SEC Adopts Credit Rating Agency Reforms Including Differentiation of Asset-Backed Securities Products
Aainst the backdrop of a financial crisis partially caused by a lack of confidence in the accuracy of credit ratings, the SEC has adopted rules reforming the credit rating agency process. (Release No. 34-59342). Essentially, the current financial crisis was partially caused because the credit rating agencies failed investors by awarding their highest ratings to complex debt instruments that were undeserving of investment grade status.
The SEC has continued the regulatory reform of the credit rating agencies with a set of new requirements focusing heavily on the complex structured products whose ratings were at the center of the financial crisis. The SEC thus embraces the doctrine of differentiation, which is also being adopted by the European Commission in its reform of credit rating agencies. The changes are designed to improve the quality of credit ratings by fostering accountability, transparency, and competition in the credit rating industry, particularly with respect to credit ratings for structured and asset-backed financial products.
The Commission has enhanced the disclosure of credit ratings performance measurement statistics; increased the disclosure of information about the assets underlying structured finance products; required more information about the procedures and methodologies used to determine structured finance ratings; and addressed conflicts of interest arising from the structured finance rating process.
The SEC amended the instructions to Exhibit 1 to Form NRSRO to require NRSROs to provide more detailed performance statistics and, thereby, make it easier for users of credit ratings to compare the ratings performance of the NRSROs. In addition, these amendments will make it easier for an NRSRO to demonstrate that it has a superior ratings methodology or competence and, thereby, attract clients.
One change to the Exhibit 1 instructions would require an NRSRO when generating the performance statistics to include credit ratings of any security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction. Another change would require that the class-by-class disclosures be broken out over 1, 3 and 10-year periods.
The SEC also amended the instructions to Exhibit 2 of Form NRSRO to provide greater clarity around three areas of the NRSROs’ rating processes that have raised concerns in the context of the recent credit market turmoil: 1) the level of verification performed on information provided in loan documents; 2) the quality of loan originators; 3) and the on-going surveillance of existing ratings and how changes made to a model used for initial ratings are applied to existing ratings.
Level of Verification
The rating agency must disclose information about verification performed on assets underlying or referenced by a security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction relied on in determining credit ratings.
Quality of Originators
The rating agency will also have to disclose whether and, if so, how assessments of the quality of originators of assets underlying or referenced by a security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction play a part in the determination of credit ratings. Originators of assets were key players in the originate and distribute securitization process that contributed to the financial crisis.
The Commission believes that certain qualities of an asset originator, such as its experience and underwriting standards, may impact the quality of the loans it originates and the accuracy of the associated loan documentation. This, in turn, could influence how the assets ultimately perform and the ability of the NRSRO’s models to predict their performance.
Consequently, the failure to perform any assessment of the loan originators could increase the risk that an NRSRO’s credit ratings may not be accurate. Therefore, disclosures as to whether the NRSRO performs any qualitative assessments of the originators would be useful in comparing the efficacy of the NRSROs’ procedures and methodologies.
Surveillance
Finally, the SEC will require rating agencies to disclose 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.