Written Testimony Concerning SEC Oversight of Credit Rating Agencies
Submitted by the United States Securities and Exchange Commission
Before the United States Senate Committee on Banking, Housing and Urban Affairs
August 5, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee:
Thank you for the opportunity to submit for the record testimony concerning the Commission’s oversight of credit rating agencies since the enactment of the Credit Rating Agency Reform Act of 2006 (“Rating Agency Act”). As you requested, this testimony describes the rules we have implemented to date as well as the Commission staff’s July 2008 examination findings concerning certain credit rating agencies. It also provides a summary of ideas presented at our April 2009 Roundtable on credit rating agencies.
In September 2006, Congress passed the Rating Agency Act with the stated goals of improving ratings quality and fostering accountability, transparency, and competition in the credit rating industry. Primarily, the Rating Agency Act:
In June 2007, the Commission approved rules implementing a registration and oversight program for NRSROs under the Rating Agency Act, with the rules becoming effective that same month. Over the next year, ten credit rating agencies registered with the Commission as NRSROs. Also, in response to credit market turmoil, beginning in August 2007 the Commission staff conducted an examination of the NRSROs most active in rating residential mortgage-backed securities backed by subprime mortgage loans and collateralized debt obligations linked to such loans. In February 2009, the Commission adopted a second round of rules to address issues raised by the role played by NRSROs in the credit market turmoil. As you requested, this testimony describes these actions in detail.
II. The Commission Oversight Program for NRSROs
The first round of post-Rating Agency Act rulemaking established the Commission’s rating agency oversight program. Specifically, in June 2007 the Commission adopted six rules (Rules 17g-1, 17g-2, 17g-3, 17g-4, 17g-5 and 17g-6) and an application and ongoing disclosure form (“Form NRSRO”).
Rule 17g-1, among other things, requires an NRSRO to disclose information about the: (1) firm’s ratings performance statistics (e.g., default and transition statistics); (2) firm’s methodologies for determining credit ratings; (3) firm’s policies for preventing the misuse of material non-public information; (4) firm’s organizational structure; (5) firm’s code of ethics; (6) conflicts of interest inherent in the firm’s activities; (7) firm’s policies for managing conflicts of interest; (8) general qualifications of the firm’s credit analysts; and (9) identification and qualifications of the firm’s designated compliance officer.
Rule 17g-2, among other things, requires an NRSRO to make and retain certain financial records; document the identities of the credit analysts who determine a rating action and persons who approve the rating action; document the identities of issuers that have paid for ratings and the ratings determined for them; and document all ratings methodologies. NRSROs also are required to retain records such as compliance and internal audit reports, marketing materials, and communications (e.g., emails) relating to determining ratings actions.
Rule 17g-3, among other things, requires an NRSRO, on a confidential basis, to furnish the SEC with annual reports that include: (1) audited financial statements; (2) an unaudited report of revenues received from the different types of rating services offered by the NRSRO; (3) an unaudited report of the aggregate and median compensation of the NRSRO’s credit analysts; and (4) an unaudited report of the 20 largest clients of the NRSRO as determined by revenues received.
Rule 17g-4, among other things, requires an NRSRO to establish, maintain and enforce procedures reasonably designed to prevent the inappropriate dissemination of material, non-public information received during the rating process; the trading of securities while in possession of material, non-public information; and the selective disclosure of a pending ratings decision.
Rule 17g-5, among other things, requires an NRSRO to disclose and manage each conflict of interest resulting from its business activities, including from the issuer-pay and the subscriber-pay models. It also prohibits an NRSRO from having the following conflicts: (1) receiving more than 10% of its annual revenues from a single client; (2) having an analyst rate or approve the rating for a security the analyst owns; (3) rating an affiliate; and (4) having an analyst rate or approve the rating for a security of a company where the analyst is a director or officer of the company.
Rule 17g-6, among other things, prohibits an NRSRO from engaging in certain practices that are unfair, coercive or abusive. Such practices include: (1) conditioning a rating on the rated person buying another service of the NRSRO; (2) deviating or threatening to deviate from established methodologies for determining credit ratings because an issuer did not agree to pay for the rating; (3) modifying or threatening to modify a rating because the issuer does not agree to continue to pay for the rating; and (4) employing a methodology for rating structured finance products that discounts or “notches,” for anticompetitive purposes, the ratings of other NRSROs for assets underlying the structured finance product.
In response to the role played by NRSROs in the credit market turmoil and informed by the Commission staff’s first round of NRSRO examinations (as discussed in Section III below), the Commission adopted a second round of rules in February 2009. Most of the new requirements specifically target the rating process for structured finance products. The new rules require the following, among other things:
III. 2008 Examination of S&P, Moody’s and Fitch Subprime RMBS and CDO Rating Process
In August of 2007, the Commission’s staff initiated examinations of three NRSROs — Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s Ratings Services — to review their policies and practices related to rating subprime residential mortgage-backed securities (“RMBS”) and collateralized debt obligations (“CDOs”) linked to subprime RMBSs.
The examination review period generally covered January 2004 through July 2008. The firms under examination had become subject to regulation as NRSROs when they registered with the Commission in September 2007. All three NRSROs agreed to undertake remedial actions as a result of the examinations. The staff published a summary of the examination’s findings and observations in July 2008.
A. Staff’s Findings and Recommendations
1. Increased Deal Volume and Complexity
The staff found a substantial increase in the number and complexity of RMBS and CDO deals beginning in 2002, and also that some of the NRSROs appeared to struggle with the growth. Staffing increases with respect to CDOs at two NRSROs did not appear to match the increases in deal volume. Internal documents at two of the NRSROs appeared to reflect struggles to adapt to the increased deal volume and complexity. As a result of these findings, the staff recommended that the NRSROs evaluate whether they had sufficient staff and resources to manage their volume of business.
2. Disclosure of Ratings Process
The staff found that significant aspects of the ratings process were not always disclosed. For example, relevant ratings criteria were not fully disclosed. In addition, the NRSROs made “out of model adjustments” without documenting the rationale for such adjustments. Accordingly, the staff recommended that each NRSRO review whether it was fully disclosing its ratings methodologies with respect to RMBS and CDOs.
3. Documentation of Ratings Policies and Procedures
The staff found that the NRSROs’ policies and procedures for rating RMBS and CDOs could be better documented. None of the NRSROs had consolidated and comprehensive written procedures for rating RMBS and CDOs. This lack of full documentation impaired the staff’s ability to review deals and ratings criteria, and, the staff believed, could impair an internal auditor’s ability to review the deals and ratings criteria. The staff also found that the NRSROs did not appear to have specific policies and procedures to identify or address errors in their models or methodologies. As a result of these findings, the staff recommended that each NRSRO review whether its written policies and procedures used to determine credit ratings for RMBS and CDOs were fully documented.
4. Documentation of the Ratings Process
The staff discovered that the NRSROs did not always document significant participants and steps in the ratings process. For example, RMBS and CDO deal records did not always document the rationale for deviations from the model or out of model adjustments. There was also a lack of documentation of committee actions and decisions and sometimes no documentation of committee attendees. As a result of these findings, the staff recommended that each NRSRO conduct a review of its current policies and practices for documenting the credit ratings process.
5. Surveillance Processes
The staff found that the NRSROs’ surveillance processes appeared to be less robust than their initial ratings processes. Lack of resources appeared to impact the timeliness of the surveillance efforts. Moreover, there was poor documentation of the surveillance that was conducted. For example, one NRSRO could provide no documentation of the surveillance performed. The staff also found that two NRSROs did not have internal written procedures documenting the steps that their surveillance staff should undertake to monitor RMBS and CDOs. As a result of these findings, the staff recommended that each NRSRO conduct a review to determine if adequate resources were devoted to surveillance of outstanding RMBS and CDO ratings.
6. Management of Conflicts of Interest
Each of the examined NRSROs operates under the “issuer pays” model, in which the arranger or other entity that issues the security also is seeking the rating and pays the NRSRO for the rating. While each NRSRO had policies and procedures restricting analysts from participating in fee discussions with issuers, the policies at each of the firms still allowed key participants in the ratings process to participate in fee discussions. The staff observed that the analysts appeared to be aware, when rating an issuer, of the firm’s business interest in securing the rating. In addition, the NRSROs did not appear to take steps to prevent the possibility that considerations of market share and other business interests could influence ratings or ratings criteria. Accordingly, the staff recommended that each NRSRO consider and implement steps that would insulate or prevent the possibility that considerations of market share and other business interests could influence ratings or ratings criteria.
The staff also observed that each NRSRO had adopted policies prohibiting employees from owning any security that was subject to a credit rating by a team on which the employee was a member. However, the NRSROs varied in how rigorously they monitored or prevented prohibited transactions, including personal trading by their employees, from occurring. As a result of its findings, the staff recommended that each NRSRO conduct a review of its policies and procedures for managing the securities ownership conflict of interest to determine whether these policies are reasonably designed to ensure that employees’ personal trading is appropriate and complies with the requirements of NRSRO regulations.
7. Internal Audits
The staff found that the internal audits of the ratings processes of two NRSROs appeared to be inadequate. At one NRSRO, the internal audits of its RMBS and CDO groups constituted a one-page checklist limited in scope to evaluate the completeness of deal files. That NRSRO provided only four examples where the reviewer forwarded findings to management and no examples of any management response. The examination of another NRSRO’s internal audits of its RMBS and CDO groups uncovered numerous shortcomings, including the failure of management to formally review/validate derivative models prior to posting for general use. As a consequence of these findings, the staff recommended that two of the NRSROs review whether their internal audit functions are adequate and whether they provide for proper management follow-up.
8. Due Diligence Practices
The staff found that the NRSROs did not engage in any due diligence or otherwise seek to verify the accuracy or quality of the loan data underlying the RMBS pools they rated during the review period. The rating agencies each relied on the information provided to them by the sponsor of the RMBS.
During the examination period, NRSROs were not required to verify the information contained in RMBS loan portfolios presented to it for rating. Additionally, rating agencies were not required to insist that issuer perform due diligence, nor were the agencies required to obtain reports concerning the level of due diligence performed by issuers. Notwithstanding the lack of regulatory requirement to do so, all the NRSROs implemented, or announced that they would implement, measures designed to improve the integrity and accuracy of the loan data they receive on underlying RMBS pools.
B. Ongoing NRSRO Examination Program
Since issuing the July 2008 public report, the Commission staff has been monitoring the examined NRSROs as they continue to address the staff’s examination findings. In addition, staff has initiated examinations of other NRSROs. Finally, the Commission recently allocated resources for a branch of examiners dedicated specifically to NRSRO oversight. Once fully staffed, this branch will conduct routine, special and cause examinations of the NRSROs to review their activities for compliance with the Rating Agency Reform Act and SEC rules.
IV. Roundtable on Credit Rating Agencies
On April 15, 2009, the Commission held a “Roundtable to Examine Oversight of Credit Rating Agencies” at its Washington, D.C. headquarters (“Roundtable”). Roundtable participants included individuals from investor organizations, financial services associations, government agencies, credit rating agencies, and academia. Discussion topics at the Roundtable included issues related to recent Commission rulemaking initiatives, such as conflicts of interest, competition, and transparency. The Commission received a number of proposals from participants with suggestions on how to improve the regulation of NRSROs. The Commission does not necessarily endorse any of the proposals received, each of which received varying levels of support at the Roundtable. Ideas and proposals by Roundtable participants, among others, included: establishing compensation models to replace the issuer pay model in order to address conflicts of interest;1 transitioning away from reliance on credit ratings to market-based measures of credit risk, including credit spreads and credit default swap spreads;2 increasing disclosure regarding the information underlying a particular credit rating to NRSROs not hired to issue a rating and to other market participants in order to enable the development or alternative ratings;3 and removing the NRSROs’ exemption from misstatements in registration statements in Section 11 of the Securities Act of 1933 and their exemption from liability as experts under Securities Act Rule 436, and also adopting legislation indicating that NRSROs are subject to private rights of action under specified statutory criteria. 4
All of the written statements of the panel participants as well as the transcript of the Roundtable are available on the Commission’s Web site.5
V. Looking Forward
As previously noted, in February 2009, the Commission adopted several measures to increase transparency and accountability at NRSROs to address concerns about the integrity of their credit rating procedures and methodologies. In conjunction with the adoption of these new measures, the Commission proposed an additional amendment which would require NRSROs to disclose on a 12-month delayed basis ratings history information for 100% of all issuer-paid credit ratings determined on or after June 26, 2007.6 On the same date, the Commission re-proposed an amendment that would prohibit an NRSRO from issuing a rating for a structured finance product paid for by the product’s issuer, sponsor, or underwriter unless the information about the product provided to the NRSRO is made available to other NRSROs.7 The Commission also previously had proposed rules concerning use of different rating symbols8 and removing references to NRSRO credit ratings from Commission rules and forms.9 The Commission is assessing the comments received in response to all of these proposals and working towards taking appropriate action this summer.
In addition, at the direction of Chairman Schapiro, the Commission staff has been exploring possible new regulations in this area, such as proposals to require disclosure of rating shopping by issuers. One possible approach would be to require disclosure by issuers of all pre-ratings obtained from NRSROs prior to selecting a firm to conduct a rating, in conjunction with other disclosures. The Commission staff also has been exploring possible requirements that would result in enhanced NRSRO’s internal controls and greater disclosure of the nature of their business activities.
Furthermore, the Commission has allocated resources to establish a branch of examiners dedicated specifically to conducting examination oversight of the NRSROs. This branch will conduct routine, special and cause examinations of the ratings agencies to review compliance with the Rating Agency Act and SEC rules. These actions in combination with the Commission’s regulatory efforts should help to establish a stronger oversight regime for NRSROs.
The Chairman recently testified that the Commission is committed to working with Congress to ensure a strong and robust regulatory framework for credit rating agencies and noted her personal belief that legislation to require mandatory registration by credit rating agencies would be a significant step forward. The recent financial regulatory reform legislation submitted to Congress by the Administration includes such a proposal as well as other proposals for addressing the oversight of credit rating agencies. As this Committee considers this and other related proposals, the Commission stands ready to lend our expertise or provide other assistance as may be helpful. Thank you again for the opportunity to discuss these important issues.
1 See letter from Joseph A. Grundfest and Eugenia Petrova, Stanford Law School and The Rock Center on Corporate Governance, (File No. 4-579), dated April 9, 2009; letter from Mayree Clark and Andrew Jones, (File No. 4-579), dated April 9, 2009; letter from Alex J. Pollock, Resident Fellow, American Enterprise Institute, (File No. 4-579), dated April 15, 2009.
2 See letter from Frank Partnoy, George E. Barrett Professor of Law and Finance, University of San
Diego School of Law, San Diego, California, (File No. 4-579), dated April 15, 2009.
3 See letter from Ethan Berman, RiskMetrics Group, (File No. 4-579), dated April 15, 2009 (“Berman Letter”); letter from James H. Gellert, President and CEO, and Dr. Patrick James Caragata, Founder and Executive Vice Chairman, Rapid Ratings International, Inc., (File No. 4-579), dated April 15, 2009.
4 See letter from Gregory W. Smith, General Counsel, Colorado Public Employees’ Retirement
Association, (File No. 4-579), dated April 8, 2009.
6 See “Re-proposed Rules for Nationally Recognized Statistical Rating Organizations”, February 2, 2009, http://www.sec.gov/rules/proposed/2009/34-59343.pdf, (“February 2, 2009 Re-proposing Release”).
7 See February 2, 2009 Re-proposing Release.
8 See “Proposed Rules for Nationally Recognized Statistical Rating Organizations”, June 16, 2008, http://www.sec.gov/rules/proposed/2008/34-57967.pdf, (“June 16, 2008 Proposing Release”).
9 See “References to Ratings Of Nationally Recognized Statistical Rating Organizations”, July 1, 2008, http://www.sec.gov/rules/proposed/2008/34-58070.pdf, (“July 1, 2008 Proposing Release, 34-58070”), “Security Ratings”, July 1, 2008, http://www.sec.gov/rules/proposed/2008/33-8940.pdf, (“July 1, 2008 Proposing Release, 33-8940”), and “References to Ratings of Nationally Recognized Statistical Rating Organizations”, July 1, 2008, http://www.sec.gov/rules/proposed/2008/ic-28327.pdf, (“July 1, 2008 Proposing Release, IC-28327”).