SEC gets a B+ for credit-rating reform

Despite criticism by some in the financial services industry, the Securities and Exchange Commission's proposals for reforming the credit rating agencies deserve a grade of B+. That is, they aren't perfect, but a good first step. No doubt, more reforms will follow if these proposals don't significantly improve the credit rating process and the final products. As we have argued in the past, sunlight is the best disinfectant. Wherever the mold of conflict of interest grows, the beam of disclosure is the remedy. The SEC's proposals are heavy on such disclosure. In brief, here is what they would re-quire of the rating agencies: • That all ratings and subsequent rating actions must be publicly available, and that anyone who participates in determining a rating be prohibited from negotiating the fee charged to the issuer. • That rating agencies differentiate in some way between their ratings on structured products and their ratings on bonds and other securities. • That the agencies publish performance statistics for one-, three-, and 10-year periods within each rating category in a way that facilitates comparison with their competitors in the industry. • That they disclose the ways in which they rely on the due diligence of others to verify the assets underlying a structured product. • That they disclose how frequently credit ratings are reviewed; whether different models are used for ratings surveillance than for initial ratings; and whether changes made to models are applied retroactively to existing ratings. • That they make an annual report of the number of ratings actions they took in each ratings class, and maintain an XBRL database of all rating actions on their website, permitting easy analysis of both initial ratings and ratings change data. • That they disclose publicly the in-formation used to determine a rating on a structured product, including information on the underlying assets. They also would have to document the rationale for any significant out-of-model adjustments, and couldn't issue a rating on a structured product unless information on assets underlying the product was available. The second part of the SEC's proposal would require credit rating agencies to differentiate the ratings they issue on structured products from those they issue on bonds, either through the use of different symbols, such as attaching an identifier to the rating, or by issuing a report disclosing the differences between ratings of structured products and other securities.

LOTS OF SUNLIGHT

That is a great deal of sunlight being thrown on to the rating agencies' practices. Perhaps the SEC could have tried to require disclosure of each rating agency's proprietary models, but that would have generated great resistance and probably slowed any reform. The SEC also might have tried to ban the practice of originators' paying for ratings, but that too would have generated much resistance. Since there are now rating agencies offering the investor-pay model, time will tell which model produces the best ratings. Meanwhile, the SEC's proposals, combined with public outcry over the rating agencies' recent poor performance, likely will improve their practices going forward, to the benefit of all investors.