Tags: SEC | Moodys | S&P | Fitch

SEC Finds Problems in Review of Credit-raters

Thursday, 15 Nov 2012 05:05 PM

 

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Some credit-rating agencies failed to disclose ratings method changes or were lax in following policies on timely downgrades of securities, according to a report issued by U.S. securities regulators on Thursday.

The Securities and Exchange Commission summarized the results of its annual examination of raters, a requirement under the 2010 Dodd-Frank Act that called for greater scrutiny of ratings agencies following the 2007-2009 financial crisis.

The largest ratings firms, Moody's Corp. and McGraw-Hill Cos. Inc.'s Standard & Poor's, have been criticized for helping to exacerbate the crisis by giving rosy ratings to subprime mortgage securities that quickly turned toxic.

Thursday's SEC report does not name which firms had violations, but does distinguish between larger versus smaller credit-raters.

The SEC's exams were conducted on site at all nine raters registered with the SEC, which include smaller firms like Egan-Jones, as well as the big three - Moody's, Standard & Poor's and Fimalac SA's Fitch.

The SEC found that each of the larger raters and two smaller firms failed to follow their own methodologies and policies for determining ratings.

In one case, the SEC said, one of the big three changed its method for calculating a key financial ratio for asset-backed securities ratings and failed "for several months" to publicly disclose the change and its impact.

This firm, the SEC said, "appeared to have weak internal supervisory controls and lacked transparency over the process of rating these asset-backed securities."

The SEC added that market share and business considerations may have played a role in how this rater applied its methodology - a potential conflict of interest that many critics see as a problem in the industry.

The big three use what is called an "issuer-paid" business model, in which companies seeking ratings pay for them.

The big raters say this conflict can be managed but critics argue this model should be scrapped.

The Dodd-Frank law requires the SEC to study possibly replacing the model with a new method in which a public or private utility would assign structured product ratings to firms at random. So far, its findings have not been released.

S&P said on Thursday it has "enhanced its ratings process, governance and compliance function, including proactively making a number of the changes that are now being recommended by the SEC."

Spokesmen for Moody's Investors Service and Fitch both said they were working with regulators and looking for ways to improve their processes.

Sean-Egan, president of the smaller rival firm Egan-Jones and a vocal critic of the issuer-paid model, said Thursday's report only underscores his concerns.

"This is the elephant in the room that keeps appearing," said Egan, whose firm is compensated by its subscribers and not by the companies seeking ratings.

"There isn't an activity on the face of the earth where motives are not relevant and compensation for actions is not relevant."

It is unclear whether any of the compliance deficiencies uncovered in the SEC's exams could lead to enforcement actions.

The SEC has been criticized by some for failing to hold credit-raters accountable for their role in the financial crisis.

In July, S&P disclosed that the Justice Department and the SEC were probing potential violations in connection with its ratings of structured products.

Earlier this year, the SEC did file civil charges against credit-rater Egan-Jones for allegedly making false statements. That was only the second time ever the SEC has taken action against a rating agency, and it was not for anything related to the financial crisis.

The matter is still pending. Egan on Thursday called it an "obvious case of selective enforcement" by the SEC.

But making a case against raters is difficult, especially when dealing with the financial crisis.

That is because the SEC only started overseeing rater conduct in September 2007, when a new 2006 law went into effect giving the SEC authority to regulate raters for the first time.

In addition, the SEC is prohibited from regulating the substance of ratings, a provision that has helped shield raters from enforcement actions.

The 2010 Dodd-Frank law strengthened the SEC's oversight of raters and required annual exams, though the agency still cannot meddle in the ratings process itself.

Last year was the first time the SEC released a report with the results of the exams.

© 2014 Thomson/Reuters. All rights reserved.

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