Rating Agency Reform: Band-Aids or Overhauls?

The SEC will consider a laundry list of ways to fix the credibility-tainted raters. Ideas range from new disclosures to new business models.

The Securities and Exchange Commission will be back at the reform drawing board on Wednesday, mulling the regulator’s oversight of the credit-rating agencies.

It’s been a familiar place for the SEC, which became the raters’ overseer in 2006 under the Credit Rating Agency Reform Act. Enacted after some agencies misidentified Enron as a good credit risk just days before the scandal-ridden energy giant filed for bankruptcy, the law gave the SEC the power to designate rating companies as nationally recognized statistical organizations (NRSROs). It also authorized the commission to review the agencies’ disclosures and the consistency of their policies and penalize them for wrongdoing.

But the SEC can’t second-guess the agencies’ opinions. Thus, the regulator doesn’t have the power to sanction agencies whose ratings, in retrospect, did not accurately depict the riskiness of the underlying loans of some structured financial products before the subprime-mortgage market imploded. For the past two years, critics of the agencies have questioned whether the SEC has done enough to keep the raters accountable, particularly in their ratings of mortgage-backed securities and collateralized debt obligations.

Indeed, the SEC has had to play catch-up with its new authority ever since the CRA act was signed. To be sure, the commission’s adoption of new regulations for the agencies ran parallel to the burgeoning problems in the mortgage market and the veiled risk embedded in the structured financial products tied to those loans. It’s only under fairly new SEC rules, for example, that agencies are now barred from helping to structure the financial products they rate and some have to publicly post a random sample of their ratings histories.

Critics of the industry, including lawmakers, have questioned how the agencies’ credibility can be repaired and whether more should be done to require them to better manage the ill effects of their conflicts of interests. Critics believe it’s hard to rid the agencies of conflicts when they collect fees from the issuers they review — in contrast to the agencies that use a subscriber-based model. With a new chairman at the helm, the SEC is again considering whether more reforms are needed for this niche business, which is dominated by three players: Standard & Poor’s, Moody’s Investor Service, and Fitch Ratings.

Representatives of those agencies, as well as those other NRSROs and trade groups, issuers, professors, and investor advocates will consider those issues during a daylong roundtable on Wednesday. They are scheduled to discuss the raters’ actions since the financial crisis hit, lack of competition in the industry, users’ perspectives, and ideas for improving the oversight of the SEC. SEC chairman Mary Schapiro said the insight received at the meeting will help the commission “as it continues to pursue aggressive oversight of the industry.” Earlier this year, Schapiro promised congressmen she would consider ways to fix the industry.

Longtime critics of the agencies are hoping Schapiro has significant reforms in mind. “We’re at a point where incremental changes aren’t going to be effective,” James Kaitz, president of the Association for Financial Professionals and a speaker at Wednesday’s hearing, told CFO.com. “We’ve got to make dramatic changes in the areas of transparency, how rating agencies are paid, and also really making sure that absolutely no conflicts of interest exist between the part of the company that’s rating and the other part that’s providing consulting services. I don’t think those issues have effectively been addressed yet.”

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