Risk Professional: SEC to improve supervision over credit rating agencies

The term "credit ratings agency" is a mistake: the companies that produce credit ratings are not agencies at all. They are commercial concerns providing their opinions on a wide range of matters.

And as the credit crisis has cruelly revealed, they often speak on matters which they do not understand, or where they have conflicts of interest, and yet they have credibility and authority that their position does not justify.

The reason for that credibility and authority, in the USA at least, is an SEC dictat that financial institutions must have regard to the credit rating of businesses as defined one or more of three companies as part of the risk profiling for business.

It does not take long to point the finger at the credit rating companies over the current financial crisis: there is no doubt that they were a factor. They provided AAA rating on bundles of debt based not on the quality of that debt but primarily or even solely on their assessment of the company marketing the consolidated debt as a package.

Bear Sterns and Lehman Brothers both saw their packages given the highest credit ratings. But the cancerous growth of bad lending decisions began to eat away at those packages until they were killed by the level of default within them.

The conflict of interest was blatant: credit reference agencies sell their data to the very same people that they rate. They are afraid that a poor credit rating for a customer will lead to that customer swapping to another supplier.

And if that smacks of the same kind of audit / adviser conflict that led, ultimately, to the collapse of several large US corporations when audit was not properly performed, then that's because there is a direct parallel.

Once more, investors were misled so that a service provider did not risk losing a client.

The SEC's statement says "

Credit rating agencies are organisations that rate the creditworthiness of a company or a financial product, such as a debt security or money market instrument. In particular, the Commission voted to adopt or propose measures intended to improve the quality of credit ratings by requiring greater disclosure, fostering competition, helping to address conflicts of interest, shedding light on rating shopping, and promoting accountability.

"These proposals are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security," said SEC Chairman Mary Schapiro. "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."

In 2006, Congress passed the Credit Rating Agency Reform Act that provided the SEC with authority to impose registration, recordkeeping, and reporting rules on credit rating agencies registered as Nationally Recognised Statistical Rating Organizations (NRSRO). Currently, 10 credit rating agencies are registered with the Commission as NRSROs.

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.
• Adopted amendments to the Commission's rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.
• 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.
• Proposed new rules that would require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any "preliminary ratings" were obtained from other rating agencies - in other words, whether there was "ratings shopping."
• 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."

Consultation closes 60 days after publication in the Federal Register. That has not, yet, happened.

The proposals appear to strengthen the position of the credit rating companies. It appears to have heard their complaints that they could not properly rate securitised products because they could not see the underlying data, and therefore proposes that they should have access to that data.

This is, it is here submitted, a cop-out. There is, in effect, an admission that the companies rated products that they did not understand an in respect of which they had insufficient knowledge to make an informed decision.

These proposals appear to be a reward for that.

The companies were also rewarded for their failure to spot weaknesses in financial institutions when the US government gave them contracts to assess financial institutions for state aid.

A much deeper question arises: what are credit rating agencies for? Are they anything more than a form of sub-standard audit, when the value of audit is, itself, open to question?

The consultation does not go far enough. It needs to consider the fundamental question of whether credit rating companies should even exist. And if the data is needed, then should regulators provide it rather than rely on the private sector with all the conflicts and pressures that entails?