Credit Raters to Face New Conflict Curbs Under SEC Rules

By Dave Michaels  

Credit-rating firms, whose lapses played a central role in the 2008 financial crisis, will face new restrictions on conflicts of interest under rules set to be adopted by the U.S. Securities and Exchange Commission.
Firms including Moody’s Investors Service and McGraw Hill Financial Inc.’s Standard & Poor’s would have to ensure they follow internal methodologies when grading debt and revising ratings under rules commissioners will consider at a meeting in Washington today. They will also have to disclose more about the accuracy of ratings, including a common way of presenting rates of defaults and downgrades.
The rules seek to prevent raters from lowering their standards to win business after subprime mortgage bonds carrying inflated grades helped fuel the
worst financial meltdown since the Great Depression. Ratings companies are paid to grade bonds by the firms selling them, which means they can lose business to rivals that offer higher ratings.
“These guys face huge incentives for rating inflation right now,” said Marcus Stanley, policy director for Americans for Financial Reform. “You’ve got to create an incentive on the other side that there will be something negative that happens to you if you inflate ratings.”
The Financial Crisis Inquiry Commission said in its January 2011 report that debt graders led by S&P and Moody’s helped ignite the credit squeeze that began in August 2007 by lowering standards to win business. Investors who bought the complex bonds often relied on ratings that indicated the securities had a very low probability of default.

Dodd-Frank Directive

The Dodd-Frank Act of 2010, enacted in response to the credit crisis, directed the SEC to institute controls on the firms’ conflicts of interest and ensure their rating symbols -- such as Moody’s Aaa or S&P’s AAA -- are applied consistently among securities including corporate bonds, sovereign debt and mortgage-backed securities.
The Consumer Federation of America has met with SEC Chair Mary Jo White and other agency officials in recent months to ask for changes that would make ratings more comparable across different types of bonds, said Barbara Roper, the group’s director of investor protection.
“This is directly related to how and why the rating agencies were able to assign AAA ratings to securities whose risks they did not understand and couldn’t measure,” Roper said in a phone interview.

Investors’ Reliance

The SEC also will vote today on a separate set of rules intended to reduce investors’ reliance on credit ratings. The rules require sellers of bonds backed by mortgages and auto loans to give investors data that can be used to judge the riskiness of the debt. The details include the borrowers’ income and credit scores, according to two people briefed on the plan.
Securities backed by loans for houses, autos and commercial real estate would fall under the rules, which require more extensive disclosure to bond buyers than the SEC’s initial 2010 plan, the people said. The agency’s vote comes amid a surge in subprime auto loans that are being fed into securities, a business being probed by U.S. prosecutors.
The SEC requirements would extend to private sales of asset-backed securities, which historically have been exempted from reporting to the agency.