Rating Agencies Face More Scrutiny

September has not been a good month for rating agencies. Earlier in the month, U.S. District Court Judge Shira Scheindlin ruled that agency ratings were not deserving of broad protection under the First Amendment of the U.S. Constitution. Now, California Attorney General Edmund Brown Jr. launched an investigation into credit rating agencies' role in fueling the financial crisis, and the Securities and Exchange Commission (SEC) voted to increase oversight credit ratings agencies.

 Brown issued subpoenas to Standard & Poor's (S&P), Moody’s and Fitch to determine whether the firms violated California law when they gave "stellar ratings to shaky assets." He contends that at the peak of the housing boom, these agencies gave their highest ratings to complicated financial instruments—including securities backed by subprime mortgages—making them appear as safe as government-issued Treasury bonds. "Standard & Poor's, Moody's and Fitch put their seal of approval on high risk mortgage-backed securities, recklessly giving stellar ratings to shaky assets that proved toxic to the entire financial system," Brown says. "This investigation is meant to determine how these agencies could get it so wrong and whether they violated California law in the process."

Brown is directing the agencies to provide by Oct. 19, 2009, information that will help conclude whether:

• the rating agencies failed to conduct adequate due diligence in the rating process;

• the rating agencies gave high ratings to particular securities when they knew or had reason to know that high ratings were not warranted;

• the rating agencies failed to comply with their own codes of conduct in rating certain securities;

• the rating agencies profited from giving inaccurate ratings to particular securities;

• the rating agencies made fraudulent representations concerning the quality or independence of their ratings;

• the rating agencies compromised their standards and safeguards for profits;

• the rating agencies' statistical models captured the risk inherent in subprime and other risky assets and, if not, what was the rating agencies' response; and

• the rating agencies conspired with the companies whose products they rated to the detriment of investors.

S&P tells INN that the agency has received the subpoena and is reviewing it. Moody’s and Fitch did not respond at press time.

The California attorney general isn’t the only governing body to question the actions of rating agencies. The SEC voted unanimously to bolster oversight of credit ratings agencies by enhancing disclosure requirements.

The Commission voted to adopt or propose measures intended to improve the quality of credit ratings by requiring greater disclosure, fostering competition, helping to address conflicts of interest, shedding light on rating shopping and promoting accountability.

"These proposals are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security," says SEC Chairman Mary Schapiro. "That reliance did not serve them well over the last several years, and it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust."

In 2006, Congress passed the Credit Rating Agency Reform Act that provided the SEC with authority to impose registration, recordkeeping and reporting rules on credit rating agencies registered as Nationally Recognized Statistical Rating Organizations (NRSRO). Currently, 10 credit rating agencies—Fitch, Moody’s and S&P included—are registered with the Commission as NRSROs.

Among the Commission's actions to create a stronger, more robust regulatory framework for credit rating agencies:

• Adopted rules to provide greater information concerning ratings histories—and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.

• Proposed amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.

• Adopted amendments to the Commission's rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.

• Reopened the public comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.

• Proposed new rules that would require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any "preliminary ratings" were obtained from other rating agencies—in other words, whether there was "ratings shopping."

• Voted to seek public comment on whether to amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.

In more negative ratings news, The Wall Street Journal (WSJ) reports that recently departed Moody's Corp. analyst Eric Kolchinsky contends inflated ratings are still being issued. He said Moody's Investors Service gave a high rating to a complicated debt security in January 2009 knowing that it was planning to downgrade assets that backed the securities. Within months, the securities were put on review for a downgrade.

According to WSJ, a Moody's spokesman says the firm "takes any allegations of misconduct very seriously." The spokesman said Kolchinsky "refused to cooperate with an investigation" into the issues he raised and was suspended for this refusal with pay.

Kolchinsky, who was a managing director in a nonratings unit and wasn't involved in ratings of the securities in question, says he was invited by congressional investigators to testify on Thursday on ratings-firm reform before the House Committee on Oversight and Government Reform.