; and whether changes made to models and criteria for performing ratings surveillance are incorporated into the models and criteria for determining initial ratings.

SEC identifies prohibited conflicts of interest

The final rule adds three new prohibited conflicts to Rule 240.17g-5(c), bringing the total number of prohibited conflicts to seven. They are:

* An NRSRO cannot issue or maintain a credit rating solicited by a person who, in the most recently ended fiscal year, provided the NRSRO with net revenue equal to or greater than 10 percent of the NRSRO's total net revenue for the fiscal year. The SEC has granted one-year exemptions from this rule for two registration applicants in order to increase competition among NRSROs.

* An NRSRO and its credit analysts who determine or approve the credit rating cannot directly own securities of or directly hold an ownership interest in the "person" (an undefined term used by the SEC in its final rule) who is the subject of the credit rating. Sovereign nations and their agencies are excluded. Indirect ownership interests, such as through mutual funds or blind trusts, are also excluded.

* An NRSRO cannot issue or maintain a credit rating for persons associated with the NRSRO.

* An NRSRO cannot issue or maintain a credit rating where a credit analyst who participated in determining or approving the credit rating is an officer or director of the person subject to the credit rating.

* Prohibits an NRSRO from providing consulting services on the same deal it or an affiliate is rating ("core" services). NRSROs cannot give recommendations to arrangers on how to structure a trust or complete an asset pool to receive a desired credit rating, and then rate the securities issued by the trust (effective April 10, 2009).

* Prohibits credit analysts within an NRSRO who are responsible for determining credit ratings or developing methodologies for determining credit ratings to participate in fee discussions (effective April 10, 2009).

* Prohibits credit analysts from accepting gifts valued at more than $25, including entertainment, from the obligor being rated or from the issuer, underwriter or sponsor of the securities being rated (effective April 10, 2009). Items provided in the context of normal business activities such as meetings do not constitute gifts. This rule eliminates the potential undue influence that gifts can have on those responsible for determining credit ratings. The $25 limit is per analyst and per interaction rather than a one time or annual limit.

SIFMA presents additional global reform measures

The Securities Industry and Financial Markets Association (SIFMA) is a non-profit industry association that represents participants in the global financial services markets. It has offices in New York; Washington, D.C.; London; and Hong Kong, where its sister organization, the Asia Securities and Financial Markets Association (ASIFMA), is located. SIFMA formed its global, investor-led Credit Rating Agency Task Force to examine key issues related to credit ratings and credit-rating agencies worldwide. SIFMA has submitted comment letters to both the SEC and the European Commission on their respective credit-rating-agency reform rules, and is currently working with credit-rating agencies here and abroad to develop by summer 2009 jointly agreed-upon best-practice recommendations.

SIFMA released its own recommendations on ways to reform the credit-rating industry in July 2008. Those recommendations are largely in line with the SEC's current and 2009 final rules. Among other things, SIFMA recommends that there be a coordinated, globalized response to industry issues, and it supports the development of a more fully harmonized and convergent global regulatory framework in order to maintain an orderly, transparent, properly functioning global financial marketplace.

SIFMA also recommends that issuers and underwriters work toward improving transparency and disclosure with regard to structured finance issues by standardizing reporting and disclosure on underlying assets. To this end, SIFMA is collaborating with the American Securitization Forum (ASF), New York, and the European Securitization Forum, London, to develop recommendations in 2009 on disclosure practices, underwriter due-diligence practices and reporting standardization, and similar issues.

Melissa L. Richards is a shareholder at the Buchalter Nemer law film, based in San Francisco and serves as outside general conuse to the California Mortgage Bankers Association. A former savings-and-loan regulator during the 1980s she has served as regulatory compliance and licensing counsel to the mortgage banking industry for almost 20 years Richards is co-author of Mortgage Procedure Guide to Federal and State Compliance published by Sheshunoff Information Services. Austin, Texas, She can be reached at
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Title Annotation:Cover Report: Secondary Market
Comment:Credit-rating-agency reforms: as an outgrowth of the meltdown in the mortgage-backed securities (MBS) markets, the Securities and Exchange Commission has adopted new rules to tighten oversight of the credit-rating agencies.(Cover Report: Secondary Market)
Author:Richards, Melissa L.
Publication:Mortgage Banking
Article Type:Cover story
Date:Apr 1, 2009
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