In a wide-ranging set of proposed reforms, the Securities and Exchange Commission is following through on its promise to clamp down on the credit rating agencies. The agencies — and the SEC, which is supposed to be the industry watchdog — have come under intense congressional criticism over their role in the subprime mortgage crisis. During a series of Capitol Hill appearances in the spring, SEC chairman Christopher Cox pledged immediate action (see “When Sentinels Go Astray,” May 2008).
The new rules, formally proposed on June 11 and likely to be implemented this summer, would bar rating agencies from consulting with clients on how to structure a security to get a good rating. Suggested changes in the disclosure requirements would make the agencies reveal what information goes into ratings so that investors can better evaluate the scores.
The credit rating agencies, which include Moody’s, Standard & Poor’s and Fitch Ratings, have come under fire in recent months for their failure to accurately assess certain subprime debt, much of which, in hindsight, received far better ratings than it deserved. A broad variety of investors — including pension funds, endowments, hedge funds and individuals — have historically relied on the agencies for insight into the underlying value of securities.
The most controversial of the pro-posed reforms would require the agencies to use a new, separate set of symbols or modifiers for rating structured investment vehicles like collateralized debt obligations, some of the very investments that are at the root of the credit crunch. The Securities Industry and Financial Markets Association, a major trade group, warns that such a change would set off a fire sale of securities in an already difficult market and impair credit for student loans, auto loans, credit cards, mortgages and so on.
“When you pull on a string, it is usually a good idea to consider what might unravel,” says Deborah Cunningham, chief investment officer of Boston-based investment management firm Federated Investors and co-chair of an association task force on credit rating agencies. “The possible consequences for our markets if rating modifiers are adopted could be disturbing.”
The SEC is obliged to weigh public comment before reaching a decision. But given the level of public interest in the issue, it seems poised to implement the changes as proposed, perhaps within weeks. Cox says the goal is to get at conflicts of interest that are “hardwired” into the rating agency business model.
“We have learned that the ratings of structured products in the subprime area made those conflicts of interest even more acute,” Cox said at an open SEC meeting in June, adding that one practice in particular had been especially egregious. “Selling consulting services to entities that purchased ratings became a triple-A conflict of interest,” he said.
