Credit Raters Face New SEC Rules

Restrictions on conflicts of interest are designed to prevent rating agencies from pandering to the bond issuers that pay the bills.

Credit-rating firms, whose lapses played a central role in the 2008 financial crisis, will face new restrictions on conflicts of interest under rules adopted by the U.S. Securities and Exchange Commission (SEC).

The rules, approved on a 3-2 vote today, require firms including Moody’s Investors Service and Standard & Poor’s to ensure they follow internal methods when grading debt and revising ratings. They will also have to boost disclosure on their accuracy, including a common way of presenting default and downgrade rates for bonds backed by loans for homes and commercial buildings.

Seeking to prevent graders from pandering to the bond issuers, who pay for the ratings, the rules include a strict prohibition on allowing sales motives to influence them. Firms also would have to re-examine the ratings of analysts who leave to join companies whose products they rated.

“This package of reforms will improve the overall quality of credit ratings and protect against the re-emergence of practices that contributed to the recent financial crisis,” SEC Chair Mary Jo White said in a statement before today’s vote.

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.

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 rules require that firms such as S&P, Moody’s, and Fitch Ratings Ltd. establish internal controls over the quality of ratings, including policies that provide for public input on their ratings methodologies and a judgment of whether some innovative securities are simply too complex to rate.

“The Commission’s examinations of the rating agencies continue to identify situations where agencies fail to follow their procedures and methodologies for producing ratings,” Commissioner Luis A. Aguilar, a Democrat, said today.

The SEC’s detailed requirements for internal controls are too prescriptive, said Commissioner Michael Piwowar, who voted against the requirements. Piwowar, a Republican, also objected to the ban on sales and marketing, which he said was too broad.

“This new rule text sets an impossible standard for compliance and has no limiting principle,” Piwowar said at today’s meeting.

 

'Critical Protections'

The SEC also unanimously approved a separate set of rules that enhance protections for investors who buy bonds backed by mortgages, auto loans and leases, and commercial buildings. Sellers of the bonds will have to provide investors with loan-level data that can be used to judge the riskiness of the securities. The details include the borrowers’ debt levels and credit scores, according to two people briefed on the plan.

The new requirements would apply to the $750 billion market for private mortgage-backed securities, which imploded in 2008 and financed just 1 percent of new mortgages in 2013.

Banks eligible to accelerate sales of asset-backed bonds with minimal SEC review will have to provide an executive’s certification that investor disclosures are accurate. They also will have to provide a process for reviewing soured assets that may be eligible to be repurchased.

“The reforms before us today will add critical protections for investors and strengthen our securities markets by targeting products, activities, and practices that were at the center of the financial crisis,” White said in a statement before the vote. “Investors will have powerful new tools for independently evaluating the quality of asset-backed securities and credit ratings.”

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