SEC's attempt to reform rating agencies criticized

Proposed rules package doesn't go far enough to address conflicts, observers say

Jun 16, 2008 @ 12:01 am

By David Hoffman

Attempts by the Securities and Exchange Commission to fix problems that led credit rating agencies to inaccurately gauge the creditworthiness of mortgage-related securities don't go far enough, according to industry critics. Last week, the commission proposed a package of rules that would regulate the conflicts of interests, disclosures, internal policies and business practices of rating agencies designated "nationally recognized statistical ratings organizations." The designation is important because the commission in many cases requires funds especially bond funds that invest in high-quality bonds to invest only in securities rated by at least two such entities. There are now nine nationally recognized statistical ratings organizations, with many more to come. Before the passage of the Credit Rating Agency Reform Act of 2006, which enabled the SEC to speed up the process by which organizations can apply to be designated an NRSRO, there were only five. Making the NRSRO designation available to more organizations "is one important way to promote high-quality ratings and to provide a check against laxity and substandard practices," Christopher Cox, chairman of the SEC, said last week before an open meeting of the commission. Critics of the credit rating agencies, however, dismissed the SEC's actions as too little, too late. "I'm not convinced there is any real desire to drastically reform or remake the industry," said Jerome Fons, principal of Fons Risk Solutions of New York, an investment consultant. The SEC's proposed rules don't wean investors off their reliance on credit rating agencies, said Mr. Fons, a former managing director of Moody's Investor Service of New York, one of the NRSROs. And the proposed rules do nothing to ensure accurate ratings, said Joshua Rosner, a managing director at Graham Fisher & Co. Inc., a New York-based industry consultant. "What the SEC proposes is a furtherance of the abdication of its responsibility," he said. "It doesn't want to oversee, or look at, the models and methodologies employed by the rating agencies."

Mr. Cox himself described the proposed rules package divided into three parts as disclosure-oriented.

The first part includes rules that, among other things, would prohibit rating agencies from structuring the same products that they rate; require the agencies to make all their ratings and subsequent rating actions publicly available; and attack the practice of buying favorable ratings by prohibiting anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for it.

The second part would require agencies to differentiate the ratings that they issue on structured products from those that they issue on bonds, either through the use of different symbols or by issuing a report disclosing the differences between ratings of structured products and other securities.

The third part, which commissioners will consider at the next open meeting on June 25, would seek to provide a more thorough description of the basis for the SEC's use of ratings as a surrogate for compliance with various regulatory conditions and requirements.

The three largest NRSROs Standard & Poor's, a unit of McGraw-Hill Cos. of New York; Fitch Ratings Ltd., a unit of Fimalac SA of Paris; and Moody's expressed cautious support for the proposed rules.

"A number of the proposals discussed today are positive steps forward," Stephen Joynt, chief executive of Fitch Ratings, said in a statement.

The Investment Company Institute, the Washington-based mutual fund trade organization, also expressed its support for the new rules.

"If credit ratings are to be useful to investment decision-making by funds and other investors, they must be the product of a transparent, unconflicted and objective process," Paul Schott Stevens, president and chief executive of the ICI, said in a statement. "We welcome reforms that will open up the rating process, ensure that rating agencies are accountable and lay out any potential conflicts that could color an agency's ratings."

At least one financial adviser said he would have been more impressed with the proposed rules had the SEC done more to address the conflict of interest that exists when rating agencies specifically Standard & Poor's, Moody's and Fitch are paid to rate securities by the issuer of those securities.

"The problem is they get paid by the people they give the ratings to," said J. Michael Martin, president at Financial Advantage Inc., a Columbia, Md.-based firm with $260 million in assets.

"There's not that arms-length relationship," he said. "I'm not saying everything is shady, but nature is what it is."

The newly designated NRSROs aren't paid by the issuer for their ratings. Instead, they are paid by investors, which removes any conflicts of interest, they claim.

For example, Lace Financial Inc. of Fredericksburg, Md., which received its NRSRO designation in February, is free to downgrade a credit "without the hand-wringing" that sometimes comes if a rating agency is paid by the credit issuer, said Damyon Mouzon, president of the company.

That may be true, but that doesn't necessarily mean its ratings will be any better than those of an agency compensated by the issuer, Mr. Fons said.

In fact, increased competition may lead to a "commoditization" of ratings that could result in their being less useful, he said.

"If you commoditize the products ... then you will have a scramble to really assert and define how you as a rating agency can differentiate yourself," Mr. Fons said.

That can put pressure on rating agencies to come up with ratings that clients want, not necessarily those that are deserved, he said.

And it doesn't matter if the client is the issuer or the investor, said Harold Evensky, president of Evensky & Katz Wealth Management, a Coral Gables, Fla., firm with $600 million under management.

"Let's say a wirehouse pays for ratings," he said.

"They potentially have a vested interest in ensuring that a [security] gets a high rating so they can sell it." Mr. Evensky said. "Ultimately, it's my client who's left holding the bag."

E-mail David Hoffman at dhoffman@investmentnews.com.

0
Comments

What do you think?

View comments

Recommended next

Upcoming event

Nov 20

Conference

Future of Financial Advice

An innovative conference dedicated to improving the client experience by enhancing digital technology, mainstreaming healthcare and optimizing wealth management strategies.The Future of Financial Advice will provide a forum for... Learn more

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print