SEC blows whistle on bond raters

Credit crisis update

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Issue #1: America's Money - Everyday on CNN

NEW YORK (CNNMoney.com) -- Government officials said Tuesday that the country's three largest credit raters failed in their reviews of subprime mortgage-backed securities.

In a press conference in Washington, D.C., on Tuesday, U.S. Securities and Exchange Commission Chairman Christopher Cox said that the agency's 10-month examination found failures by the three largest firms - Standard & Poor's, Moody's Investors Service (MCO) and Fitch Ratings (FIM).

"After an extensive examination of the adequacy of the credit ratings agencies ... we uncovered serious shortcomings in these firms," said Cox.

The $5 billion-a-year ratings industry plays an important role, issuing ratings on the creditworthiness of companies and securities so investors can determine the risks of a particular investment. But the three largest firms have been criticized for failing to identify risks in securities backed by subprime mortgages.

Cox cited a lack of disclosure, improper and inadequate documentation of policies, and insufficient attention to conflicts of interest as reasons behind their failure to identify those risks. He said the agencies were unable to keep up with the explosion in complex securities, especially subprime mortgage-backed securities.

"Sometimes the firms deviated from models and procedures, and sometimes they cut corners when not properly staffed," said Cox.

Since August, the SEC has been investigating inadequacies in the credit rating agencies. They looked at hundreds of thousands of internal records and e-mails that dated as far back as January 2004.

Still, the findings in the report were hardly surprising.

"This wasn't groundbreaking," said H. Sean Mathis, managing director of the boutique investment bank Miller Mathis. "It was more a critique of process rather than a framework to go forward."

The three major credit raters downgraded thousands of mortgage-backed securities in 2008. The agencies were publicly criticized by Congress and others as those securities plummeted in value after mortgage delinquencies rose astronomically over the past year.

The SEC voted 3-0 last month to tentatively approve rules that would "promote ratings with integrity and curb the questionable practices that contributed to the credit market turmoil," according to Cox. The new regulations are designed to stem conflicts of interest, expand disclosure in the rating industry and encourage new firms to enter.

Earlier in June, Moody's, S&P, and Fitch also reached a cooperation agreement with New York state Attorney General Andrew Cuomo in an attempt to overhaul the firms' incentives for providing their services.

"The good news is many of these problems have been fixed in real time," said Cox. "Each firm has agreed to meet our measures."

Prior to the recent regulations, 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.

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.

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.

But some say the new regulations do 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.

"I don't think the SEC has gotten there yet on this issue," said Mathis. "The regulations will have a slight positive effect, but the key is not to [micromanage] the rating process but to set a good framework."

S&P, Moody's and Fitch each said they would continue working with regulators.

"We remain dedicated to helping restore confidence in our capital markets, and we look forward to working with the commission as we take these additional steps," said an S&P spokesman.

For its part, Moody's said through a spokesman that it "has initiated a wide range of reforms that refine our analytical methodologies ... to enhance ratings performance quality and expand the usefulness of our ratings, research and analytical tools for all market participants."

A Fitch spokesman said that "Fitch continues to view a number of the SEC's recently proposed rules regarding the practices of credit rating agencies as a positive step forward ... and is currently in the process of updating its policies, procedures and code consistent with the recent SEC proposals."