SEC to Rein In Credit Rating Agencies

October 7, 2009 Updated: October 7, 2009

During the financial crisis, many economists blamed credit rating agencies for failing investors, assigning top ratings to complex and risky mortgage-backed securities. The agencies’ close relationship with securities issuers also clouded their independence.

A year later, the Securities and Exchange Commission (SEC) is taking steps to introduce new rules to oversee and regulate the industry. The credit rating agencies—Standard & Poor’s and Moody’s being the most prominent—assign credit ratings to companies and securities, and in turn, investors rely on such ratings to determine risk and default possibilities.

The SEC proposed six initiatives that attempt to strengthen oversight, tighten the regulatory framework, require increased historical rating information, and address conflict of interest and other relevant issues to improve transparency and accountability.

Currently, only 10 agencies—A.M. Best Company Inc., DBRS Ltd., Egan-Jones Ratings Co., Fitch Ratings Inc., Japan Credit Rating Agency Ltd., LACE Financial Corp., Moody’s Investors Service Inc., Rating and Investment Information Inc., Realpoint LLC, and Standard & Poor’s (S&P) Ratings Services made the list of the SEC’s approved rating agencies. S&P is a division of McGraw-Hill Cos.

SEC Micromanaging?

Since January, President Barack Obama has introduced a slew of new measures aimed at shoring up regulation of the financial markets. New and extensive powers were granted to the Federal Reserve, the SEC, the U.S. Treasury, and the Federal Deposit Insurance Corp.

Populist backlash from Americans has also contributed to the recent hand-wringing by federal regulators.

“Investors often consider ratings when evaluating whether to purchase or sell a particular security,” said Mary L. Schapiro, SEC chairwoman, in a recent SEC open meeting. “That reliance did not serve them well over the last several years and it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust.”

At the meeting, SEC Commissioner Luis A. Aguilar indicated that rating agencies in the past have veered away from serving the public. Investors lost trust, as the agencies were at best, ambiguous about their ratings criteria, and at worst, hid their conflicts of interest.

While Aguilar discussed all that is wrong with rating agencies and how specific issues are being addressed by the proposed rules, he cautioned about overreaction due to the present crisis.

“I am becoming increasingly concerned that the Commission is imposing too large of a burden on Boards of Directors of investment companies by blurring the line between appropriate oversight and day-to-day management,” Aguilar said. “I do not think that it is in the best interests of investors for directors to be expected to be in the business of day-to-day credit determinations.”

Some SEC officials pointed to a lack of competition in the industry, noting that 98 percent of all ratings were generated by the three top rating agencies—Moody’s, S&P, and Fitch.

“Policymakers should proceed cautiously when trying to increase competition among raters, and be aware of the potential drawbacks. Modest competition may allow raters to think more about their long-term standing and less about winning business today,” Bo Becker, professor at the Harvard Business School, said in a recent interview with Working Knowledge, the publishing arm of the Harvard Business School.

More competition would make it easier for the SEC to bar or discipline a single rating agency for misleading ratings, while still retaining enough players for a healthy and competitive environment.

Conversely, Becker found in his research that competition could lead to more favorable ratings, as the agencies want to obtain future business from the securities issuers.

“Third-party ratings are produced by profit-making firms, and that system, which has generally worked very well, is not flawless. If you want to really know the value of a security, there is no shortcut to doing the work yourself [instead of relying on the ratings],” Becker said in the interview.