Crackdown: SEC Gets Tougher on Rating Agencies

Raters become the first industry to be handed new regulations as a result of the credit crisis.

As part of a new set of rules adopted today, the Securities and Exchange Commission will prohibit credit rating agencies from helping to structure the same financial products they rate.

The regulator — which was given formal oversight of the rating agencies two years ago — will also require the raters to keep better records of their rating processes and third-party complaints, as well as make them decline gifts of more than $25 from securities issuers. The changes are designed to mend a credibility-tainted industry by reducing the firms’ conflicts of interests and making them more accountable for their evaluations. The new rules may also open up the concentrated market to more competition.

In addition, the SEC is requiring firms that are paid by issuers to post online a random sample of their ratings’ history, based on asset class. Firms that rely on subscriber fees will not have to comply, although the SEC is asking for feedback on whether to extend the rule to cover those raters as well.

The SEC also softened a few proposed rules that were first introduced in June. For example, a new proposal, which will be released for public comment soon, requires raters that are paid by issuers to immediately share client information with other nationally recognized statistical rating organizations (the official term for the 10 SEC-registered ratings firms). Under the initial proposal, that information would have been publicly disseminated after six months.

The reputation of credit rating agencies took a beating over the past year because their downgrades of mortgage-backed securities seemed to come too late to warn investors of the impending meltdown. Lawmakers, regulators, and investor advocates have accused the agencies of not giving accurate or timely assessments to structured financial instruments embedded with risky, subprime loans. As a result, the raters have been blamed for investors’ losses during the economic downturn. “While credit rating agencies did not create the credit crisis, their practices contributed to the debacle,” wrote the Council of Institutional Investors in a letter to the SEC.

The agencies’ “significant role” in the crisis forced the SEC to take action, according to commissioner Kathleen Casey. “The Big Three rating agencies have failed investors,” she said.

Chief executives at the trio of agencies that dominate the market — Standard & Poor’s, Moody’s Corp., and Fitch Ratings — have admitted their firms’ assessments of mortgage-backed securities could have been more accurate. But they have pushed aside accusations that they played a heavy role in the credit crisis. Their ratings are restricted to what securities issuers tell them, the officials have said.

The raters asked the SEC to tone down the proposed rules, saying that full disclosure of what they are told by their clients would have a “chilling effect” on the market. The SEC believes the new version of its rules, which would keep the data-sharing only among NRSROs, should limit those concerns. It could also make it easier for smaller NRSROs to use that information to make their own assessments and gain better traction in the marketplace.

The SEC has tabled a proposal that would wipe out the nearly 40 references to NRSROs in its own rules, effectively requiring investors to trust the ratings. The commission also dropped a proposal to distinguish traditional corporate bonds from complex asset-backed securities with new labels.

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