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Credit rating agencies, the poster children of the financial crisis, face a litany of new regulations under reforms enacted by US lawmakers to make their ratings more transparent, improve accountability and address conflicts of interests.
Under the rules, most of which have not been finalised, agencies will be required to make ratings more transparent by disclosing information about the assumptions underlying their methodology on a rating-by-rating basis. They will also need to be more accountable and create policies regarding their processes that must be certified by the firm’s chief executive.
Legal changes are also aimed at limiting conflicts of interest. This will be achieved by requiring firms to take steps to ensure analysts issuing ratings are not swayed by compensation or future employment. Half the board members of the rating firms must be independent.
The transition to the new rules is a big change. Firms have gone from being unregulated five years ago, to being subjected to new policies and annual Securities and Exchange Commission examinations that can result in sanctions including suspension for violating the new rules.
In its first annual examination as required by the legislation, and issued in October, the SEC identified policy shortfalls by each of the 10 registered credit rating firms. However, it said none of the concerns were considered material deficiencies.
Nonetheless, Consumer Federation of America and Americans for Financial Reform, the investor groups, said in a letter to the SEC that the new proposals “offer little hope of making significant progress on addressing the deep-rooted problems with credit ratings that were revealed by the financial crisis”.
Their complaint is that a core conflict of interest will not be addressed: credit rating firms are still paid by the companies whose debt or investment products they rate. Lawmakers who studied the root causes of the financial crisis alleged firms inflated ratings on mortgage-related products and altered their methodologies to win business.
The issue is controversial because the three biggest ratings firms – Moody’s, Standard & Poor’s and Fitch – operate under this model.
While proponents of an investor-paid model argue it would cure that conflict, others say it is not a profitable way to operate a business and could result in other pressures, such as an investor not wanting the security it has invested in to be downgraded.
The legislation does not change the pay model. It kicks the decision down the road by requiring the SEC to study options. One of these is the creation of a self-regulatory body or some other entity to assign a credit rating firm to rate structured products, such as residential mortgage-backed securities. if they do not choose this option, they must come up with an alternative by next year. Agencies generally do not favour this model, saying it could result in rating complacency and less competition.
The SEC was first given authority to oversee credit rating firms in 2006, and that oversight was enhanced by the financial reforms contained in the 2010 Dodd-Frank Act. As a sign of more serious oversight, the SEC is required to establish an office to regulate the rating firms, but its creation has been stalled by budgetary constraints. The SEC proposed several rules to implement the law earlier this year and expects they will be binding by early next year.
The first one to go into effect will be a requirement that credit rating firms disclose the representations and warranties, or disclosures by banks and mortgage originators about the quality of the underlying loans, in asset-backed products and how that compares to similar deals.
The law states that anyone at an agency working on a rating will be prohibited from any involvement in the sale and marketing of ratings. The SEC is also directed to require analysts to meet training standards and be tested. Credit rating firms want to be able to create and institute the training, which is something the investor groups reject.
Under the law, credit rating firms will be also be required to “look back” or review ratings when an analyst is later employed by the customer whose product it rated. The goal is to detect if unwarranted ratings were given to win future employment.
Firms will have to disclose more information about their work, such as the assumptions in their methodologies and whether the issuer or investor is paying for the rating.
If a credit rating firm or underwriter uses a due diligence report by a third party when evaluating an asset-backed security, it is required to disclose the report’s conclusions publicly. During the credit crisis, bank underwriters allegedly dismissed critical reports by due diligence firms that found weaknesses in the quality of the assets that backed the securities, according to private lawsuits.
Rating firms must also disclose the historic performance of ratings so that investors can evaluate their accuracy.
The wrinkle is that the credit history is made public 12 months after a rating change if the underwriter or company paid for the rating, and within 24 months if an investor paid for the rating. Investor groups say that delay is too long to be practicable.