Tag: Nationally Recognized Statistical Rating Organizations

The SEC and Rating Agencies

The SEC examined all 10 firms registered Nationally Recognized Statistical Rating Organization (.pdf 23 pages) and found all 10 had “apparent failures”. The SEC has requested remediation plans from each of the agencies within 30 days and is continuing its investigation.

The issues found included “apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest.”

Personally, I think the rating agencies have not gotten enough of the blame for their roles in the events leading up to the 2008 financial crisis. Without the golden top rating they issued to the toxic mortgage-backed securities,  I think the popping of the housing bubble would not have been so vicious.

In 2006, the Credit Rating Agency Reform Act granted the authority to establish a registration and oversight program for credit rating agencies to the SEC and gave them oversight over those credit rating agencies that register with the Commission as Nationally Recognized Statistical Rating Organizations (“NRSROs”). However, it expressly prohibits the SEC from regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.

The Dodd-Frank Wall Street Reform and Consumer Protection Act enhanced the regulation and oversight by imposing new reporting, disclosure, and examination requirements. The new law also requires the SEC to conduct an examination of each NRSRO at least annually.  The 2011 Summary Report of t Commission’s Staff Examinations of Each Nationally Recognized Statistical Rating Organization (.pdf 23 pages) is the first to look at the ten under the new framework.

  1. A.M. Best Company, Inc.
  2. DBRS Inc.
  3. Egan-Jones Rating Company
  4. Fitch, Inc.
  5. Japan Credit Rating Agency, Ltd.
  6. Kroll Bond Rating Agency
  7. Moody’s Investors Service, Inc.
  8. Morningstar Credit Ratings, LLC
  9. Rating and Investment Information, Inc.
  10. Standard & Poor’s Ratings Services

The SEC did not determine that any finding discussed in this Report constitutes a “material regulatory deficiency”. That would have meant a referral to the Division of Enforcement and gotten more lawyers involved. The SEC does not single out by name any credit-rating agency for questionable actions in the report, but it does describe specific problems it found.

It will be interesting to see what happens next year. As most compliance people know, the failure to fix a problem pointed out by the SEC is likely to lead to trouble the next time they show up.

Sources:

Nationally Recognized Statistical Rating Organization (.pdf 23 pages)

Credit Rating Agency Investigated for Fraud

The SEC brought an action against LACE Financial for issues with its independence. We also learned that the SEC had investigated whether rating agency Moody’s Investors Service, Inc. violated the registration provisions or the antifraud provisions of the federal securities laws.

Moody’s was working on a rating for some new European securities. They ended up giving the security an Aaa rating. They later discovered a problem with their model and found a coding error. After finding the error, a Moody’s rating committee met and discussed the problem.

They made no change to the outstanding credit rating. The SEC found smoking gun emails that showed rating committee members were concerned about the impact on Moody’s reputation if it revealed an error in the rating model.

“In this particular case we seem to face an important reputation risk issue. To be fully honest this latter issue is so important that I would feel inclined at this stage to minimize ratings impact and accept unstressed parameters that are within possible ranges rather than even allow for the possibility of a hint that the model has a bug.”

That does not sound like the company was living up to the principle of the Rating Agency Act to “improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry.”

The SEC declined to bring an enforcement action “of uncertainty regarding a jurisdictional nexus to the United States in this matter.” The rating committee responsible for the credit ratings of the rated securities met in France and the United Kingdom. The rated securities were arranged by European banks and marketed in Europe.

The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions of the Securities Act of 1933 or the Exchange Act involving “conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors” or “conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act, Pub. L. No 111-203, § 929P(b)(1), (2) (2010) (to be codified at 15 U.S.C. §§ 77v(c), 78aa(b)). NRSROs should expect that the Commission, where appropriate, will pursue antifraud enforcement actions, including pursuant to such jurisdiction.

It sure sounds like the SEC is looking hard at rating agencies and their culpability for the Great Panic of 2008.

Sources:

Credit Rating Agencies and Conflicts of Interest

Personally, I place a big chunk of blame on the Credit Rating Agencies for the Great Panic of 2008. They were throwing AAA ratings at piles of garbage. There is an inherent conflict in the rater being paid by the security issuer instead of the security purchaser. They are beholden to the customer and the customer wants a great rating for its security.

Exchange Act Rule 17g-5(c)(1) prohibits a Nationally Recognized Statistical Rating Agency from issuing or maintaining a credit rating solicited by a person that, in the most recently ended fiscal year, provided the NRSRO with net revenue equaling or exceeding 10 percent of the total net revenue of the NRSRO for the fiscal year.

“The Commission’s rules were designed to further the goals of the Rating Agency Act to “improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry.” To meet these goals, it is critical that firms provide accurate information to the Commission and the public in their Form NRSROs and financial reports, that they do not have prohibited conflicts, and that they establish, maintain, and enforce policies and procedures to address conflicts of interest.”

LACE Financial submitted an application to register as an NRSRO on October 31, 2007. LACE also requested an exemption from the 10 percent rule, which the SEC granted. LACE requested the exemption because LACE’s largest client (“Firm A”) provided LACE with more than ten percent of LACE’s total revenue during fiscal year 2007. Firm A managed Collateralized Debt Obligation (“CDO”) and hired LACE to prepare regular reports that Firm A distributed to investors in these CDOs.

According to the SEC Release, in an attempt to keep the 2007 revenue from Firm A as close as possible to ten percent of its total revenues for the year, LACE postponed billing Firm A for reports completed during December 2007 until January 2008. In its exemption request letter, LACE stated that its estimated annual revenues from Firm A for 2007 would be $119,000 when calculated on a cash basis and $179,000 when calculated on an accrual basis. “The total value of work performed for Firm A by LACE during 2007 was in fact $233,268.28, approximately 28 percent of LACE’s revenues for the year when properly calculated on an accrual basis as required by GAAP.”

LACE got slapped with a civil money penalty in the amount of $20,000 and an injunction not to break the law again. They also charged Damyon Mouzon, the president of LACE, blaming him for trying to shift revenue and deliberately hide the conflict of interest.

It seems clear to me that the rating agencies were not trying to protect investors. They were trying to generate revenue. That means keeping their clients, the securities issuers happy.

Sources:

SEC Attacks the Rating Agencies

The SEC took its first swing at the failure of credit rating agencies by serving a Wells Notice on Moody’s Investor Service.

At issue, according to the Moody’s filing, is the determination in 2007 that members of one of its European rating committees “engaged in conduct contrary to Moody’s Code of Professional Conduct.”  Members of a credit committee knew that some of the products had been given inflated ratings because of a problem in the company’s risk modeling software.

Moody’s is one of only 10 Nationally Recognized Statistical Rating Organizations under the Credit Rating Agency Reform Act of 2006.

The disclosure in Moody’s 10-Q states that the SEC “is considering recommending that the SEC institute administrative and cease-and-desist proceedings against MIS in connection with MIS’s initial June 2007 application on SEC Form NRSRO to register as a nationally recognized statistical rating organization under the Credit Rating Agency Reform Act of 2006.” The theory is that Moody’s description of its procedures and principles were “rendered false and misleading” as of the time the application because of the Company’s finding that a rating committee policy had been violated.

The case reminds me of the Hennessee Group action where the SEC brought an action against a hedge fund for failing to conduct adequate diligence. The reason was that the hedge fund claimed that they had a particular due diligence program, but failed to follow the program. The diligence failure by itself was not actionable, but failing to live up to your self-professed standards made it actionable.

It sounds the SEC is making a similar case against Moody’s. In their application, they claimed to have a certain procedure but failed to follow it. We all know that credit agencies did a poor job of rating CDOs. That by itself caused damages but may not be actionable. So the SEC is going after them for failing to follow their own self-professed standards and policies.

It’s too early to tell what may happen. A worst case scenario would be removing Moody’s status as a NRSRO.  Obviously that would be a nuclear option that would destroy the company. The SEC action sounds like it is related to Moody’s ratings of just one type credit product, so the effects might be minimal.

Will the SEC go after the other rating agencies? or will Moody’s be the sacrificial lamb to warn the others?

Sources: