SEC Staff Report On Credit Rating Agencies: Conflicts

The SEC staff issued a summary report discussing its examinations of three credit rating agencies which were key in the subprime residential mortgage-backed securities (“RMBS”) and collateralized debt obligations (“CDO”) markets from January 2004 to the present. The report raises significant questions about the procedures and conflicts of three key rating agencies in those markets, Fitch Ratings, Ltd, Moody’s Investor Services, Inc. and Standard & Poor’s Ratings Services. Summary of Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, July 2008, (“Report”).

The Report begins with an overview of the regulatory structure and the RMS and CDO markets. The existing regulatory structure stems from The Rating Agency Reform Act of 2006 (“Act”). That Act provided for registration in certain instances and added Section 15E to the Exchange Act. The Act also amended Exchange Act Section 17(a), giving the SEC authority to require reporting and record keeping requirements and examination authority. The 2006 Act however expressly prohibited the SEC from regulating the substance of credit ratings. In June 2007, the SEC adopted certain rules to implement these provisions.

Key findings from the Report include:

? Some rating agencies appeared to struggle with the substantial growth in the RMBS and COD deals. The internal documents from two rating agencies suggest a struggle to handle the work load. For example, one internal e-mail notes in part that an issue had been “poorly addressed – needs to be checked in the next deal … .” Report at 12, n. 7. Another e-mail states in part 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. ;o)’.” Id. at n. 8.

? Relevant rating criteria were not always disclosed, although the agencies made claims to the contrary. In some instances there was a lag between the time the firm implemented changes to its criteria and the date at which it published notice of the changes. In some instances, e-mails indicated that the firm used an unpublished model to assess data.

? None of the rating agencies had specific written procedures for rating RMBS and CDOs. In addition, the agencies did not appear to have specific policies and procedures to identify or address errors in their models or methodologies. Likewise, the agencies did not always document significant steps in the process, including the rationale for deviations from their model and for Rating Committee actions and decisions.

? Instances were discovered where the rating agencies failed to follow their internal procedures.

? While rating agencies are required to establish, maintain and enforce policies and procedures reasonably designed to address and manage conflicts of interest, there are, in fact, significant conflicts.

a) In the “issuer pays” model, the arranger or other entity that issues the security also seeks the rating. While each agency has policies and procedures which address this, those policies allow key participants in the rating process to participate in fee discussions. Indeed, the Report found that rating agencies do not appear to prevent consideration of market share and other business considerations.

b) One e-mail quoted in the Report noted: “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision [on assigning separate ratings to principal and interest] and if so, how much?” Id. at 26.

c) Another quoted e-mail notes in part: “[w]e are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals.” Id. at 26.

d) According to the Report, there are conflicts with respect to all asset classes that receive rating but in the “issuer pays” model in rating “structured finance products, particularly RMBS and related-CDOs, [it] may be exacerbated … the arranger is often the primary designer of the deal and as such, has more flexibility to adjust the deal structure to obtain a desired credit rating as compared to arrangers of non-structured asset classes. As well, arrangers that underwrite RMBS and CDO offerings have substantial influence over the choice of rating agencies hired to rate the deals.” Id. at 31.

In the wake of the recent market turmoil, and as the staff conducted the inspections which resulted in the Report, the SEC proposed additional Rules in June 2008. Proposed Rules for Nationally Recognized Statistical Rating Organizations, June 16, 2008. These Proposed Rules are keyed in part to the findings in the Report.