Credit rating agencies were the drivers of the financial crisis. Their AAA stamps of approval encouraged investors to purchase massive quantities of subprime mortgage-backed securities. As we now know, these assurances of complete safety led investors right into a toxic meltdown.
This was entirely foreseeable: Rating agencies get paid to rate securities by the companies who issue them. This places an inherent conflict of interest at the heart of their business model: If they make it easier for a client to sell questionable securities by rating them highly, then that client will return with future business. Examples of rating inflation abound, and even the Justice Department, which has shown little willingness to go to trial over financial fraud, has an active $5 billion lawsuit against Standard and Poor’s for granting AAA ratings to securities the company knew was junk.
But despite bipartisan efforts in the Dodd-Frank financial reform law to overhaul the flawed rating agency compensation model, it remains in place four years later. This week, the Securities and Exchange Commission (SEC) tried to attack the conflict of interest issue once again, with new reporting requirements and a broad promise of enforcement. But to believe that the SEC will actually police rating inflation, you would have to ignore all of its recent history.
Senators Al Franken and Roger Wicker passed an amendment into Dodd-Frank in 2010, with 64 votes, where the SEC would randomly assign securities to nationally accredited rating agencies, and increased or decreased their workload annually based on performance. The more accurate the ratings, the more business the SEC would give the rating agency.
However, the Franken-Wicker amendment got watered down in the final version of Dodd-Frank. Instead, the SEC was required only to issue a study about rating-agency conflict of interest, and then implement rules that either used the random assignment model, or some other solution deemed more “feasible.”
The SEC waited two-and-a-half years to release the study, which gave the rating agencies and industry participants significant space to argue that their industry should not be overhauled. And the new rules, released yesterday, do not follow the Franken-Wicker model whatsoever. “Although we’ve made some progress to fix Wall Street since the 2008 financial meltdown, I’m frustrated that my amendment to end the pay-to-play scheme in the credit rating industry still isn’t fully implemented,” said Senator Franken in an emailed statement.
In its place, the SEC’s new rules set up an internal-control structure at the rating agencies, which ensures review of the methods used to generate effective ratings. The CEO must deliver and sign a report attesting to his company’s internal controls every year. Other “look-back” reviews will determine whether conflicts of interest led to rating inflation, and change any affected credit rating. The SEC added other disclosure mandates, forcing rating agencies to publish their methodologies, credit-rating histories, and additional information for investors. And the ratings themselves must be consistent across all asset classes—in other words, AAA must mean the same thing, regardless of the type of bond.
Finally, the rules prohibit anyone involved in sales and marketing to play a role in determining the credit rating. According to the SEC, if it finds violations of this rule, they will suspend or revoke the registration of that rating agency—a measure that could prove to have real teeth. “Today’s reforms will help protect investors and markets against a repeat of the conduct and practices that were central to the financial crisis,” said SEC chair Mary Jo White.
Most reform advocates believe the rules improve upon an initial 2011 version, which they criticized for letting the rating agencies to determine their own standards. However, instead of fundamentally restructuring the rating agency business, the SEC loaded on a series of paperwork requirements to the current system. Older internal risk-management controls on financial institutions, such as those in the Sarbanes-Oxley Act, have not led to any significant enforcement, despite mountains of evidence that those controls were violated (the entire financial crisis being one example).
The prohibition of sales and marketing conflicts offers promise, but the SEC has not shown itself to be a tough cop for a long time. Its own career lawyers have blasted the agency for an enforcement policy that “polices the broken windows on the street level and rarely goes to the penthouse floors.” Documents released in April show that the SEC effectively colluded with banks on prosecutions over collateralized debt obligations (CDOs), assuring them that they would only face small cash penalties. Even federal judges have questioned the SEC’s lack of desire to investigate fraud claims, instead chasing quick and cheap settlements.
It doesn’t take a genius to figure out when credit ratings have been inflated. There tons of examples of a rating agency downgrading the ratings on thousands of similar bonds at once. Under Dodd-Frank authority, the SEC could seriously sanction rating agencies after downgrades, but they have declined to do so. In 2010, Standard and Poor’s and other rating agencies mass-downgraded “re-REMICs,” basically collections of all the mortgage-backed securities nobody would buy, remixed into a new and allegedly safe security. The SEC never investigated. Perhaps the new rules give the SEC additional tools, but it also needs something sorely lacking lately: will.
A second set of rules released yesterday would force banks to deliver more details to investors about securities, which could reduce reliance on rating agencies as the sole source of information about their quality. However, the rules contain a massive loophole, because they don’t extend disclosure to “private placements,” where bonds get sold privately to sophisticated investors rather than on the public market. Banks could simply shift their sales into private placements to avoid the requirement.
Too much of the financial industry relies on duping investors about the quality of investments. The SEC is supposed to be the first line of defense against that, but has failed in that mission repeatedly in recent years. That feeds skepticism about its seriousness in combating fraud at the rating agencies, especially since it refused to alter the inherently flawed compensation model. As long as the rating agencies get paid by issuers, they’ll have incentives to please them with high ratings.
“There’s a fundamental business incentive for ratings inflation, and there’s got to be something on the other side,” said Marcus Stanley of Americans for Financial Reform. “This rule could do that, but it’s a very tough challenge.”