Credit rating agencies

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caption = John Moody, founder Moody's Investors Service

Contents

Credit rating regulation under the Dodd-Frank Act

On July 21, 2010, U.S. President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") following earlier passage of the legislation by a 237 to 192 vote in the U.S. House of Representatives and a 60 to 39 vote in the U.S. Senate. Dodd-Frank represents Congress's response to what the House Committee on Financial Services calls "years without accountability for Wall Street [and] the worst financial crisis since the Great Depression."

Subtitle C of Title IX of Dodd-Frank – "Improvements to the Regulation of Credit Rating Agencies" ("Subtitle C") – establishes an almost wholly new framework for governing and regulating credit rating agencies, including nationally recognized statistical rating organizations ("NRSROs"). The overhaul stands to dramatically change the role NRSROs play in the markets, and is based on Congressional findings that "the systemic importance of credit ratings and the reliance placed on credit ratings by individual and institutional investors and financial regulators" makes the activities and performance of NRSROs "matters of national public interest, as credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the United States economy."

Dodd-Frank imposes new requirements covering key areas of NRSRO function and oversight, including:

  • Increased Authority of the Securities and Exchange Commission (the "SEC"): Subtitle C gives the SEC substantial rulemaking authority and establishes an Office of Credit Ratings (the "OCR") within the SEC.
  • Liability Provisions: By lowering pleading requirements, removing safe-harbor protections, and imposing filing and other requirements, Subtitle C heightens the liability that NRSROs face.
  • NRSRO Governance: Subtitle C contains many provisions aimed at minimizing the impact of conflicts of interest on the integrity of NRSROs' issuance of credit ratings.
  • Public Disclosure: Under the terms of Subtitle C, NRSROs are required to disclose an array of new information, such as the performance record of their credit ratings and the procedures and methodologies used in the credit ratings process.

Impact on Existing Federal Securities Laws: Subtitle C removes a wide range of statutory references to NRSROs and, among other matters, calls for the SEC and other federal agencies to develop new standards of creditworthiness.

Asset-Backed Securities ("ABS"): Dodd-Frank includes many provisions designed to improve the asset-backed securitization process, including new disclosure requirements and an SEC study to identify the appropriate way to reconstruct the current issuer-pays business model of obtaining credit ratings for ABS (also referred to as structured finance products).

Looking Forward: In addition to the SEC study on the issuer-pays model, Dodd-Frank, and Subtitle C in particular, requires that the SEC, the Government Accountability Office (the "GAO") and others conduct studies that may result in additional rules and regulations affecting the role and import of NRSROs and credit ratings in the markets.

Read more here.

SEC suspends rule for ratings in ABS offerings

"... So what’s the SEC to do? For now, they’ve offered a 6-month reprieve to issuers and rating agencies.

On Thursday, the director of the SEC’s division of corporate finance issued the following statement (emphasis ours):

"Within the next day, the Division of Corporation Finance expects to issue a ‘no action’ letter allowing issuers for a period of 6 months to omit credit ratings from registration statements filed under Regulation AB. Although there are currently few issuers in the registered asset-backed securities market, we understand from some issuers that they cannot currently obtain credit rating agency consent to include the credit ratings in these ‘Reg AB’ filings. This action will provide issuers, rating agencies and other market participants with a transition period in order to implement changes to comply with the new statutory requirement while still conducting registered ABS offerings."

Raters request issuers to remove ratings from ABS offering docs

The nation's three dominant credit-ratings providers have made an urgent new request of their clients: Please don't use our credit ratings.

The odd plea is emerging as the first consequence of the financial overhaul that is to be signed into law by President Obama on Wednesday. And it already is creating havoc in the bond markets, parts of which are shutting down in response to the request.

Standard & Poor's, Moody's Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days. Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law.

The new law will make ratings firms liable for the quality of their ratings decisions, effective immediately. The companies say that, until they get a better understanding of their legal exposure, they are refusing to let bond issuers use their ratings.

That is important because some bonds, notably those that are made up of consumer loans, are required by law to include ratings in their official documentation. That means new bond sales in the $1.4 trillion market for mortgages, autos, student loans and credit cards could effectively shut down.

Franken amendment adopted in legislation

The legislation that passed the Senate on May 20, 2010 contained a provision, Sec. 939D, authored by Senator Al Franken that conducted a frontal attack on the conflict of interest problem by adding new Exchange Act Sec. 15E(w) to create an SRO overseen by the SEC that would assign credit rating agencies to provide initial ratings for asset-backed securities and structured financial products on a rotating basis. There was no comparable provision in the legislation the House passed on December 11, 2009. The House-Senate conference committee that produced the Dodd-Frank Act reached a compromise that directs the SEC to conduct a study on the feasibility of assigning a rating agency to issue ratings on structured products and, if no better method is found, implement the Sec. 15E(w) as authored by Senator Franken. (Sec. 939F of the Dodd-Frank Act).

The SEC study must determine the extent to which the creation of such a system would be viewed as the creation of moral hazard by the Federal Government, and examine any constitutional or other issues concerning the establishment of such a system. The study must also look at the range of metrics that could be used to determine the accuracy of credit ratings; and alternative means for compensating nation rating organizations that would create incentives for accurate credit ratings. The study must assess potential mechanisms for determining fees for the raters and appropriate methods for paying the fees. (Sec. 939F(b) of the Dodd-Frank Act).

Within two years of enactment, the SEC must report to Congress on the findings of the study. (Sec. 939F(c) of the Dodd-Frank Act). After submission of the report, the SEC must establish a system for the assignment of nationally recognized statistical rating organizations to determine the initial credit ratings of structured finance products in a manner that prevents the issuer, sponsor, or underwriter of the product from selecting the rating agency that will determine the initial credit ratings and monitor such credit ratings. In issuing rules, the Commission must give thorough consideration to the Franken-authored Exchange Act. Sec. 15W(e) and must implement the system set forth in Sec. 15W(e) unless the Commission decides that an alternative system would better serve the public interest and protect investors. (Sec. 939F(d) of the Dodd-Frank Act).

The Franken Amendment further attacks the conflict of interest problem by creating a board overseen by the SEC that will assign credit rating agencies to provide initial ratings on a rotating basis. The SEC will create a credit rating agency board, a self-regulatory organization, tasked with developing a system in which the board assigns a rating agency to provide a product’s initial rating. Requiring an initial credit rating by an agency not of the issuer’s choosing will put a check on the accuracy of ratings, in the Senator’s view. The amendment does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing. The amendment leaves flexibility to the Board to determine the assignment process. Thus, the new board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn’t get to choose its rating agency. Cong. Record, May 10, 2010, S3465.

Crisis Commission examines credit raters


Warren Buffett, the chief executive of Berkshire Hathaway Inc (BRKa.N), will testify next week before the U.S. panel examining the causes of the deep financial crisis.

The Financial Crisis Inquiry Commission, a Congressionally appointed panel charged with writing by the end of the year a full account of the crisis, said Buffett will testify with Moody's Corp (MCO.N) Chief Executive Raymond McDaniel on June 2 in New York.

The hearing will look at the credibility of credit ratings, and the investment decisions made based on those ratings, the panel said in a release on Wednesday.

Credit rating agencies have been accused of contributing to the global financial crisis by assigning inflated ratings to subprime mortgage-related products.

Buffett earlier this month defended credit rating agencies as an investment, including stakes by Berkshire Hathaway.

He told Berkshire's annual meeting that rating agencies "made the same mistake" that he, politicians, mortgage brokers and others did in overestimating the health of the housing market.

During the first quarter of this year, Buffett further reduced his stake in Moody's, which stood at about 13 percent as of March 31.

Buffett said at the annual meeting on May 1 that the agencies, which also include McGraw-Hill Cos' (MHP.N) Standard & Poor's and Fimalac SA's (LBCP.PA) Fitch Ratings, have scant capital needs and have strong pricing power.

Buffett will be one of the biggest names to appear before the 10-member panel, which is modeled after the Pecora Commission that probed the 1929 Wall Street crash.

In the past few months, the commission has also heard from Goldman Sachs CEO Lloyd Blankfein, JPMorgan CEO Jamie Dimon, former Federal Reserve Chairman Alan Greenspan and former Bear Stearns CEO James Cayne.

It must deliver its findings to Congress and President Barack Obama by Dec. 15.

Also scheduled to testify on June 2 are current and former Moody's executives, including Nicolas Weill, the group managing director for Moody's Investors Service, and Brian Clarkson, former chief operating officer for Moody's Investors Service.

The full list of witnesses can be found at: here

Credit rating agencies are facing tough reforms in the financial regulation legislation moving through Congress.

The Senate version of the bill would have the government set up a clearinghouse to match rating agencies on a semi-random basis with debt issuers.

That could ease pressures the agencies face to assign rosy ratings to securities issued by the firms that hire them, backers said.

Another provision in the Senate's legislation would require federal regulators to develop their own standards of credit-worthiness rather than rely solely on assessments from rating agencies.

Shares of credit rating agencies dropped when the Senate approved the measures on May 13, but it is unclear whether they will make it into the final bill, which must be melded with a version passed by the U.S. House of Representatives

Senate to hold hearing on rating agencies April 23

The Permanent Subcommittee on Investigations has scheduled a hearing, "Wall Street and the Financial Crisis: The Role of Credit Rating Agencies," on Friday, April 23, 2010, at 9:30 a.m., in Room G-50 of the Dirksen Senate Office Building.

This hearing will be the third in a series of Subcommittee hearings examining some of the causes and consequences of the recent financial crisis. This third hearing will focus on the role of credit rating agencies in the financial crisis, using as case histories the credit rating agencies of Standard and Poor’s and Moody’s. A witness list will be available Monday, April 19, 2010.

"... A Senate panel will release 550 pages of exhibits on Friday — including these and other internal messages — at a hearing scrutinizing the role the two rating agencies played in the 2008 financial crisis. The panel, the Permanent Subcommittee on Investigations, released excerpts of the messages Thursday.

“I don’t think either of these companies have served their shareholders or the nation well,” said Senator Carl Levin, Democrat of Michigan, the subcommittee’s chairman.

Neither company would comment saying that they had not been provided with the subcommittee findings.

The investigation, which began in November 2008, found that S.&P. and Moody’s used inaccurate rating models from 2004 to 2007 that failed to predict how high-risk residential mortgages would perform; allowed competitive pressures to affect their ratings; and failed to reassess past ratings after improving their models in 2006.

The companies failed to assign adequate staff to examine new and exotic investments, and neglected to take mortgage fraud, lax underwriting and “unsustainable home price appreciation” into account in their models, the inquiry found.

By 2007, when the companies, under pressure, admitted their failures and downgraded the ratings to reflect the true risks, it was too late..."

House Committee passes credit ratings legislation


"Today, the House Financial Services Committee passed H.R. 3890, the Accountability and Transparency in Rating Agencies Act, introduced by Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. The Committee passed H.R. 3890, with bipartisan support, by a vote of 49-14.

“The Accountability and Transparency in Rating Agencies Act aims to curb the inappropriate and irresponsible actions of credit rating agencies which greatly contributed to our current economic problems,” said Chairman Kanjorski. “This legislation builds on the Administration’s proposal and takes strong steps to reduce conflicts of interest, stem market reliance on credit rating agencies, and impose a liability standard on the agencies. As gatekeepers to our markets, credit rating agencies must be held to higher standards. We need to incentivize them to do their jobs correctly and effectively, and there must be repercussions if they fall short. This bill will take such steps. I look forward to moving it through the legislative process.”

A summary of H.R. 3890 follows:

  • Stronger than the Administration's Plan on Rating Agencies. The Accountability and Transparency in Rating Agencies Act expands on the initial credit rating agency legislation proposed by the Administration in that it:
  • Creates Accountability by Imposing Liability. The bill enhances the accountability of Nationally Recognized Statistical Rating Organizations (NRSROs) by clarifying the ability of individuals to sue NRSROs. The bill also clarifies that the limitation on the Securities and Exchange Commission (SEC) or any State not to regulate the substance of credit ratings or ratings methodologies does not afford a defense against civil anti-fraud actions.
  • Duty to Supervise. The bill adds a new duty to supervise an NRSRO's employees and authorizes the SEC to sanction supervisors for failing to do so.
  • Independent Board of Directors. The bill requires each NRSRO to have a board with at least one-third independent directors and these directors shall oversee policies and procedures aimed at preventing conflicts of interest and improving internal controls, among other things.
  • Mitigate conflicts of interests. The legislation also contains numerous new requirements designed to mitigate the conflicts of interest that arise out of the issuer-pays model for compensating NRSROs. Additionally, the bill significantly enhances the responsibilities and accountability of NRSRO compliance officers to address conflicts of interest issues.
  • Greater Public Disclosure. As a result of the bill, investors will gain access to more information about the internal operations and procedures of NRSROs. In addition, the public will now learn more about how NRSROs get paid.
  • Revolving-Door Protections. When certain NRSRO employees go to work for an issuer, the bill requires the NRSRO to conduct a 1-year look-back into the ratings in which the employee was involved to make sure that its procedures were followed and proper ratings were issued. The bill also requires NRSROs to report to the SEC, and for the SEC to make such reports public, the names of former NRSRO employees who go to work for issuers.

SEC action on credit raters Sept 17

"Among the Commission's actions today to create a stronger, more robust regulatory framework for credit rating agencies:

  • Adopted rules to provide greater information concerning ratings histories - and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.
  • Proposed amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.
  • Reopened the public comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.
  • Voted to seek public comment on whether to amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.

Public comments on new rules or amendments proposed today must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed and final rules and amendments voted on by the Commission today will be posted to the SEC Web site as soon as possible.


Senate hearing, August 5th

EXAMINING PROPOSALS TO ENHANCE THE REGULATION OF CREDIT RATING AGENCIES

Wednesday, August 5, 2009, 09:30 AM, 538 Dirksen Senate Office Building

The witnesses will be:

  • The Honorable Michael Barr, Assistant Secretary for Financial Institutions, U.S. Department of the Treasury
  • Professor John C. Coffee, Adolf Berle Professor of Law, Columbia University School of Law
  • Professor Lawrence White, Leonard E. Imperatore Professor of Economics, Stern School of Business, New York University
  • Mr. Stephen Joynt, President and CEO, Fitch Ratings
  • Mr. James Gellert, President and CEO, Rapid Ratings
  • Mr. Mark Froeba, Principal, PF2 Securities Evaluations, Inc.

US Treasury proposal to the Congress

"WASHINGTON (Dow Jones)--The U.S. Treasury Department on Tuesday unveiled a stronger-than-expected proposal to reform credit ratings agency regulation, but the proposal still doesn't go as far as some lawmakers and observers would like.

The proposed legislation, sent to Congress Tuesday, would ban firms from providing consulting services to firms they rate and require agencies to disclose fees issuers pay to obtain ratings. Ratings reports would have to include a history of issuers' fee payments dating back for two years.

It also calls for the disclosure of preliminary ratings sought by firms engaging in "ratings shopping," a practice by which companies seek a range of preliminary ratings, paying only for the highest.

Securities and Exchange Commission Chairman Mary Schapiro called the proposal "a valuable step forward, saying it "will help to better align the interests of credit rating agencies with the investors who rely on them."

"I look forward to working with Congress to ensure that there is meaningful oversight of these influential players in the market," she said.

The legislation, however, doesn't address the issue of making it easier for investors to file and win lawsuits against credit-ratings agencies for knowingly or recklessly failing to review key information, something Schapiro has said could result in higher quality work from the firms.

It could "certainly make a very big difference," she said recently, echoing the sentiments of Sen. Jack Reed, D-R.I.

Reed earlier this year introduced a bill that would make it easier for investors to file class-action cases against credit-rating firms for shoddy work by essentially scaling back some of the protections afforded to credit-rating agencies in the Private Securities Litigation Reform Act of 1995.

Treasury chose not to include a similar type of provision in the proposal in an effort to avoid boosting "blind-faith reliance" on ratings, said Michael Barr, the department's assistant secretary for financial institutions.

"Our view was that including such a provision in the statute would overly inflate the role of credit ratings agencies," he said in a conference call Tuesday. "We're not going to be able to eliminate the need for investors to use their own judgment."

The legislation also doesn't attempt to reform the methods through which major agencies generate revenue.

"This is a non-solution to a massive problem," said Sean Egan, managing director of the Egan-Jones Rating Co. "The incentives for issuing inflated ratings remain healthy and well. Unfortunately, the proposal issued by the Treasury will do nothing to correct that."

Unlike larger ratings firms like Standard & Poor's, Moody's Investors Service and Fitch Ratings which charge issuers for ratings, Egan-Jones earns fees through payments from institutional investors.

S&P, Moody's and Fitch came under scrutiny last year after they gave overly positive ratings to certain kinds of debt, including some backed by subprime mortgages. Critics have assailed the firms, saying their business model creates an inherent conflict because issuers of the structured products pay them to rate the debt.

The proposed legislation does, however, provide for the SEC to examine policies and procedures used in determining ratings. While the SEC would be able to review methodology used by ratings agencies, it wouldn't gain the power to rewrite those business practices.

The SEC also would get a dedicated office through which it could supervise ratings agencies and the power to require firms to register with it. The SEC already has established a branch of examiners specializing in overseeing credit-rating agencies.

Moody's on Tuesday expressed support for the Obama Administration's "goals of increased transparency and enhanced ratings quality," saying in a statement, "We look forward to engaging in a constructive dialogue with the Administration and the Congress over the coming months."

Fitch Ratings CEO Stephen Joynt issued a similar statement, saying the administration's proposal is "generally consistent" with Fitch's views on promoting transparency and managing conflicts of interest.

"Fitch supports a thoughtful review of ways to encourage the market to use ratings in a balanced and constructive manner," Joynt said.

S&P said it still is reviewing the proposal."

Continuing its push to establish new rules of the road and make the financial system more fair across the board, the Administration today delivered proposed legislation to Capitol Hill to increase transparency, tighten oversight, and reduce reliance on credit rating agencies.

The legislation would also work to reduce conflicts of interest at credit rating agencies while strengthening the Securities and Exchange Commission's (SEC) authority over and supervision of rating agencies.

In recent years, investors were overly reliant on credit rating agencies that often failed to accurately describe the risk of rated products. This lack of transparency prevented investors from understanding the full nature of the risks they were taking. The Administration's legislation would tighten oversight of credit rating agencies, protect investors from inappropriate rating agency practices, and bring increased transparency to the credit rating process.

Conflicts of Interest

  • Bar Firms From Consulting With Any Company That They Also Rate: Credit ratings agencies will face similar restrictions to other professional service providers, like accountants, and will be prohibited from providing consulting services to companies that contract for ratings.
  • Strengthen Disclosure And Management Of Conflicts Of Interest: The legislation will prohibit or require the management and disclosure of conflicts arising from the way a rating agency is paid, its business relationships, affiliations or other conflicts.
  • Disclose Fees Paid By An Issuer Along With Each Rating Report: Each rating report will disclose the fees paid by the issuer for a particular rating, as well as the total amount of fees paid by the issuer to the rating agency in the previous two years.
  • Look-Back Requirement To Address The Conflicts From A "Revolving Door": If a rating agency employee is hired by an issuer and if the employee had worked on ratings for that issuer in the preceding year, the rating agency will be required to conduct a review of ratings for that issuer to determine if any conflicts of interest influenced the rating and adjust the rating as appropriate.
  • Designate A Compliance Officer: Each rating agency will be required to designate a compliance officer – reporting directly to the board or the senior officer of the firm – with direct responsibility over compliance with internal controls and processes. The compliance officer will not be allowed to engage in any rating activities, marketing, sales, or setting of compensation; and will be required to submit a report annually to the SEC.

Transparency & Disclosure

  • Require Disclosure Of Preliminary Ratings To Reduce "Ratings Shopping": Currently, an issuer may attempt to "shop" among rating agencies by soliciting `preliminary ratings' from multiple agencies and then only paying for and disclosing the highest rating it received for its product. We would shed light on this practice by requiring an issuer to disclose all of the preliminary ratings it had received from different credit rating agencies so that investors will see how much "shopping" happened and whether there were discrepancies with the final rating.
  • Require Different Symbols To Be Used To Distinguish The Risks Of Structured Products: One of the challenges in the current crisis was that investors did not fully realize that the risks posed by structured products such as asset-backed securities are fundamentally different from those posed by corporate bonds, even with similar credit ratings. Our proposal requires rating agencies to use different symbols for structured finance products as an indication of these disparate risks.
  • Require Qualitative And Quantitative Disclosure Of The Risks Measured In A Rating: Agencies will be required to provide a much fuller picture of the risks in any rated security through the addition of qualitative and quantitative disclosure of the risks and performance variance inherent in any given security. Ratings cannot be a substitute for investor due diligence. Therefore, to facilitate investor analysis, we will require that each rating also include a clear report containing assessments of data reliability, the probability of default, the estimated severity of loss in the event of default, and the sensitivity of a rating to changes in assumptions. This report will present information in a way that makes it simple to compare this data across different securities and institutions. This additional information will increase market discipline by providing clearer estimates of the risks posed by different investments.

Strengthen SEC authority and supervision

  • Establish A Dedicated Office For Supervision Of Rating Agencies: Our legislative proposal establishes a dedicated office within the SEC to strengthen supervision of rating agencies and to carry out the enhanced regulations required.
  • Mandatory Registration: Unlike the current voluntary system of registration, our proposal would make registration mandatory for all credit rating agencies. This will bring all ratings firms into a strengthened system of regulation.
  • SEC Examination Of Internal Controls And Processes: The SEC will require each rating agency to document its policies and procedures for the determination of ratings. The SEC will examine the internal controls, due diligence, and implementation of rating methodologies for all credit rating agencies to ensure compliance with their policies and public disclosures.

Reduce Reliance on Credit Rating Agencies

  • PWG Review of Regulatory Use of Ratings: Treasury will work with the SEC and the President's Working Group on Financial Markets to determine where references to ratings can be removed from regulations.
  • SEC Recently Requested Public Comment on Whether to Remove References to Ratings in Money Market Mutual Fund Regulation: As part of a comprehensive set of money market fund reform proposals, the SEC requested public comment on whether to eliminate references to ratings in the regulation governing money market mutual funds, as a way to reduce reliance on ratings. Treasury will work with the SEC to examine opportunities to reduce reliance and increase the resilience of the money market mutual fund industry.
  • Require GAO Study On Reducing Reliance: In addition to regulatory efforts to reduce reliance on credit ratings, this legislation would require the GAO to study and issue a report on the reliance on ratings in federal and state regulations.

Strongly support SEC actions on credit rating agencies

  • Enable Additional Ratings On Structured Products: Because structured products are often complex and require detailed information to assess, it can be difficult for a rating agency to provide "unsolicited ratings" – ratings on products it was not paid to rate. These ratings, while in existence previously, were ineffective because investors understood that these unsolicited ratings did not benefit from the same information as the fully contracted ratings. The SEC has proposed a rule that would require issuers to provide the same data they provide to one credit rating agency as the basis of a rating to all other credit rating agencies. This will allow other credit rating agencies to provide additional, independent analysis to the market.
  • Require Disclosure Of Full Ratings History: The SEC has proposed to require NRSROs to disclose, on a delayed basis, ratings history information for 100% of all issuer-paid credit ratings.
  • Strengthen Regulation And Oversight Of Credit Rating Agencies: In response to the credit market turmoil, in February the SEC adopted several measures to increase the transparency of the rating agencies' methodologies, strengthen disclosure of ratings performance, prohibit certain practices that create conflicts of interest, and enhance recordkeeping and reporting obligations to assist the SEC in performing its regulatory and oversight functions. The SEC has allocated resources to establish a branch of examiners dedicated specifically to conducting examination oversight of rating agencies.

The President's Plan

The President's Whitepaper for financial markets reform says about credit rating agencies:

“The SEC should continue its efforts to strengthen the regulation of credit rating agencies, including measures to promote robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise strengthen the integrity of the ratings process.”

Proposed legislation by the US Congress

S. 1073, Senator Reed's bill

Rating Accountability & Transparency Enhancement Act

A bill to provide for credit rating reforms, and for other purposes. Sponsored by Sen. Jack Reed.

Accountability and Transparency in CRA Act

Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises today sponsored the Accountability and Transparency in Credit Rating Agencies Act.

H.R. 2549 Muni bond fairness act

Municipal Bond Fairness Act

  • To ensure uniform and accurate credit rating of municipal bonds and provide for a review of the municipal bond insurance industry. Sponsored by Chairman Frank.

The current US law for credit rating agencies

Credit Rating Agency Reform Act of 2006 govtrack.us version

PDF version of the Credit Rating Agency Reform Act of 2006


SEC rules and oversight

"...Since September 2006, the Commission has engaged in several rounds of rulemaking and has conducted examinations of NRSROs under its new authority. The first round of rulemaking established the Commission’s rating agency oversight program. Specifically, in June 2007 the Commission adopted six rules and an application and public disclosure form.

The first rule, among other things, requires an NRSRO to publicly disclose information about the firm’s: (1) ratings performance statistics (e.g., default and transition statistics); (2) methodologies for determining credit ratings; (3) policies for preventing the misuse of material non-public information; (4) organizational structure; (5) code of ethics; (6) conflicts of interests; (7) policies for managing conflicts of interest; (8) credit analysts; and (9) designated compliance officer.[12]

The second rule, among other things, requires an NRSRO to make and retain certain financial records; document the identities of the credit analysts who determine a rating action and persons who approve the rating action; document the identities of issuers that have paid for ratings and the ratings determined for them; and document all ratings methodologies. NRSROs also are required to retain records such as compliance and internal audit reports, marketing materials, and communications (e.g., emails) relating to determining ratings actions. [13]

The third rule, among other things, requires an NRSRO, on a confidential basis, to furnish the SEC with annual reports that include: (1) audited financial statements; (2) an unaudited report of revenues received from the different types of rating services offered by the NRSRO; (3) an unaudited report of the aggregate and median compensation of the NRSRO’s credit analysts; and (4) an unaudited report of the 20 largest clients of the NRSRO as determined by revenues received.[14]

The fourth rule, among other things, requires an NRSRO to establish, maintain, and enforce procedures reasonably designed to prevent: the inappropriate dissemination of material, non-public information received during the rating process; the trading of securities while in possession of material, non-public information; and the selective disclosure of a pending ratings decision.[15]

The fifth rule, among other things, requires an NRSRO to disclose and manage each conflict of interest resulting from its business activities, including from the issuer-pay and the subscriber-pay models. It also prohibits an NRSRO from having the following conflicts: (1) receiving more than 10% of its annual revenues from a single client; (2) having an analyst rate or approve the rating for a security the analyst owns; (3) rating an affiliate; and (4) having an analyst rate or approve the rating for a security of a company where the analyst is a director or officer of the company. [16]

Lastly, the sixth rule, among other things, prohibits an NRSRO from engaging in certain practices that are unfair, coercive, or abusive. Such practices include: (1) conditioning a rating on the rated person buying another service of the NRSRO; (2) deviating or threatening to deviate from established methodologies for determining credit ratings because an issuer did not agree to pay for the rating; (3) modifying or threatening to modify a rating because the issuer does not agree to continue to pay for the rating; and (4) employing a methodology for rating structured finance products that discounts or “notches,” for anticompetitive purposes, the ratings of other NRSROs for assets underlying the structured finance product. [17]

In September 2007, the first seven credit rating agencies were registered with the Commission as NRSROs. Around that time, and in response to gradually worsening market conditions, the Commission used its new oversight authority to initiate examinations of the three largest NRSROs. Specifically, the Commission staff examined Fitch, Moody’s, and Standard & Poor’s and reviewed their policies and practices relating to ratings of structured finance products linked to aggressively underwritten mortgages. The period reviewed by the examination generally covered January 2004 through July 2008. All three NRSROs agreed to undertake remedial actions as a result of the examinations. The staff published a summary of their findings and observations in July 2008.[18]

The examinations revealed a number of troubling results. In particular, the examinations raised serious questions about the NRSROs’ management of: (1) conflicts of interest, (2) internal audit processes, and (3) due diligence activities.[19]

For example, the examiners found that analysts appeared to be aware, when rating an issuer, of the firm’s business interest in securing the rating of the deal; that there did not appear to be any internal effort to shield analysts from emails and other communications that discussed fees and revenues from the issuers; and that, in some instances, analysts were involved in fee discussions for a rating. In addition, the NRSROs did not appear to take steps to prevent the possibility that considerations of market share and other business interests could influence ratings or ratings criteria. Accordingly, the staff recommended that each NRSRO consider and implement steps that would insulate or prevent the possibility that considerations of market share and other business interests could influence ratings or ratings criteria.

The examiners found that the internal audits of the ratings processes of two NRSROs appeared to be inadequate. For example, at one NRSRO, the internal audits of its RMBS and CDO groups constituted a one-page checklist to evaluate the completeness of deal files. As a consequence of the examinations, the staff recommended that two of the NRSROs review whether their internal audit functions are adequate and whether they provide for proper management follow-up.

The staff found that the NRSROs did not engage in due diligence or otherwise seek to verify the accuracy or quality of the loan data underlying the RMBS pools they rated during the review period. The NRSROs each relied on the information provided to them by the sponsor of the RMBS.

The findings from these initial examinations informed another round of rule amendments, which the Commission proposed in June 2008 and adopted in February 2009.[20] These amendments enhanced requirements to disclose ratings performance statistics and ratings methodologies, and imposed additional recordkeeping and reporting requirements. They also prohibited additional conflicts of interest; in particular, the conflict of rating a product that the NRSRO or its affiliate had provided advice on how to structure.

In September 2009, the Commission adopted additional amendments.[21] One amendment is designed to create a mechanism for NRSROs not hired to rate structured finance products to nonetheless determine and monitor credit ratings for these instruments. To this end, the new amendments require an NRSRO that is hired to provide an initial credit rating for a structured finance product to disclose on a password-protected Internet website: (1) that it is in the process of determining such a credit rating; and (2) the location where information provided by the issuer to determine and monitor the credit rating can be located. The hired NRSRO must make this information available to any other NRSRO that provides it with a copy of a certain certification. The hired NRSRO also is required to obtain representations from the arranger that, among other things, the arranger will provide the same information to the non-hired NRSROs.

The design of this rule is to enable non-hired NRSROs to provide unsolicited ratings in the structured finance market, just as is done in the corporate debt market. NRSROs can determine unsolicited ratings in the corporate debt market using information filed with the Commission by public companies. There have been calls to make the structured finance market more transparent by enhancing issuer disclosure requirements. This new rule – by requiring issuers to disclose information to all NRSROs – is an incremental step in that direction. The goal is to improve the quality of credit ratings by increasing the number of NRSROs (hired and not hired) that rate structured finance products.

The second amendment adopted by the Commission requires an NRSRO to disclose, on a delayed basis, ratings history information in a downloadable format for all credit ratings initially determined on or after June 26, 2007.[22] This new disclosure requirement is designed to foster greater transparency of ratings quality as well as increase accountability among NRSROs, by making it easier for persons to analyze the actual performance of credit ratings. To this end, the ratings history information will generate “raw data” that market observers can use to statistically analyze performance across NRSROs.

Current SEC rules


The SEC continues its rulemaking to improve rating agencies. Today it adopted rule amendments that impose additional disclosure and conflict of interest requirements on nationally recognized statistical rating organizations (“NRSROs”) in order to address concerns about the integrity of the credit rating procedures and methodologies at NRSROs.

In addition, the agency is proposing rule amendments and a new rule that would impose additional requirements on nationally recognized statistical rating organizations (“NRSROs”). The proposed amendments and rule would require an NRSRO:

  1. to furnish a new annual report describing the steps taken by the firm’s designated compliance officer during the fiscal year with respect to compliance reviews, identifications of material compliance matters, remediation measures taken to address those matters, and identification of the persons within the NRSRO advised of the results of the reviews;
  2. to disclose additional information about sources of revenues on Form NRSRO; and
  3. to make publicly available a consolidated report containing information about revenues of the NRSRO attributable to persons paying the NRSRO for the issuance or maintenance of a credit rating.

Finally, the SEC announced that it is deferring consideration of action with respect to a proposed rule that would have required an NRSRO to include, each time it published a credit rating for a structured finance product, a report describing how the credit ratings procedures and methodologies and credit risk characteristics for structured finance products differ from those of other types of rated instruments, or, alternatively, to use distinct ratings symbols for structured finance products that differentiated them from the credit ratings for other types of financial instruments.

The SEC is also soliciting comments regarding alternative measures that could be taken to differentiate NRSROs’ structured finance credit ratings from the credit ratings they issue for other types of financial instruments through, for example, enhanced disclosures of information.

The Commission also is soliciting comment on whether the rule amendments being adopted today in a separate release designed to remove impediments to determining and monitoring non-issuer-paid credit ratings for structured finance products should be extended to create a mechanism for determining non-issuer-paid credit ratings for structured finance products that were issued prior to the rule becoming effective (e.g., to allow for non-issuer-paid credit ratings for structured finance products of the 2004-2007 vintage).

Equivalent disclosure for SF to begin June 2, 2010

Original posted on the Sidley Austin PLC website (PDF version here):

Rules adopted in November 2009 by the Securities and Exchange Commission (the SEC) under the Credit Rating Agency Reform Act of 2006 will require issuers, sponsors or underwriters (referred to as “arrangers”) of structured finance securities to post on a password-protected internet website, the information provided by arrangers to credit rating agencies hired by an arranger to rate or monitor the credit ratings of the securities. The new rules will require the arranger to provide access to the website to other credit rating agencies that provide the arranger with a required certification.1 The deadline for compliance with these new rules is June 2, 2010.

Rules 17g-5(a) and 17g-5(b) under the Securities Exchange Act (the Exchange Act) require credit rating agencies registered with the SEC (NRSROs) to disclose and manage certain specified types of conflicts of interest and prohibit NRSROs from rating securities where other specified conflicts of interest exist. The recently adopted Rule 17g-5(b)(9) identifies as a new conflict (referred to as an “issuer-pay” conflict) the issuance or maintenance by an NRSRO of a credit rating for a security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction (referred to as a “structured finance product”)2 that was paid for by a related arranger.

New Rule 17g-5(a)(3) will require each hired NRSRO to maintain a password-protected internet website listing each structured finance product for which the hired NRSRO is in the process of determining an initial credit rating and for which there is an issuer-pay conflict. The list must be in chronological order and identify the type of structured finance product, the name of the issuer, the date the rating process was initiated and the internet website address where the issuer, sponsor or underwriter of the structured finance product provides the required information described below. Once the hired NRSRO issues the final credit rating or determines that it will not provide a final credit rating on a structured finance product, information on that structured finance product may be removed from the list.

The hired NRSRO will be required to provide free, unlimited access to the website to any other NRSRO that provides the hired NRSRO with the certification specified in Rule 17g-5(e) under the Exchange Act (described below). The SEC’s stated purpose for requiring the hired NRSRO’s listing is to alert other NRSROs to the new transactions and to direct them to the arranger’s website to obtain the information that would enable the non-hired NRSROs to rate and monitor the structured finance products on an unsolicited basis.

A hired NRSRO also will have to obtain from the issuer, sponsor or underwriter of a structured finance product with an issuer-pay conflict a written representation that can reasonably be relied upon that the issuer, sponsor or underwriter:

  • will maintain an identified password-protected internet website that includes all information an arranger provides to the hired NRSRO, or contracts with a third party to provide, for the purpose of determining the initial credit rating and for undertaking credit rating surveillance for the structured finance product, in each case at the same time the information is provided to the hired NRSRO; and
  • will provide access to the website to any NRSRO that provides a 17g-5(e) certification.

The website maintained by the arranger also must identify the information currently used to determine or monitor the credit ratings.3 Note that the rule applies to all information provided to a hired NRSRO and in the text of the adopting release, the SEC contemplates a transition to a more formalized process through which structured finance products will be rated. “The [SEC] acknowledges that the requirements of paragraph (a)(3) of Rule 17g–5 as a whole likely will formalize the process of information exchange from the arranger to the NRSRO for structured finance products, including the written submission of information that may, in the past, have been provided orally.”4

Under Rule 17g-5(e), any NRSRO accessing a password-protected internet website of an arranger or a hired NRSRO listing issuer-pay conflict structured finance products will be required to provide an annual certification to the SEC (with a copy to the arranger and the hired NRSRO) that, among other things, such non-hired NRSRO:

  • is accessing the website solely for purposes of determining or monitoring credit ratings;

will keep the information it accesses confidential and treat it as material non-public information; and

  • will determine and maintain credit ratings for at least 10% of the issued structured finance products for which it accesses information if it accesses information for 10 or more issued structured finance products in the calendar year covered by the certification.

In order to monitor compliance with the Rule 17g-5(e) certifications, Rule 17g-5(a)(3)(ii) limits access to the issuer-pay NRSRO lists and arranger information to NRSROs, which are registered with, and regulated by, the SEC, rather than all credit rating agencies.

Corresponding Amendments to Regulation FD.

Regulation FD contains the SEC’s rules addressing selective disclosure and generally requires that an issuer of a security publicly disclose material non-public information if the issuer, or any person acting on its behalf, provides the material non-public information to certain enumerated persons. Information provided to credit rating agencies solely for the purpose of determining a credit rating that is publicly available is excepted from the public disclosure requirements of Regulation FD. As adopted, Rule 100(b)(2)(iii) under Regulation FD expands this exception to cover information provided to NRSROs pursuant to Rule 17g-5(a)(3) regardless of whether the credit rating is publicly available. Therefore, information provided to “subscriber pay” NRSROs, the credit ratings of which are generally private, pursuant to Rule 17g-5(a)(3), would not be subject to the Regulation FD disclosure requirements.

If you have questions about any of these items, please contact your regular Sidley Austin LLP contact.

  1. The text of the new rules, together with the adopting release, is available at here. In contrast to the originally proposed rules, the information provided by the arranger is not required to be made available to the public. See Recent Developments Related to Credit Ratings on Structured Finance Securities; SEC Proposes New Rules under the Credit Rating Agency Act of 2006, Sidley Austin LLP, June 26, 2008 available at here and SEC Adopts Final Rule Amendments and Proposes New Rules under the Credit Rating Agency Reform Act of 2006, Sidley Austin LLP, February 23, 2009, available here for a summary of the rules as originally proposed and the re-proposed rules, respectively.
  2. The SEC specifically states in the adopting release, that the reference to a security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction is not limited to asset-backed securities as defined in Regulation AB, and also states that “the [SEC] intends this provision . . . to cover the full range of structured finance products, including, but not limited to, securities collateralized by static and actively managed pools of loans or receivables (e.g., commercial and residential mortgages, corporate loans, auto loans, education loans, credit card receivables, and leases), collateralized debt obligations, collateralized loan obligations, collateralized mortgage obligations, structured investment vehicles, synthetic collateralized debt obligations that reference debt securities or indexes, and hybrid collateralized debt obligations.” See adopting release at page 63844.
  3. For example, if the pool collateral changed, the arranger website would need to identify the current pool information and the information used by the hired NRSRO in the final rating.
  4. See adopting release at page 63847.

Moody's will standardize rating scales

Municipal debt rankings by Moody’s Investors Service will shift to a global rating system next month that will put the 70,000 state and local bonds it assesses on a scale that’s comparable with corporate securities.

“We are responding to the evolving needs of the market for greater comparability between the ratings of these obligations and those issued by other entities,” Gail Sussman, group managing director at New York-based Moody’s, said in a press release today.

The new ratings don’t “represent a change in our opinion of the credit quality of affected issuers.” U.S. Representative Barney Frank, a Massachusetts Democrat who chairs the House Financial Services Committee, called the different rating scales “ridiculous” at a hearing on the $2.8 trillion market in May 2008.

The Moody’s announcement came a day after Senator Christopher Dodd proposed, as part of the biggest Wall Street regulatory overhaul since the 1930s, that municipalities be assessed in the same manner as companies. The same requirement was included in Frank’s financial-services legislation last year.

“This represents a transfer of money from wealthy investors back to municipalities,” Frank said in a telephone interview. “This recognizes what we have been saying all along.”

SEC, FBI and DOJ examining raters

"Enforcement officials from the Securities and Exchange Commission and Justice Department said Wednesday that their staffs are targeting the role of Wall Street rating agencies in the financial meltdown.

The three dominant agencies -- Moody's Investors Service, Standard & Poor's and Fitch Ratings -- have been widely criticized for failing to give investors adequate warning of the risks in subprime mortgage securities, whose collapse touched off the financial crisis.

SEC Enforcement Director Robert Khuzami told the Senate Judiciary Committee that his staff is "looking very closely at credit rating agencies" and is "focused on that area."

A 2007 law empowers the SEC to bring enforcement actions against rating agencies based on false statements they may have made, he said.

Assistant U.S. Attorney General Lanny Breuer said the Justice Department also is "looking at" rating agencies.

New York Attorney General Andrew Cuomo pursued the three big Wall Street raters last year, securing an agreement from them to overhaul how they evaluate investments backed by risky mortgage debt. The accord was meant to end what the industry calls "ratings shopping" that pits the agencies against one another.

The agencies are crucial financial gatekeepers. Their grades of creditworthiness can be key factors in determining at what cost securities will be purchased by banks, mutual funds, state pension funds or local governments.

Khuzami, Breuer and Kevin Perkins, assistant director of the FBI's Criminal Investigative Division, detailed federal efforts to pursue fraud and rising abuses in the aftermath of the financial crisis.

Mortgage fraud, which spiked to record levels in the wake of the subprime loan collapse in 2007, is an especially intense area of focus by federal and state prosecutors. Mortgage fraud investigations by the FBI now total more than 2,700, compared with 881 three years ago..."

Moody's faces possible SEC action

  • Source: [ Moody's Faces Possible SEC Action] Wall Street Journal, May 7, 2010

The Securities and Exchange Commission told Moody's Investors Service that it may face enforcement action for misleading regulators in a license application, an escalation of the pressure on a major player in the credit crisis.

In its annual report released late Friday, Moody's Corp., the parent of the New York rating firm, disclosed that the SEC is considering a recommendation to start an administrative case against Moody's based on a 2007 application to the SEC to remain an officially recognized credit-rating firm. The firm said it had received a so-called Wells Notice in March.

The SEC, according to Moody's filing, is arguing that Moody's failed to adhere to policies it detailed in its application.

The threat of an SEC case is the latest setback for Moody's, which has been buffeted by criticisms about its failure to properly rate billions of dollars worth of mortgage-related securities and other complex debt products.

In this case, the SEC is focusing on Moody's approach to problems it discovered in its models for rating certain exotic European debt products, which weren't mortgage-related. Allegations at the time were that Moody's failed to immediately downgrade securities because it would have been embarrassing to the firm, or possibly hurt certain market participants. This contradicted Moody's stated policy that no factor other than a bond's credit worthiness should dictate its rating.

SEC IG Audit Report, August, 2009


The inspector general of the Securities and Exchange Commission said in a report released Friday that the commission has “historically been slow to act” in regulating the nation’s credit ratings agencies before the financial crisis and recommended a broad range of improvements to the S.E.C.’s oversight.

The report, released Friday, also called for further evaluation of several controversial policies, such as the ability of debt issuers to shop among different rating agencies for the highest possible rating.

The S.E.C. ordered the internal audit after the financial crisis raised serious questions about the rating agencies, including Moody’s, Fitch and Standard and Poor’s, which often gave top ratings to mortgage-backed securities that now may be worthless.

The audit report found that the commission delayed adopting rules on the rating agencies, and sometimes failed to follow the rules that existed.

SEC 2008 Examinations of Select Credit Rating Agencies

Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies (July 2008)

Federal Reserve rules for TALF lending

SUMMARY: This final rule amends Regulation A to provide a process by which the Federal Reserve Bank of New York may determine the eligibility of credit rating agencies in the Term Asset-backed Securities Loan Facility. The final rule does not apply to discount window lending or other extensions of credit provided by the Federal Reserve System. In addition, the final rule only applies to asset-backed securities that are not backed by commercial real estate. The amendment does not represent a change in the stance of monetary policy.


The set of eligible credit rating agencies will be determined by the New York Fed in accordance with a final rule adopted by the Federal Reserve Board that establishes criteria in designating an NRSRO as TALF-eligible within each of the seven non-mortgage-backed ABS TALF asset sectors referenced in the TALF haircut schedule (excluding securities backed by collateral originated under SBA's 7(a) and 504 programs which do not require credit ratings). The set of NRSROs eligible pursuant to the final rule will take effect commencing with the February 2010 non-mortgage-backed ABS subscription. The current list of TALF-eligible NRSROs specified in the FAQs will continue to apply for the December and January non-mortgage-backed ABS subscriptions.

Under the rule, credit rating agencies that wish to have their ratings accepted for TALF transactions should send a written notice as soon as possible to the Credit, Investment and Payment Risk Group of the New York Fed including the information required by the rule. Such written notice can be submitted via the TALF mailbox (talf@ny.frb.org, placing "Credit Rating Agency Submission" in the subject line). Any questions about the process or required documentation should be forwarded to the same mailbox address with the same subject line. The New York Fed intends to announce the list of TALF-eligible rating agencies for the February 2010 non-mortgage-backed ABS subscription as soon as possible after it has completed its review of the submissions and notified each of the applicable credit rating agencies regarding its eligibility to have its ratings accepted at TALF.

Global regulatory efforts on credit rating agencies

Committee of European Securities Regulators oversight


I. INTRODUCTION

1. Background

  1. On 12 November 2008, the European Commission published a Draft Regulation on credit rating agencies (CRAs)1. The amended version of this Regulation was approved on 23 April 2009 by the European Parliament2. The jurist linguistic revision took place and the European Council approved the document on the 27 July 20093. The European Council4 signed the Regulation on the 16th September 2009. It is expected to enter into force 20 days after it will be officially published in the Journal Official of European Commission by November 2009 and to apply by May 2010.
  2. According to the Regulation, CESR will be required to discharge important co-ordination and advisory functions alongside its traditional role of promoting convergence through Level 3 guidelines and recommendations.
  3. The Commission‟s proposals article 21 requires CESR to issue guidance, among others, on: The registration process and coordination arrangements between competent authorities and with CESR, including on the information set out in Annex II, and regime for applications submitted to CESR; The operational functioning of the colleges, including on the modalities for determining the membership to the colleges, the application of the criteria for the selection of the facilitator referred to in points (a) to (d) of Article 29.5, the written arrangements for the operation of colleges and the coordination arrangements between colleges; The application of the endorsement regime under Article 4.3 by competent authorities; Information that the credit rating agency must provide for the application for certification and for the assessment of its systemic importance to the financial stability or integrity of financial markets referred to in Article 5.
  4. CESR has to provide this guidance within 6 months of the entry into force of the Regulation, i.e. by April/May 2010.
  5. A CESR Expert Group (EG) has been set up to assist in preparing CESR for these new tasks relating to CRAs. Three subgroups have been set up within the EG to deal with the different topics on which CESR is requested to issue guidance. The 3 subgroups work in parallel and with full transparency and the CESR Secretariat and the Chair of the EG ensure coordination between the three groups. Subgroup 1 focuses on the registration process, colleges, co-operation, and mediation; Subgroup 2 focuses on applications, surveillance and enforcement and Subgroup 3 deals with disclosure by CRAs of historical performance data and the Central Repository database.
  6. The EG has decided to establish a consultative working group (CWG) composed of senior practitioners from the industries concerned by the Regulation to continuously support it in its work program by advising on all matters relating to the implementation and application of the future legal framework. In particular, the CWG is to be asked to comment on draft documents prior to public consultation.
  7. CESR asked the CWG to comment on Pre-Consultation Papers by September 2009. Based on the feedback it received, CESR has produced this Consultation Paper.


A. Background

  1. On 12 November 2008, the European Commission published a Draft Regulation on credit rating agencies (CRAs)1. The amended version of this Regulation was approved on 23 April by the European Parliament2. It is expected to enter into force by October 2009 and to apply by March 2010.
  2. According to this Draft Regulation, CESR will be required to discharge important co-ordination and advisory functions alongside its traditional role of promoting convergence through Level 3 guidelines and recommendations.
  3. Amongst other tasks, the Commission’s proposal article 9(2) and 18(2) lit. c). requires CESR to:
    1. Establish a central repository (CRep) where credit rating agencies shall make available information on their historical performance data including the ratings transition frequency and information about credit ratings issued in the past and changes thereto.
    2. Define a standardised form which the credit rating agencies shall use to provide information for this repository.
    3. Make the information provided accessible to the public and publish summary information on the main developments observed on an annual basis (Art. 9 (2)).
    4. Issue guidance on common standards on the presentation of the information, including structure, format, method and period of reporting, which credit rating agencies shall disclose in accordance with Article 9(2) and Annex I, Section E, Part II, Point 13 of the proposed Regulation.
  4. CESR has to provide guidance on common standards on the presentation of historical performance data within 6 months of the entry into force of the proposed Regulation, i.e. by March 2010. There is no deadline with regard to the implementation of the central repository. This step will largely depend on the need for a public tender process and IT development work.
  5. A CESR expert group (EG) has been set up to assist in preparing CESR for these new tasks relating to CRAs. Three subgroups have been set up within the EG to deal with the different topics on which CESR is requested to issue guidance. The 3 subgroups work in parallel and with full transparency and the CESR Secretariat and the Chair of the EG ensure coordination between the three groups. Subgroup 1 focuses on the registration process, co-operation, and mediation; Subgroup 2 focuses on applications, surveillance and enforcement and Subgroup 3 deals with disclosure by CRAs of historical performance data and the CRep.
  6. The EG has decided to establish a consultative working group (CWG) composed of senior practitioners from the industries concerned by the Regulation to continuously support it in its work program by advising on all matters relating to the implementation and application of the future legal framework. In particular, the CWG is to be asked to comment on draft documents prior to public consultation.
  7. As an initial step in the analytical process to develop common standards and the technical specifications for the CRep, CESR gathered information on the historical and performance data available from CRAs by means of questionnaires. These questionnaires related specifically to the 3 large classes of ratings, i.e. corporate, sovereigns/public and structured finance. CESR submitted the questionnaires to the largest CRAs as well as to smaller players 4.
  8. In a second step, CESR asked the CWG to comment on a Pre-Consultation Paper by 29 May 2009. Based on the feedback it received, CESR has produced this Consultation Paper.5


3. This final report focuses on whether a CRA’s code of conduct is compliant with, or deviates from, the IOSCO Code. CESR’s analysis is exclusively based on a CRA’s code and does not take into account other documents that are on the CRA’s website. In addition, CESR does not opine on the practical application of a CRA’s own code. This means that CESR does not check whether a CRA complies in practice with what is stated in its code. Equally, where a CRA’s code deviates from an IOSCO provision, CESR does not check whether the CRA nevertheless complies with the IOSCO provision in practice.

4. CESR’s overall conclusion with respect to the codes of conduct of the larger, global CRAs (S&P, Moody’s, Fitch, DBRS and AM Best) is that they are broadly compliant with the IOSCO Code. It also notes that they have updated their codes of conduct to take into account most, but not all, of the revisions made to the IOSCO Code in May 2008, in particular with respect to structured finance products. However, there are also a number of provisions detailed within this report on which these CRAs deviate from the IOSCO Code and therefore CESR believes room for improvement exists.


CESR’s Second Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance.


A body representing Europe's 9,200 listed companies said on Friday it wants all references to credit ratings stripped from European Union law, mirroring an initiative from the Obama administration in the United States.

Credit rating agencies have been accused of being too generous in their ratings of products that sank in value or became untradeable during the credit crunch.

"Rating agencies have argued repeatedly that their function is merely to provide 'opinions'," EuropeanIssuers, a campaigning body based in Brussels, said in a statement.

"Thus, although inaccurate and unreasonable credit ratings were a primary cause of the recent crisis, rating agencies remained largely free of any responsibility," it said.

The EU has adopted a law that takes effect in 2010 that will require credit rating agencies to be authorised to operate in the 27-nation bloc and be directly supervised.

"However, the stronger supervision that will be achieved herewith does not remove the need to address the excessive reliance on ratings," EuropeanIssuers said.

"We therefore urge the European Commission to continue the work it started when consulting the market on this subject in July 2008, and to come forward soon with concrete proposals to eliminate references to credit ratings in the European legislation," it added.

Investors use ratings to decide on which shares or bonds to buy. Ratings also play a key role in how much capital banks set aside to cover risks.

The Obama administration has proposed that U.S. laws are purged of requirements to use credit ratings but earlier this week a U.S. congressional committee began watering this down. Obama's proposal could be restored next week as the credit rating legislation proceeds through Congress.

IOSCO Report on Due Diligence for Structured Products

Good Practices in Relation to Investment Managers´ Due Diligence When Investing in Structured Finance Instruments July, 2009

Proposed regulation by the European Parliament

European Parliament Committee on Economic and Monetary Affairs - Rapporteur: Jean-Paul Gauzès

EU Commissioner questions US rating agency dominance

The European Union’s financial services commissioner, Michel Barnier, vented his frustration with American-based credit ratings agencies Wednesday as Moody’s Investors Service put Portugal on review for another possible downgrade that could make it more difficult for the country to service its debt, James Kanter reports in The New York Times.

Mr. Barnier was briefing reporters before his first official visit to the United States, where he will meet next week with Ben S. Bernanke, the Federal Reserve chairman, and Timothy F. Geithner, the Treasury secretary. He will also meet with Wall Street leaders like Lloyd C. Blankfein, the chief executive of Goldman Sachs, and Jamie Dimon, the chief executive of JPMorgan Chase.

Mr. Barnier complained that there were too few debt rating agencies, and he suggested that they were dominated by American owners.

“There are not enough ratings agencies, not enough competition and not enough diversity,” he said. “Why should there not be an agency that is more European than those that exist today?”

A decision by Standard & Poor’s, also based in the United States, to downgrade Greece’s debt to junk status last month enraged European officials, who questioned whether the ratings agencies were accurately assessing how likely it was that countries in the euro zone would default on their sovereign debts.

Mr. Barnier said it was “an open question” whether such an alternative agency should be run by the private sector or by a public body.

FSA reports

Various reports from the Financial Services Authority (FSA, the UK regulator) which cover credit rating agencies.

India proposes overhaul for rater oversight

  • Source: [Panel seeks strict regulation of rating agencies] Business Standard, Mumbai, January 24, 2010

A committee appointed by financial regulators has recommended an overhaul of regulatory norms governing credit rating agencies (CRAs) and sought a host of disclosures from them to make the system more transparent.

The panel, headed by KP Krishnan, a joint secretary in the finance ministry, has suggested that the Securities and Exchange Board of India be designated as the lead regulator with whom rating agencies should be registered.

The registered agencies would also require accreditation from other regulatory bodies such as the Reserve Bank of India and insurance and pension regulators for rating instruments that came under their domain, said the committee, whose report was made public on the finance ministry website today. In addition, the regulators should also conduct joint inspections of the agencies, it added.

The regulators have already decided to make internal audit mandatory for rating agencies. Besides, the Krishnan committee said while only five agencies were registered with Sebi, a few others were using the words credit rating agency in their names. It has called for an immediate ban on non-registered entities from using credit rating in their names.

The other focus area is potential conflict of interest. To avoid this, the committee has advocated stringent disclosure norms for subsidiaries floated by rating agencies. These disclosures should include the details of the fee received from a company by it, its subsidiaries or its promoters over the preceding three years.

“CRAs should not be allowed to enter into any business that may directly or indirectly have conflict of interest with the job of rating. Internal Chinese Walls are porous mechanisms to prevent such conflict of interest, as other businesses such as consultancy and advisory services should not be undertaken by CRAs,” the committee said.

Agencies such as Crisil and Icra have floated subsidiaries providing advisory services.

There is special reference to structured finance and structured products, which had triggered a review of the rating mechanism. The committee suggested that an agency or its subsidiary should be barred from providing advisory services — either formal or informal – on the design of a structured finance instrument and also rate the product.

Also, if the recommendations are accepted, the entities will have to differentiate the ratings for structured products, improve their disclosure of rating methodologies and assess the quality of information provided by the originators, arrangers and the issuers of such structured products. “It may be made mandatory that the CRAs make a clear distinction between credit ratings of structured finance instruments and other credit ratings,” the committee said.

After reviewing the issuer pays payment model, it has suggested that the system be continued, though the system be made more transparent by mandating disclosure of the compensation arrangements with the rated entities. Analysts should not be part of any fee discussion with the issuer, and added that employee involvement in the rating process should not come into conflict with ownership pattern.

There are suggestions to also publish the information about the assumptions underlying their rating methodologies and the committee said that internal records, including working paper, should be retained by the agencies.

Australia assigns liability to raters

"THE Australian Investments and Securities Commission has drawn credit rating agencies into the firing line, trying to make them more accountable for their actions.

From next year ASIC will remove the exemption that protected the big rating agencies - Standard & Poor's, Moody's, and Fitch - from any liability for their ratings published in prospectus documents. ASIC said the changes would make the agencies accountable for the ratings published in product disclosure statements, prospectuses, or takeover documents.

The Federal Government will also require rating agencies to hold Australian Financial Services (AFS) licences from next year, forcing them to manage conflicts of interest in line with others in the industry.

The changes are the latest step in a wider crackdown on rating agencies, often blamed as the unsung villains of the global financial crisis.

Until now, rating agencies in Australia have operated largely outside of the regulatory net.

As well as not holding an AFS licence, issuers of financial products could quote ratings without the agencies' consent, which ASIC said protected the agencies from liability.

Under the new rules, issuers will have to obtain the consent of the rating houses before publishing their ratings, giving the agencies more control over how their products are used.

The regulator also revealed special licence conditions for rating agencies, including a rule that agencies must disclose the methodologies and assumptions behind credit ratings.

Standard & Poor's said yesterday that it was reviewing ASIC's policy announcement and the impact on its business. Moody's said it was in active dialogue with the regulator, and it expected to receive a licence by January.

The crackdown on rating agencies has come after aggrieved investor claims that rating agencies profited by helping to spread toxic debt through the financial system.

Through its new ratings regime, the Government is aiming to expose credit ratings to greater scrutiny, and deter investors from relying on ratings as a simple gauge of risk.

John Walker, the managing director of the litigation funder IMF Australia, described it as a positive move that would bring more scrutiny to the industry. However, he said it had come too late for investors who had incurred losses by buying AAA-rated products that had plunged in value.

A whole lot of capital was misallocated not only in Australia but around the world as a result of the ratings which did not adequately assess the risks of the debt instruments, Mr Walker said.

IMF is considering targeting rating agencies through a possible class action on behalf of dozens of local councils and charities that have lost millions through AAA-rated products.


Australian oversight


"CREDIT rating agencies could face far-reaching regulatory changes aimed at making the so-called three horsemen of the financial apocalypse -- Moody's, Standard & Poor's and Fitch -- more accountable, transparent and liable for their ratings.

In a statement yesterday, the Australian Securities and Investments Commission announced that from January 1 agencies would need to obtain an Australian Financial Services (AFS) licence. They also face the removal of an exemption that protects them from liability for their ratings in product disclosure documents (PDS).

ASIC will also consider withdrawing an existing class order relief for issuers to cite credit ratings without consent from the credit rating agencies in a PDS.

These and other proposals were outlined in a consultation paper released yesterday. Comments are due on October 22, and a final decision will be made in November.

Ratings agencies have been accused of playing a key role in the global financial crisis, in particular the favourable ratings given to complex structured products. Some of these products, such as collateralised debt obligations, were sold to unwitting investors locally and globally, and have now been exposed as worthless.

The ratings agencies were recently labelled "hopelessly conflicted" by Kevin Rudd in The Monthly magazine.

"Dependent as they were on the banks for their revenue, the agencies were hopelessly conflicted by the lure of big profits in return for easy ratings," the Prime Minister said.

Those regulations, which relate to management of conflicts of interest and the quality and integrity of the ratings processes, are contained in the recently updated International Organisation of Securities Commissions' code of conduct for credit rating agencies.

Litigation funder IMF's Hugh McLernon said the question was not whether ASIC should now lift the protection from liability it gave to the ratings agencies, but rather why it gave that protection in the first place.

Mr McLernon said ASIC posed the question in its consultation paper as to whether credit ratings were important to unsophisticated retail investors.

"Why does ASIC need to seek advice on this question? Why does ASIC think the agencies have been paid billions of dollars by issuers to rate their products?

"Surely the answer is obvious: because all concerned including the issuer and the rating agency know that without the rating the investing public will not touch the product."

John Bailey, managing director of Standard & Poor's Australia & New Zealand, said he was reviewing the consultation paper.

But he said on the issue of licensing, S&P had lodged a licence application with ASIC.

"Regulation will supplement the changes we have made independently," he said.

Moody's said in a statement that it had "always sought to maintain an active dialogue with policymakers and regulatory authorities in Australia and elsewhere". It said it wanted to provide as much transparency as possible with regard to Moody's policies and practices.

Currently, ASIC gives relief to S&P, Moody's and Fitch from the requirement to hold an AFS licence. From January 1, holding an AFS licence will require all agencies to complete an annual report on compliance; disclose their methodologies, assumptions and procedures resulting in a credit rating; have adequate processes for keeping a credit rating current; and consent to ASIC sharing information about the credit rating agency with regulators overseas."

Australian 2008 report

Published in 2008 a report from the Australian securities regulator on credit rating agencies

New Zealand Reserve Bank report

Report from the New Zealand Reserve Bank

=Hong Kong regulator issues Consultation Paper on ratings

In keeping with the recent global trend towards subjecting credit rating agencies (CRAs) to enhanced regulatory oversight, Hong Kong’s Securities and Futures Commission (SFC) has announced a proposed regulatory regime requiring the licensing and supervision of CRAs. The Consultation Paper Concerning the Regulatory Oversight of Credit Rating Agencies, released on July 19, 2010, outlines the proposed regime, which is intended to both “mandate minimum conduct standards for CRAs, including requirements that credit rating activities be conducted in accordance with principals of integrity, transparency, responsibility and good governance” and “ensure that ratings prepared in Hong Kong continue to be serviceable in other jurisdictions, including for regulatory purposes.”

The Consultation Paper proposes making “providing credit rating services” a new type of regulated activity under the Securities and Futures Ordinance to be known as a “Type 10” regulated activity. The proposed legislation would define “credit ratings” as “opinions ‘primarily regarding the creditworthiness’ of the rating target” and would define “providing credit rating services” to include “the preparation of credit ratings for dissemination or distribution by subscription, whether in Hong Kong or elsewhere, or with a reasonable expectation that they will be so disseminated or distributed.” Excluded from the definition of “providing credit rating services” would be activities connected with the operation of internal credit ratings systems; private credit ratings prepared in accordance with an individual order; the gathering, collating, disseminating or distributing of information concerning the indebtedness or credit history of commercial enterprises; and the sharing or analyzing of personal consumer credit information. The proposed legislation would also permit the SFC or the Financial Secretary to exempt the activities of certain individuals from the definition of “providing credit rating services.”

As proposed, the legislation would amend Schedule 1 of the Securities and Futures Rules to impose minimum capital requirements for all Type 10 regulated activity. A draft Code of Conduct for Persons Providing Credit Rating Services, which would require CRAs to both operationally and legally separate their credit rating business from other types of business, and a draft list of Recognized Industry Qualifications and Local Regulatory Framework Papers are appended to the Consultation Paper. Existing ratings analysts would be grandfathered into the proposed regulatory regime, provided that they complete a course relating to the legal and regulatory framework for Type 10 regulated activity within six months of being licensed under the new regime.

It is intended that the new regime be implemented by the end of January 2011. Comments on the Consultation Paper are due by August 20, 2010.

State insurance commissioners pick PIMCO to replace raters

Pacific Investment Management Co., manager of the world’s largest bond fund, was selected by the National Association of Insurance Commissioners to help assess companies’ portfolios of residential mortgage-backed securities.

Pimco will help evaluate about 18,000 RMBS owned by U.S. insurers, the NAIC said in a statement today. The evaluations will help regulators determine how much capital insurers need to guard against losses on slumping home-loan investments.

Regulators are seeking assistance in valuing investments after the housing slump pushed up mortgage defaults. State insurance commissioners, which monitor portfolios to make sure carriers have enough money to pay claims, discontinued their use of RMBS credit grades issued by ratings firms including Moody’s Investors Service after downgrades caused a fivefold increase in capital requirements this year.

Pimco, a unit of Munich-based Allianz SE, was selected from a short list of 11 vendors that were considered by the NAIC, the regulator group said. Mark Porterfield, a spokesman for Pimco, didn’t immediately return a call seeking comment.

State insurance commissioners plan to grill the top credit rating agencies as to why the commissioners shouldn’t seek other guidance in evaluating insurers’ securities holdings, a key regulator said.

“The commissioners are going in with an open mind, but there’s been a lot of criticism out there,” said Hampton Finer, deputy superintendent and chief economist with the New York Insurance Department.

Mr. Finer spoke in advance of a hearing set for Sept. 24 by a unit of the National Association of Insurance Commissioners, to which the Nationally Recognized Statistical Rating Organizations (NRSROs) have all been invited.

NAIC evaluates the holdings of insurers, and based on how the NRSROs rate the carriers’ securities, the NAIC sets a minimum required amount of capital reserves that the insurer most hold against possible equity losses, Mr. Finer said.

Mr. Finer said there was a “view that there’s been an overreliance on rating agencies,” mentioning recommendations by the U.S. Treasury and the Group of 20 Finance Ministers and Central Bank Governors.

He said the NAIC Rating Agency Working Group, which has invited insurance companies, pension funds and others to testify on the NAIC reliance on NRSRO ratings, will among other things ask about ratings of “structured securities where there’s been a problem.”

As an example, he mentioned residential- mortgage backed securities that plunged in value after receiving satisfactory ratings from the NRSROs.

Mr. Finer said the Working Group has sent the NRSROs questionnaires and have received “voluminous responses that were quite helpful,” but he said the NAIC wants clarification of some questions that were not answered completely.

NAIC, he said, does not believe the NRSROs have a monopoly on good rating models for securities, and the organization may perhaps use “another vendor to do some calculations and use those to develop and appropriate capital charge” for insurers.

The organization wants to “see if anybody else has a better mousetrap that can provide better warnings and more transparency,” noting that there “are a lot of folks that have very advanced models that are quite state of the art.

He mentioned Black Rock, Risk Metrics and Andrew Davidson among other firms.

Rating firms that were contacted had no immediate comment.

In its announcement of the hearing, which will be held at Gaylord Convention Center in National Harbor Md., the NAIC noted that insurance companies hold nearly $3 trillion in rated bonds, and the insurance industry constitutes the largest sector of the financial services industry to rely on credit ratings to supervise capital asset adequacy.

Insurance regulators, it noted, currently mandate the use of credit ratings to determine capital reserves and other regulatory requirements for insurance companies.

The Working Group is co-chaired by Acting New York Insurance Superintendent James J. Wrynn and Illinois Insurance Director Michael T. McRaith.

According to the announcement, the hearing will examine the historical reliance of insurance regulators on ratings and the impact of this reliance. 

Issues concerning ratings, particularly related to structured securities and municipal bonds, recent systemic remedies or procedural changes enacted by NRSROs, recommendations and alternatives to NRSROs for prudential regulation, will also be looked at.

Following the hearing, the Working Group said it will develop and present a final report documenting the findings and any recommendations for corrective action available to the NAIC and its members, as well as recommendations to the federal government on NRSRO regulation.

California AG subpoenas raters

California's attorney general said Thursday his office is investigating Wall Street's big credit rating agencies to determine what role they may have played in the collapse of the financial markets.

Attorney General Jerry Brown said he has issued subpoenas to Moody's Investors Service, Standard & Poor's and Fitch Ratings to determine whether they violated state law in "recklessly giving stellar ratings to shaky assets."

The agencies are crucial financial gatekeepers, and investors depend on their ratings of public companies and securities to gauge risk and make investment decisions.

At the peak of the housing boom, the agencies gave their highest ratings to securities backed by subprime mortgages that later fell apart. The agencies had to downgrade thousands of securities as the value of those investments plummeted, contributing to hundreds of billions of dollars in losses and write-downs at big banks and investment firms.

The rating agencies either ignored or didn't understand the risks, Brown said. He added that the agencies made billions of dollars in revenue from the securities they rated.

Michael Adler, a spokesman for Moody's, said the company will review Brown's inquiry "and we will offer our cooperation as appropriate."

Chris Atkins, a spokesman for Standard & Poor's, said the agency couldn't comment because it hasn't yet seen the subpoena. A representative of Fitch did not immediately return a call for comment.

Brown gave the agencies an Oct. 19 deadline to respond to the subpoenas to determine whether they did due diligence in the rating process and whether they profited from giving inaccurate ratings to particular securities, among other questions.

Brown's announcement came the same day federal regulators proposed new rules designed to stem conflicts of interest and provide more transparency on the credit rating industry. The five members of the Securities and Exchange Commission voted at a public meeting to propose rules that would open the agencies' practices to wider public view and subject them to some restraints.

One SEC proposal discussed Thursday is intended to bar companies from "shopping" for favorable ratings of their securities.

California's probe comes on the heels of similar investigations under way in other states.

In July, the California Public Employees' Retirement System sued Moody's, Fitch and S&P, saying they lured the fund into bad investments. The nation's largest public pension fund blames them for more than $1 billion in investment losses.

Calpers sues rating agencies

Source: Calpers Sues Rating Companies Over $1 Billion Loss July 15 (Bloomberg)

"The California Public Employees’ Retirement System, the largest U.S. public pension fund, sued the three major bond-rating companies for $1 billion in losses it said were caused by “wildly inaccurate” risk assessments.

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings used methods to analyze medium-term notes and commercial paper that were “seriously flawed in conception and incompetently applied,” Calpers said in a lawsuit filed July 9 in state court in San Francisco.

The companies all gave their highest ratings to Cheyne Finance Ltd., Stanfield Victoria Funding LLC and Sigma Finance Inc., prompting Calpers to invest in them in 2006, the fund said in its complaint. The Structured Investment Vehicles collapsed in 2007 and 2008, defaulting on payments to Calpers, it said. The underlying assets of the three firms, Calpers said, consisted primarily of risky subprime mortgages."

Original enclosure Calpers lawsuit

N.Y. insurance regulator suggests limiting Moody’s as rater

"New York state’s insurance regulator suggested Moody’s Investors Service should have its authorization to rate insurers’ holdings scaled back after the firm declined to attend a public hearing set for next week.

“This is the thing that forces one to ask questions about the role that a company like that can play in our regulatory system,” Hampton Finer, deputy superintendent and chief economist at the New York Insurance Department, said yesterday in a phone interview. “We think there should be discussion about whether Moody’s will have its authorization status going forward or having it curtailed in some fashion.”

Finer said he may advocate that regulators throughout the country rely on Moody’s competitors to rate securities held by insurance companies. Moody’s could lose business if that that happens, he said. Insurers can hold certain securities without explicit regulatory approval if those investments are rated by an authorized firm.

Standard & Poor’s, Fitch Ratings and Dominion Bond Rating Service Ltd. plan to meet next week with U.S. state regulators on the role the firms play in grading the insurers’ fixed-income holdings, the National Association of Insurance Commissioners said in a statement posted on the Web. Moody’s was invited and won’t attend, said Scott Holeman, a spokesman for the NAIC.

Thomas Lemmon, a spokesman for Moody’s, declined to immediately comment. Vanessa Sink, a spokeswoman for the NAIC, declined to discuss Finer’s remarks.

New York Insurance Superintendent James Wrynn and Michael McRaith of Illinois convened the meeting as heads of a group appointed by the NAIC to evaluate watchdogs’ reliance on the firms. U.S. insurance companies hold about $3 trillion in rated bonds including corporate debt and mortgage-linked bonds."

Rating shopping

Source:SEC Considering Rule to Curb Credit-Rating ‘Shopping’ Bloomberg, July 14, 2009

"U.S. Securities and Exchange Commission Chairman Mary Schapiro said the agency will consider rules to keep debt underwriters from soliciting ratings from firms willing to assign the highest letter grade.

The SEC staff has been told to research regulations to prevent “rating shopping” where firms gain business in return for generous grades, Schapiro said in testimony prepared for a House Financial Services subcommittee hearing today.

One approach would require issuers to release preliminary ratings from firms such as Standard & Poor’s and Moody’s Investors Service before one is hired to give a final ranking, she said.

The SEC is moving to curb conflicts at rating companies after S&P, Moody’s and Fitch Ratings were faulted by lawmakers for assigning mortgage bonds their highest rankings and maintaining the assessments after home-loan defaults accelerated in 2007. Shopping remains a “problem,” Andrew Kimball, Moody’s head of global structured finance business, said last month.

Under Pressure

The Federal Reserve’s Term Asset-Backed Securities Loan Facility, which makes low-cost loans to investors buying AAA- rated debt instruments, puts issuers under pressure to get a top rating, regardless of the quality of the evaluation, Kimball said June 4, during the company’s investor day.

The SEC has established a unit of examiners to oversee the rating firms, Schapiro said today. The agency may also require disclosure of data used to create rankings, a step that could encourage unsolicited ratings by letting companies grade bonds even if they weren’t paid by debt underwriters.

“Then you would have competition and diversity of perspective about the quality” of new instruments, Schapiro told lawmakers.

The SEC in December approved rules prohibiting credit- rating analysts who assess debt from discussing fees with underwriters. The agency also limited gifts from securities firms to rating-company employees and restricted analysts from offering advice on structuring securities to win top grades.

Additional measures required firms to publish statistics showing how well their ratings predicted the risk of default and disclose how frequently grades are re-evaluated."

"Bankers said ‘Anything’ to get high rating"

Just past midnight on May 3, 2005, Standard & Poor’s analyst Chui Ng e-mailed co-workers to broker a solution to demands by Goldman Sachs Group Inc. bankers that he said violated two or more of the ratings company’s internal guidelines.

Goldman Sachs was adding $200 million in debt at the “last minute” to a $1.5 billion bond pool called Adirondack Ltd., Ng wrote. That meant the New York investment bank would originate 13 percent of the pool itself, two-and-a-half times the 5 percent limit set by S&P.

Goldman Sachs also balked at Ng’s request to pay in advance for an insurance policy known as a credit default swap, which was being used to create the additional debt obligation.

The e-mails from Ng, who negotiated a compromise on Goldman Sachs’s requests, provide a rare window into the back-and-forth between the bank and a rating company assessing the risks in a financial product linked to subprime mortgages. The exchange was among 581 pages of private communications released last week by Senate investigators.

NY AG opens investigation into investment banks

"...The agencies themselves have been widely criticized for overstating the quality of many mortgage securities that ended up losing money once the housing market collapsed. The inquiry by the attorney general of New York, Andrew M. Cuomo, suggests that he thinks the agencies may have been duped by one or more of the targets of his investigation.

Those targets are Goldman Sachs, Morgan Stanley, UBS, Citigroup, Credit Suisse, Deutsche Bank, Crédit Agricole and Merrill Lynch, which is now owned by Bank of America.

The companies that rated the mortgage deals are Standard & Poor’s, Fitch Ratings and Moody’s Investors Service. Investors used their ratings to decide whether to buy mortgage securities.

Mr. Cuomo’s investigation follows an article in The New York Times that described some of the techniques bankers used to get more positive evaluations from the rating agencies.

Mr. Cuomo is also interested in the revolving door of employees of the rating agencies who were hired by bank mortgage desks to help create mortgage deals that got better ratings than they deserved, said the people with knowledge of the investigation, who were not authorized to discuss it publicly..."

Credit rating agency definition

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.)

The value of such ratings has been widely questioned after the 2008 financial crisis when the Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.[1]


General criticism

Credit rating agencies have been subject to the following criticisms:

10 notch rating reversal in one week

Bloomberg reports on a NRSRO changing ratings 10 notches in one week on commercial mortgage backed securities.

Source: S&P Restores Top-Ratings to Commercial-Mortgage Bonds Bloomberg, July 21, 2009

"Standard & Poor’s backtracked on ratings cuts issued last week and raised the ranking on commercial mortgage-backed debt from three bonds sold in 2007.

The securities, restored to top-ranked status, had been downgraded as recently as last week, making them ineligible for the Federal Reserve’s Term Asset-Backed Securities Loan Facility to jumpstart lending.

S&P lowered the ratings on a class of a commercial mortgage-backed bond offering from AAA to BBB-, the lowest investment-grade ranking, on July 14. The New York-based rating company reversed the cut today, S&P said in a statement. In a related report, S&P said it adjusted assumptions on the timing of projected losses on the mortgages.

“It is a stunning reversal and certainly raises questions concerning the robustness of their revised model,” said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union in New York. “It may engender further uncertainty with respect to ratings outlooks.”

Debt rated below AAA isn’t eligible for the Federal Reserve’s TALF. Investors sought $668.9 million in loans from the Fed to purchase so-called legacy commercial mortgage-backed bonds on July 16, the first monthly deadline to finance the purchase of the securities."

Additional reporting: S&P Shift on Ratings Unsettles Investors WSJ, July 23, 2009

"...The CMBS market has been on the rise since March, when the Federal Reserve announced it would expand TALF to investors buying CMBS bonds. However, the rally was interrupted in late May on S&P's warning. One month later, the market fell further after S&P tightened its ranking criteria for CMBS and said some $235 billion of CMBS debt could lose triple-A ratings. Essentially, S&P said commercial real-estate values had fallen so much that bonds that had been considered triple-A faced a higher risk of losses.

The potential downgrades raised doubts about how effective the TALF program would be in terms of restarting the securitization market for commercial real estate. Explaining the new ratings methodology in May, S&P said the loans made from 2005 through 2007 featured "increasingly more aggressive underwriting" than those made in prior years. In other words, lenders were overly optimistic about rents, occupancies and values. In fact, they have all fallen sharply. Anticipating such ratings cuts, some investment banks in recent weeks have been repackaging existing bonds to make them more downgrade-proof by adding "credit support," decreasing the potential for losses to be taken by top-rated bonds. That triggered a market rally.

The $7.6 billion benchmark deal at the center of the ratings controversy is commonly known as GG10. It was sold by RBS Greenwich Capital and Goldman Sachs Group Inc. in 2007.

When S&P downgraded the GG10 deal last week as a result of the new criteria, some investors and analysts noted that although some of the classes in the deal deserved to be cut, the ratings agency shouldn't have treated all triple-A bonds the same way. In other words, even on assumptions of bigger losses on the loan pool, investors in some of the top-rated bonds would still get repaid before those below them. After receiving inquiries from market participants on how it applied losses in the triple-A category, S&P corrected its approach and restored some of its downgraded bonds to triple-A. "They're getting to the right spot," Aaron Bryson, a CMBS analyst at Barclays Capital, said of the correction. But the ratings firm had "poor communications" with the market, Mr. Bryson said."

Lack of equivalent disclosure

The ability of issuers to selectively disclose material non-public information to NRSROs is a substantial regulatory gap. This gap reduces market transparency and stability. It was always puzzling why Federal statutes and regulations gave issuers the right to selectively disclose material non-public information to chosen NRSROs. This practice seems fundamentally unfair and potentially abusive on the part of the issuers.

It could be argued that the issuer's right to selectively disclose material non-public information to favored NRSROs (who they pay) is one cause of the significant concentration of ratings from the dominant NRSROs (Fitch, Standard & Poors and Moody's). And the reason that investors abandoned the use of credit ratings when the financial system froze.

During the Internet boom the equity markets had their own form of selective disclosure and corrupt market practices. Prior to the adoption of Regulation Fair Disclosure (Reg FD) equity issuers would disclose material non-public information to favored equity analysts. Those analysts would impart this material non-public information to their favored clients (generally institutional clients) who would trade on this knowledge ahead of other market participants. This inequality of information flows to market participants was cured with the adoption of Reg FD for the equity markets.

Former SEC Chairman William Donaldson made the following remarks to the Subcommittee on Capital Markets, Insurance, and GSEs, House Committee on Financial Services, May 21, 2001 in reference to the adoption of Reg FD.

"Selective disclosure raises several concerns. The primary issue is the basic unfairness of providing a select few with a significant informational advantage over the rest of the market. This unfairness damages investor confidence in the integrity of our capital markets. To the extent some investors decide not to participate in our markets as a result, the markets lose a measure of liquidity and efficiency, and the costs of raising equity capital are increased.

Further, if selective disclosure is permitted, corporate management can treat material information as a commodity to be used to gain or maintain favor with particular analysts or investors. This practice could undermine analyst objectivity, in that analysts will feel pressured to report favorably about a company or slant their analysis to maintain access to selectively disclosed information. Thus, selective disclosure may tend to reduce serious, independent analysis."

The proposed change to SEC Rule 17g-5 will began to address this significant information inequality for structured products. This change should be adopted for all classes of credit ratings and apply equally to all types of issuers. Issuer and investor compensated NRSROs should have equivalent disclosure upon which to render credit analysis.

Slow to downgrade

Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months. [1] [2]

Some empirical studies have documented that yield spreads of corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that the market often leads a downgrade and questioning the informational value of credit ratings. See, variously,

  • Kliger, D. and O. Sarig (2000), The Information Value of Bond Ratings, Journal of Finance, December: 2879-2902
  • Galil, Koresh (2003). The quality of corporate credit rating: An empirical investigation. EFMA 2003 Helsinki Meetings, European Financial Management Association.

This has led to suggestions that, rather than rely on CRA ratings in financial regulation, financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spreads when calculating the risk in their portfolio.

Rating agency and issuer familiarity

Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled. ("Financial gatekeepers: Can they protect investors?", Brookings Institution, 2006) [3]

These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. Furthermore, because information about ratings changes from the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings. This has led to accusations that these CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings.

At the same time, more generally, the largest agencies (Moody's and Standard & Poor's) are often seen as agents of globalization and/or "Anglo-American" market forces, that drive companies to consider how a proposed activity might affect their credit rating, possibly at the expense of employees, the environment, or long-term research and development.

These accusations are not entirely consistent: on one hand, the larger CRAs are accused of being too cozy with the companies they rate, and on the other hand they are accused of being too focused on a company's "bottom line" and unwilling to listen to a company's explanations for its actions.

Downgrades creating "vicious cycles"

The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness.

In some cases, large loans to companies contain a clause that makes the loan due in full if the companies' credit rating is lowered beyond a certain point (usually a "speculative" or "junk bond" rating).

The purpose of these "ratings triggers" is to ensure that the bank is able to lay claim to a weak company's assets before the company declares bankruptcy and a receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called "death spiral").

These rating triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting these triggers and discouraging their use, and the U.S. Securities and Exchange Commission requires that public companies in the United States disclose their existence.

Ratings oligopolies

Agencies are sometimes accused of being oligopolists, [4] because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized).

Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses. The high profit on Moody's revenues (>50% gross margin), which are consistent with the high barriers to entry, do nothing to allay market fears of monopoly pricing.

Massive misrating of structured products

  • Credit Rating Agencies have made errors of judgment in rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. This has led to problems for several banks whose capital requirements depend on the rating of the structured assets they hold, as well as large losses in the banking industry.


AAA rated mortgage securities trading at only 80 cents in the dollar, implying a greater than 20% chance of default, and 8.9% of AAA rated structured CDOs are being considered for downgrade by Fitch, which expects most to downgrade to an average of BBB to BB-. These levels of reassessment are surprising for AAA rated bonds, which have the same rating class as US government bonds. [5] [6]

As part of the Sarbanes-Oxley Act of 2002, Congress ordered the U.S. SEC to develop a report, titled Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets detailing how credit ratings are used in U.S. regulation and the policy issues this use raises.

Partly as a result of this report, in June 2003, the SEC published a "concept release" called Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws that sought public comment on many of the issues raised in its report. Public commentson this concept release have also been published on the SEC's website.

In December 2004, the International Organization of Securities Commissions (IOSCO) published a Code of Conduct for CRAs that, among other things, is designed to address the types of conflicts of interest that CRAs face. All of the major CRAs have agreed to sign on to this Code of Conduct and it has been praised by regulators ranging from the European Commission to the U.S. Securities and Exchange Commission.

Lobbying by credit rating agencies

From the WSJ, June 23, 2009, "If world-class lobbying could win a Stanley Cup, the credit-ratings caucus would be skating a victory lap this week. The Obama plan for financial re-regulation leaves unscathed this favored class of businesses whose fingerprints are all over the credit meltdown."

Litigation related to credit rating agencies

Credit rating agencies

(NRSROs) Nationally Recognized Statistical Rating Organizations - credit rating agencies registered with the SEC:

Additional Rating Agencies:

  • Baycorp Advantage (Australia),
  • Capital Intelligence Ltd (Cyprus),
  • CreditPointe (U.S.),
  • Credit Rating Agency of Bangladesh Ltd (CRAB) (Bangladesh),
  • CRISIL (India),
  • Dagong (China)
  • ICRA (India)
  • Malaysian Rating Corporation (Malaysia)
  • Morningstar
  • Pacific Credit Rating (Peru)
  • Global Rating Intelligence Services (Middle-East and Africa)
  • Rating Agency Malaysia (Malaysia)

References


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