The Big Three credit rating agencies — Standard & Poor’s, Moody’s, and Fitch Group — control about 95% of the market. They played a pivotal role in causing the 2008 financial meltdown. Rules adopted by the SEC Wednesday are intended to bring integrity back to the ratings process.
There’s a conflict of interest between rating products and selling services. Under the SEC’s new rules, the agencies will have to insulate the ratings process from sales and marketing and impose stricter internal controls.
“Many believe the rating agencies were not just facilitators of the crisis — they were its linchpin,” SEC Commissioner Luis A. Aguilar said in a statement Wednesday.
The agencies legitimized mortgage-backed securities and CDOs that flooded the market during the housing bubble.
Selling those products was possible “only because the rating agencies assured investors [they] were virtually risk free,” Aguilar said.
When the agencies were willing to give the products risk-free grades, “these assurances, in turn, emboldened issuers to create ever more toxic structured products.
The cost to the U.S. economy when the housing bubble burst, Aguilar said, was $15 trillion.
Where were the rating agencies’ compliance departments when all this was happening?
Compliance was pushed aside or out the door and replaced with sales and marketing, or co-opted completely into the sales effort.
In his statement Wednesday, Aguilar described what he called the “bleak reality” of what went wrong:
We know now that the rating agencies’ paramount concern in the years leading up to the crisis was to maximize their revenues and market share. This led the rating agencies to appease certain clients by lowering ratings criteria, failing to require reasonable due diligence reviews, and delaying the implementation of improved ratings models. As a result, the ratings issued on structured products became less and less defensible. In fact, employees of one rating agency likened their ratings to a “scam” and a “house of card[s]” that was destined to falter. The desire to maximize revenues also led some rating agencies to nullify or co-opt their internal controls programs. In a vivid illustration of this, one rating agency demoted its chief compliance officer and replaced much of his staff with the very analysts whose work the compliance department was supposed to oversee. And, a former senior analyst of another rating agency contends that the compliance department followed management’s directive to inappropriately pressure analysts whom clients viewed as being uncooperative.
Without functioning compliance departments, the ratings agencies acted not as gatekeepers and protectors of investors, as they were supposed to, Aguilar said. Instead they “allowed issuers of structured products to prey on investors.”
Louis Aguilar has been an SEC Commissioner since 2008. He was appointed by President George W. Bush and reappointed by President Obama in 2011.
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The SEC’s new rules are: Nationally Recognized Statistical Rating Organizations, Securities Exchange Act Release No. XXXXX (August 27, 2014) (File No. S7-18-11).
The SEC’s August 27, 2014 announcement about the new rules and when they’re effective is here.
Richard L. Cassin is the publisher and editor of the FCPA Blog. He can be contacted here.