Friday, April 15, 2011

Senate Report Urges SEC to Rank Accuracy of Credit Rating Agencies

A report issued by the Senate Investigations Subcommittee urged the SEC to use its regulatory authority to rank credit rating agencies in terms of performance, in particular the accuracy of their ratings. This is in addition to the reforms effected by the Dodd-Frank Act in the area of rating agencies. The recommendation was part of a large and significant bi-partisan report by the Subcommittee on the financial crisis. The report was signed by Senator Carl Levin (D-MI) and Senator Tom Coburn (R-OK).

The Subcommittee uncovered a host of factors responsible for the inaccurate credit ratings assigned to mortgage-backed securities and collateralized debt obligations, including the drive for market share, pressure from investment banks to inflate ratings, inaccurate rating models, and inadequate rating and surveillance resources. In addition, federal regulations that limited certain financial institutions to the purchase of investment grade financial instruments encouraged investment banks and investors to pursue, and credit rating agencies to provide, those top ratings. All these factors played out against the backdrop of an ongoing conflict of interest that arose from how the credit rating agencies earned their income.

If the credit rating agencies had issued ratings that accurately exposed the increasing risk in the mortgage-backed securities and collateralized debt obligations markets, posited the report, they may have discouraged investors from purchasing those securities, slowed the pace of securitizations, and as a result reduced their own profits. But, concluded the report, it was not in the short term economic self-interest of the rating agencies to provide accurate credit risk ratings for high risk mortgage-backed securities and collateralized debt obligations.

The Dodd-Frank Act effected a number of reforms in the credit rating agency process, including the establishment of a new SEC Office of Credit Ratings charged with overseeing the credit rating industry, including by conducting at least annual examinations whose reports must be made public. The SEC was also authorized to discipline, fine, and deregister a credit rating agency and associated personnel for violating the law as well as to deregister a credit rating agency for issuing poor ratings. Dodd-Frank also authorized investors to file private causes of action against credit rating agencies that knowingly or recklessly fail to conduct a reasonable investigation of a rated product. The Act also requires credit rating agencies to establish internal controls to ensure high quality ratings and disclose information about their rating methodologies and about each issued rating.

The Senate report issued recommendations that build on the Dodd-Frank reforms. In addition to the SEC ranking the rating agencies on performance and accuracy, the report urges the SEC to use its regulatory authority to facilitate the ability of investors to hold credit rating agencies accountable in civil lawsuits for inflated credit ratings when a credit rating agency knowingly or
recklessly fails to conduct a reasonable investigation of the rated security. The SEC should also use its inspection and examination authority to ensure that credit rating agencies institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy. The Senate subcommittee also urged the SEC to use its inspection and examination authority to ensure that credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record for issuing poor quality assets.

In transitioning from the fact that the rating agencies issued inaccurate ratings to the uestion of why they did, the Senate report focused on the conflicts of interest inherent in the ssuer-pays model currently permitted by the SEC. Under this system, the firm interested in profiting from a mortgage-backed security is required to pay for the credit rating needed to sell the security. Moreover, it requires the credit rating agencies to obtain business from the very companies paying for their rating judgment, resulting in a system that creates strong incentives for the rating agencies to inflate their ratings to attract business, and for the issuers and arrangers of the securities to engage in ratings shopping to obtain the highest ratings for their financial products.

There is an inherent conflict of interest because rating agencies are incentivized to offer the highest ratings, as opposed to offering the most accurate ratings, in order to attract business. Hence, the Senate report recommends that the SEC rank credit rating agencies by the accuracy of their ratings.

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