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.

Meanwhile, another E-mail note from an analyst in an agency’s CDO group quoted his manager as saying that the rating agencies continue to create an “even bigger monster — the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Cox asserted that more evidence is needed to connect any one E-mail or instant message to specific problems, but said the “take away” from the report is that credit agency employees revealed “generalized concerns about laxity and stated norms” in their exchanges.

The report also found that while conflicts of interest exist in issuer-pays models, with respect to rating all asset classes, rating structured finance products, particularly RMBS and related CDOs, “may be exacerbated for a number of reasons.” For instance, the report cited how the deal arranger is often the primary designer, and therefore has more flexibility to adjust the structure to obtain a desired credit rating, compared to arrangers of non-structured asset classes. What’s more, arrangers that underwrite RMBS and CDO offerings have substantial influence over the choice of rating agencies hired to rate deals.

In addition, the report pointed out a high concentration of firms conducting the underwriting function, which in turn, concentrates the rating agencies revenue stream. Based on data provided by the three rating agencies examined in the report, the SEC reviewed a sample of 642 deals. Of those, 22 different arrangers underwrote subprime RMBS deals, and 12 of them accounted for 80 percent of the transactions, both in number and dollar volume. Similarly, for the 368 CDOs of RMBS deals, 26 different arrangers underwrote the CDOs, with 11 arrangers accounting for 92 percent of the deals and 80 percent of the dollar volume. Also, 12 of the largest 13 RMBS underwriters were also the 12 largest CDO underwriters.

At the press conference, the SEC did not release names of arrangers, but it noted that they were publicly available.

Cox explained that Congress addressed some of the problems cited in the report when it regulated credit rating agencies in September 2007, mandating the companies to register as nationally recognized statistical rating organizations (NRSROs). That subjected the agencies to certain disclosure and policy rules. Further, a set of proposed rules issued in June by the SEC, and currently out for public comment, address many of the remaining issues noted in the report.

For example, one proposed rule would prohibit agencies from issuing a rating on a structured product, unless information on the characteristics of the assets underlying the product was available to other credit rating agencies. This would allow other agencies to rate the product and potentially expose ratings that were influenced by the product’s sponsor. Another proposed rule would prohibit anyone participating in discussions about ratings fees to rate a product, while another potential rule would ban analysts from taking gifts amounting to more than $25 from issuers.

The SEC said that it has made several recommendations for remedial action, and that all three agencies have agreed to put the SEC’s recommendations into action.

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