Subprime Slam: SEC Exposes Rating Agency Faults

In its report following a 10-month probe — citing several damning E-mails — the regulator says rating agencies suffer from conflicts of interest, deficient internal auditing, and poor disclosure policies.

The Securities and Exchange Commission issued a report saying that the three major credit rating agencies have significant deficiencies in policies and procedures for rating structured products tied to subprime mortgages — including conflict-of-interest problems with their “issuers pay” fee model.

The report culminates a 10-month SEC examination of the three top credit rating agencies — Standard and Poor’s, Moody’s Investors Service, and FitchRatings.

No enforcement action against the agencies was announced by the SEC, although officials said that as a matter of procedure the examination staff discusses findings with the SEC enforcement division, to make the division aware of any potential violations.

About 50 SEC staffers examined more than 100,000 pages of internal records and more than two million E-mail notes and instant messages, mostly related to two high-risk instruments: subprime residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). Collectively, these securities lost enormous value when homeowners began defaulting on their loans, and subsequently caused real estate and investment companies to take big write-downs, to lay off employees, and in some cases to shutter operations. In fact, significant exposure to subprime securities like RMBS and CDOs is what caused financial powerhouses such as Citigroup, UBS and Merrill Lynch to take writedowns in the tens of billions over the past year. Further, exposure to about $2 billion worth of RMBS and CDOs contributed to the collapse of Bear Stearns.

At a press conference today, SEC Chairman Christopher Cox noted that the “shortcomings” at the three agencies included issues related to the management of conflicts of interests, as well as problems with internal audit processes. Cox also said that the report, which covered the period from 2002 to 2006, revealed that rating agency employees “struggled” while trying to keep pace with the increasing number, and the complexity, of RMBS and CDO deals that have materialized since 2002. In fact, the report points out that as the deal volume increased, so did the revenues the firms derived from rating RMBS and CDOs, inferring that a conflict of interest in the issuers pay model exists.

Other deficiencies called out in the report include a lack of disclosure about the ratings process for RMBS and CDOs; substandard documentation of ratings policies and procedures; insufficient documentation regarding the rationale for deviating from models to adjust ratings; and lagging surveillance processes in updatin ratings, compared to “robust” initial ratings processes.

Although the SEC report did not tie particular deficiencies to specific agencies, it did release E-mail exchanges that underscored what Cox characterized as problems that were “boiling over” at the agencies. For example, in an E-mail exchange highlighting the pressure to adapt to the increase workload, one analyst complained to another that the firm’s model did not capture “half” the deal’s risk, while adding that the deals “could be structured by cows and we would still rate it.” In another exchange, an analytical manager in one agency’s real estate group wrote that, “staffing issues, of course, make it difficult to deliver the value that justifies our fees.”


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