Bond-rating agencies agree to reforms

Bond raters have agreed to cooperate with Andrew Cuomo to end the conflict of interest in the credit-rating market.

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NEW YORK (CNNMoney.com) -- In a move to protect investors from shady security-selling practices, major credit-rating firms Moody's, S&P, and Fitch reached a cooperation agreement with New York state Attorney General Andrew Cuomo Thursday.

Cuomo has been probing the ratings agencies' practices for just over a year. Though the investigation is ongoing, the deal attempts to overhaul the ratings firms' incentives for providing their services.

Prior to Thursday's agreement, multiple credit raters would review a residential mortgage-backed security, but only one company would get paid for its services - most often the one that offered the best rating. As a result, ratings agencies benefited from relaxing their ratings standards in order to get the business.

"The industry is basically - in my opinion - operating on a commission basis," said Cuomo at a press conference. "You can go to one agency, and if you didn't like the way the credit-rating process was going, you would go to a different agency."

With the old model, many investors purchased a security they believed to be safe because they had pristine AAA ratings, but in fact many of the assets were of poor quality. Critics and lawmakers have long argued that the rating industry did not adequately warn investors about the risks involved with mortgage investments.

The new agreement would force servicers to pay for every review of their securities - regardless if they end up using the rating - in an attempt to limit the conflicts of interest in the $5 billion-a-year credit-rating industry. That means that a credit rater could offer a harsh rating of a security and would still get paid.

"This is a major, dramatic reform of the system," said Cuomo. "This will increase the integrity of the process, and end the shopping of rates."

Chief operating officer Michel Madelain of Moody's Corp.'s (MCO) Moody's Investors Service; Deven Sharma, president of Standard & Poor's; and Stephen Joynt, chief executive of Fitch Ratings (FIM) all signed Mr. Cuomo's agreement.

But some say the deal does not go far enough. Many critics of the industry say that credit raters should not receive payments at all for the securities they review, and that the incentives led to the the raters' inability to predict the risks of subprime mortgages.

"Not far enough? I don't know what that means," said Cuomo. "Is it a perfect system? No. It's a dramatic overhaul of the system, and it's much, much better."

Separately, the Securities and Exchange Commission (SEC), which oversees the actions of the credit raters, said it is considering requiring the rating agencies to disclose detailed information on mortgages' assets - the basis for which they rate the securities. SEC commissioners are expected to vote on a proposal next week.

After the attorney general's press conference, SEC Chairman Christopher Cox weighed in on the deal, lauding Cuomo for working with the SEC to come to the arrangement.

"The attorney general's actions, as well as the comprehensive new rules for all nationally registered credit rating agencies that the Commission will consider next week, are motivated by our mutual desire to promote ratings with integrity and curb the questionable practices that contributed to the credit market turmoil," Cox said in a statement.

The three major credit raters, perhaps in anticipation of SEC legislation, downgraded thousands of mortgage-backed securities in 2008. Those securities have plummeted in value as mortgage delinquencies rose astronomically over the past year.