SEC Report Finds Deficiencies in Credit Ratings of Mortgage-Backed Securities

Against the backdrop of impending regulatory reform of credit rating agencies by the SEC and the European Commission, an SEC report found that the rating agencies did not properly manage conflicts of interest in rating asset-backed securities during the subprime era. The SEC also found that the rating agencies neither fully disclosed nor properly documented their procedures for rating mortgage-backed securities and collateralized debt obligations.. SEC Chair Christopher Cox said that the Commission uncovered serious shortcomings at the firms, including a lack of both public disclosure and of policies to manage the rating process, as well as insufficient attention to conflicts of interest.

The SEC study evolved from an extensive 10-month examination of three major credit rating agencies. Broadly, the study found that, as the securitization process exploded with a substantial increase in the number and complexity of mortgage-backed securities and CDOs, the rating agencies could not keep up with the growth.

Last month, the SEC proposed a three-pronged reform to regulate the conflicts of interests, disclosures, and business practices of credit rating agencies. The first prong would address conflicts of interest in the ratings process and require new disclosures designed to increase the transparency and accountability of ratings agencies. The second prong would require credit rating agencies to differentiate the ratings they issue on structured products from those they issue on bonds through the use of different symbols or by issuing a report disclosing the differences. The third part of the SEC's proposed rulemaking would clarify the limits and purposes of credit ratings and ensure that the role assigned to ratings in SEC rules is consistent with the objectives of having investors make an independent judgment of credit risks.

In the wake of the SEC’s proposals, the European Commission said that credit rating agencies must be subjected to regulation. Internal Market Commissioner Charlie McCreevy recently said that no regulator appears to have ``got as much as a sniff of the rot at the heart’’ of the securitized asset rating process before it blew up. European Union political leaders have already called for reform of the credit rating agency process in light of the market turbulence triggered by the subprime crisis. While supporting a market-driven solution, the leaders have said that regulation and legislation will be on the table if an appropriate market response is not forthcoming. Regulation is now on the table.

The conflict of interest issue looms large on both sides of the Atlantic. Commissioner McCreevy is skeptical that a rating agency can give an objective rating to a bank’s structured securitized product if it has advised that same bank on how to structure that same product. He believes that, in order to effectively restore trust in the process, a framework for rating agencies must be implemented under which conflicts of interest are properly and more effectively managed.

Rating agencies use the “issuer pays” model under which the issuer of the security pays the rating agency for the rating. The conflict of interest inherent in this model is that rating agencies have an interest in generating business from the firms that seek the rating, which could conflict with providing ratings of integrity. SEC rules specify that it is a conflict of interest for a rating agency being paid by issuers to determine credit ratings with respect to securities they issue. They are required to establish procedures reasonably designed to manage such conflicts of interest.

The SEC study found that, although the rating agencies had policies to manage conflicts of interest, key participants in the rating process were still allowed to participate in the fee discussions. Further, there were no efforts made to shield analysts from e-mails and other communications from issuers discussing fees and revenue

Moreover, while rating agencies had policies prohibiting employees from owning any security that is subject to a credit rating by a team on which the employee is a member, the study revealed that the agencies varied in how rigorously they monitor or prevent prohibited transactions, including personal trading by their staff, from occurring. Two rating agencies did not prohibit structured finance analysts from owning shares of investment banks participating in mortgage-backed securities transactions.

In addition, the rating agencies did not always document significant steps in the ratings process, said the report, including the rationale for deviations from their models. There was also inadequate documentation of rating committee actions and the presence of significant participants in the ratings process

None of the rating agencies had specific written procedures for rating mortgage-backed securities or CDOs. Further, they did not have specific procedures to identify errors in either their models or their methodologies.