Rating Agency Reforms

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Rating Agency Reforms Overview: Rating agencies have long been under criticism both for conflicts of interest and for the quality of their output. These criticisms have only intensified in the wake of the 2008 financial crisis, during which rating agencies did a notoriously poor job collectively. The principal charges leveled against them are:

  • Rating agencies are paid by the companies and governments whose securities they evaluate, rather than by the investors who rely on their opinions.
  • They have a long history of flagging problems much too late, once they are apparent to other observers.

Conflicts of Interest: The calls for reform stem from conflicts of interest that can impair the agencies’ objectivity. Follow the link for details.

May 13, 2010 U.S. Senate Measure: On May 13, 2010 the U.S. Senate passed a measure that established a board under SEC oversight that would start unwinding the current system, rife with conflicts of interest, in which issuers choose their own rating agencies. Instead, this board would assign a rating agency to provide the “initial rating.” The first implementation of this process was to be with certain types of asset backed securities.

May 2011 SEC Proposal: The SEC followed up by proposing that rating agencies:

  • Bar their salespeople from having input on ratings
  • Release greater detail on the methodology behind each rating
  • Conduct a review if an analyst goes to work for a company that he or she rated, or for an investment banking firm that subsequently underwrites a securities offering for that company

See “SEC Aims to Tighten the Rules on Raters,” The Wall Street Journal, 5/19/2011.

The SEC’s 2008 Rating Agency Reforms: Rating agencies faced new SEC regulations in 2008. However, a bold program of reform proposed by the SEC in June 2008, and subsequently endorsed by an influential international organization of academics called the Financial Economists Roundtable (FER), got trimmed to a much more modest set of final regulations issued on December 3, 2008. The initial set of proposals had four main parts.

First, there was a provision for improved public disclosures. The rating agencies would have to reveal their track records in predicting defaults, disclose the data used in their models, and reveal their procedures for verifying data and for reviewing and modifying ratings. Publishing statistical analyses of their upgrades and downgrades by asset type also would be required.

Second, there was a proposal to require an overhaul of procedures for rating complex securities, such as MBS. Many MBS were granted unjustifiably high ratings, giving investors a false sense of confidence in them and thus contributing heavily to the 2008 market meltdown. When the rating agencies proved completely unreliable in assessing the risk associated with MBS, this damaged the credibility of all their ratings, thereby increasing the severity of the credit crisis.

Third, the SEC had suggested reducing the use of ratings in its regulations. Veteran Wharton finance professor Marshall Blume felt that this was the most important proposal of all. It would force investors to do more of their own research, and not rely too much on the rating agencies, with all their conflicts of interest and analytical failures.

The only June 2008 SEC proposal adopted in December 2008 dealt with conflicts of interest. A rating agency must recuse itself from rating a security that it helped to design. Also, employees of rating agencies must refuse gifts from clients worth more than $25.

“It’s a quarter of a loaf at best,” said another Wharton finance professor, Richard Herring, though he was encouraged that the Obama transition team asked the FER for its views on reforming the rating agencies.

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