How Will the SEC Rate the Rating Agencies?

Just as the subprime mortgage mess came to a head, the SEC received new regulatory powers over credit rating agencies. Will they do any good?

Last September, Congress gave the Securities and Exchange Commission 270 days to figure out how it would regulate credit rating agencies under a new law. Nine months later, with 21 days to spare, the SEC released final implementation rules for the Credit Rating Agency Reform Act.

But the SEC may have a lot less time this fall to prove that it’s up to the new regulatory challenge of overseeing credit rating agencies. With global securities regulators, Congressmen, and the Bush administration wondering what caused the subprime mortgage meltdown and pointing some fingers at rating agencies, the SEC will have to respond quickly, say observers. “There’s going to be a lot of pressure on the SEC and the rating agencies — not just in the U.S., but all around the world,” says James Kaitz, CEO of the Association for Financial Professionals (AFP), which lobbied hard for the law that brought rating agencies under the SEC’s regulatory oversight for the first time.

Kaitz believes the SEC should review the practices of the agencies over the next two to three months and provide some type of report to Congress. Otherwise, he theorizes, the SEC and the industry run the risk of opening themselves up to new rules from other countries’ regulators.

That, in turn, could disrupt the SEC’s fledgling efforts to rechristen the rating agencies as nationally recognized statistical rating organizations — or NRSROs. That designation was originally assigned almost accidentally by the SEC to certain rating agencies in the 1970s. However, the designation, which implied a government blessing as a credible provider, quickly became a de facto license to operate as a rating agency.

Over time, the SEC formalized its practice of doling out NRSRO status — but without published rules, the process was an unclear one that came under heavy criticism for its lack of transparency and its apparent role in promoting an oligarchy. By 2005, there were just five NRSROs: Moody’s Investor Service, Standard & Poor’s Rating Service, Fitch Inc., A.M. Best, and Dominion Bond Rating Service. The failure of those agencies to predict the collapse of Enron in a timely fashion just a few years earlier suggested to many critics that their regulatory regime ought to be changed.

The new law sought to take away the SEC’s unofficial NRSRO naming power and replace it with a more formal regulatory process. Under the law, each agency wanting NRSRO status must apply to the SEC and detail in their application how they manage conflicts of interest, list their procedures, and provide their financial statements. As of June, the SEC said that seven agencies had applied for NRSRO status. So far, however, the SEC has not officially designated any of them as NRSROs. It has 90 days from receiving the agencies’ applications to make that determination.

But almost as soon as those rating agencies submitted their applications, the subprime mortgage crisis thrust them under an all-to-familiar glaring spotlight. As in the aftermath of Enron, critics wondered why the rating agencies, with all their access to inside information, seemed to be the last to see the crisis coming. That, in turn, has many wondering if the new law passed on September 29 actually has teeth. Members of the House Financial Services Committee recently questioned whether the law did enough to address investors’ criticisms of the ratings agencies following Enron’s collapse. And more questions are sure to come when a House Financial Services subcommittee holds a planned hearing to address the responsibilities and independence issues of NRSROs. Similar reviews are reportedly underway in the Senate and at the International Organization of Securities Commissions, and President Bush has asked Treasury secretary Henry Paulson to look into the agencies’ role in the mortgage industry.

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