Credit rating reform

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The financial crisis has shone the spotlight anew on the major credit rating agencies. Ask any number of institutional investors, the SEC, members of Congress, or corporate titans about what should be done to ensure transparency and accountability in the credit rating process, and you’ll likely get as many answers. Here are two different schools of thought.

The word from the SEC
Fewer perceived conflicts and more competition

The scope of the rules

To decrease the likelihood of conflicts of interest, new SEC rules prohibit a Nationally Recognized Statistical Rating Organization (NRSRO) from issuing a credit rating if it consulted or made recommendations regarding the securities’ issuance.

New SEC rules also require that an NRSRO disclose (1) the degree to which the assets underlying a structured finance vehicle have been verified, (2) how the quality of the originator of the structured product was assessed, and (3) whether the models used for determining the initial ratings of a structured product change as time goes on. In addition, a credit rating agency will have to make public a random sample of 10 percent of issuer-paid credit ratings and their subsequent histories for each class of assets for which the NRSRO has issued 500 or more ratings.

The SEC’s approach is to remove potential conflicts of interest, increase transparency, and promote competition among registered Nationally Recognized Statistical Rating Organizations.1

The SEC has not yet decided whether it will require credit rating agencies to provide other NRSROs with issuer-supplied information used in creating ratings.

The word from Capitol Hill
Restrict the kinds of products that agencies can rate

The bill

Congressmen Gary Ackerman (D–N.Y.) and Michael Castle (R–Del.) recently reintroduced H.R. 1181, a bill that would greatly increase the power of the SEC to regulate NRSROs.

Under this proposed legislation, the SEC would be charged with the responsibility of setting the parameters for the kinds of structured finance products on which credit rating agencies could opine. It would also gain the authority to revoke an organization’s NRSRO status. In addition, the bill requires that NRSROs review, on an annual basis, all of their ratings and issue affirmations.

Legislation could empower the SEC to define which types of asset-backed financial instruments NRSROs would be permitted to rate.

While it’s still unclear how ambitious the level of financial regulatory reform will be under the 111th Congress, there’s little doubt that credit rating agency reform is one of the items on the table—suggesting that H.R. 1181 could be at least a starting point for discussion.

1 The SEC’s most recent set of rules will most likely take effect in mid-April 2009, upon
publication in the Federal Register.