Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


E. Preventing Inflated Credit Ratings

Weak credit rating agency performance has long been a source of concern to financial regulators. Many investors rely on credit ratings to identify "safe" investments. Many regulated financial institutions, including banks, broker-dealers, insurance companies, pension funds, mutual funds, money market funds, and others have been required to operate under restrictions related to their purchase of "investment grade" versus "noninvestment grade" financial instruments. When credit agencies issue inaccurate credit ratings, both retail investors and regulated financial institutions may mistakenly purchase financial instruments that are riskier than they intended or are permitted to buy. The recent financial crisis has demonstrated how the unintended purchase of high risk financial products by multiple investors and financial institutions can create systemic risk and endanger, not only U.S. financial markets, but the entire U.S. economy.

Even before the recent financial crisis, the SEC and Congress had been reviewing the need for increased regulatory oversight of the credit rating industry. In 1994, for example, the SEC "issued a Concept Release soliciting public comment on the appropriate role of ratings in the federal securities laws, and the need to establish formal procedures for recognizing and monitoring the activities of [credit rating agencies]." |1221|

In 2002, the Senate Committee on Governmental Affairs examined the collapse of the Enron Corporation, focusing in part on how the credit rating agencies assigned investment grade credit ratings to the company "until a mere four days before Enron declared bankruptcy." |1222| The Committee issued a report finding, among other things, that the credit rating agencies:

    "failed to detect Enron's problems – or take sufficiently seriously the problems they were aware of – until it was too late because they did not exercise the proper diligence. … [T]he agencies did not perform a thorough analysis of Enron's public filings; did not pay appropriate attention to allegations of financial fraud; and repeatedly took company officials at their word … despite indications that the company had misled the rating agencies in the past." |1223|

The report also found the credit rating "analysts [did] not view themselves as accountable for their actions," since the rating agencies were subject to little regulation or oversight, and their liability for poor quality ratings was limited by regulatory exemptions and First Amendment protections. |1224| The report recommended "increased oversight for these rating agencies in order to ensure that the public's trust in these firms is well-placed." |1225|

In 2002, the Sarbanes-Oxley Act required the SEC to conduct a study into the role of credit rating agencies in the securities markets, including any barriers to accurately evaluating the financial condition of the issuers of securities they rate. |1226| In response, the SEC initiated an in-depth study of the credit rating industry and released its findings in a 2003 report. The SEC's oversight efforts "included informal discussions with credit rating agencies and market participants, formal examinations of credit rating agencies, and public hearings, where market participants were given the opportunity to offer their views on credit rating agencies and their role in the capital markets." |1227| The report expressed a number of concerns about CRA operations, including "potential conflicts of interest caused by the [issuer - pays model]." |1228|

The Credit Rating Agency Reform Act, which was signed into law in September 2006, was designed to address some of the shortcomings identified by Congress and the SEC. The Act made it clear that the SEC had jurisdiction to conduct oversight of the credit rating industry, and formally charged the agency with designating companies as NRSROs. |1229| The statute also required NRSROs to meet certain criteria before registering with the SEC. In addition, the statute instructed the SEC to promulgate regulations requiring NRSROs to establish policies and procedures to prevent the misuse of nonpublic information and to disclose and manage conflicts of interest. |1230| Those regulations were designed to take effect in September 2007.

In the summer of 2007, after the mass downgrades of RMBS and CDO ratings had begun and as the financial crisis began to intensify, the SEC initiated its first examinations of the major credit rating agencies. According to the SEC, "[t]he purpose of the examinations was to develop an understanding of the practices of the rating agencies surrounding the rating of RMBS and CDOs." |1231| The examinations reviewed CRA practices from January 2004 to December 2007. In 2008, the SEC issued a report summarizing its findings. The report found that "there was a substantial increase in the number and in the complexity of RMBS and CDO deals," "significant aspects of the ratings process were not always disclosed," the ratings policies and procedures were not fully documented, "the surveillance processes used by the rating agencies appear to have been less robust than the processes used for initial ratings," and the "rating agencies' internal audit processes varied significantly." |1232| In addition, the report raised a number of conflict of interest issues that influenced the ratings process, noted that the rating agencies failed to verify the accuracy or quality of the loan data used to derive their ratings, and raised questions about the factors that were or were not used to derive the credit ratings. |1233|

Although the Credit Rating Agency Reform Act of 2006 strengthened oversight of the credit rating agencies, Congress passed further reforms in response to the financial crisis to address weaknesses in regulatory oversight of the credit rating industry. The Dodd-Frank Act dedicated an entire subtitle to those credit rating reforms which substantially broadened the powers of the SEC to oversee and regulate the credit rating industry and explicitly allowed investors, for the first time, to file civil suits against credit rating agencies. |1234| The major reforms include the following:

    a. establishment of a new SEC Office of Credit Ratings charged with overseeing the credit rating industry, including by conducting at least annual NRSRO examinations whose reports must be made public;

    b. SEC authority to discipline, fine, and deregister a credit rating agency and associated personnel for violating the law;

    c. SEC authority to deregister a credit rating agency for issuing poor ratings;

    d. authority for investors to file private causes of action against credit rating agencies that knowingly or recklessly fail to conduct a reasonable investigation of a rated product;

    e. requirements for credit rating agencies to establish internal controls to ensure high quality ratings and disclose information about their rating methodologies and about each issued rating;

    f. amendments to federal statutes removing references to credit ratings and credit rating agencies in order to reduce reliance on ratings;

    g. a GAO study to evaluate alternative compensation models for ratings that would create financial incentives to issue more accurate ratings; and

    h. an SEC study of the conflicts of interest affecting ratings of structured finance products, followed by the mandatory development of a plan to reduce ratings shopping. |1235|

The Act stated that these reforms were needed, "[b]ecause of the systemic importance of credit ratings and the reliance placed on credit ratings by individual and institutional investors and financial regulators," and because "credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the United States economy." |1236|

To further strengthen the accuracy of credit ratings and reduce systemic risk, this Report makes the following recommendations.

    1. Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory authority to rank the Nationally Recognized Statistical Rating Organizations in terms of performance, in particular the accuracy of their ratings.

    2. Help Investors Hold CRAs Accountable. The SEC should use its regulatory authority to facilitate the ability of investors to hold credit rating agencies accountable in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or recklessly fails to conduct a reasonable investigation of the rated security.

    3. Strengthen CRA Operations. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy.

    4. Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record for issuing poor quality assets.

    5. Strengthen Disclosure. The SEC should exercise its authority under the new Section 78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required new ratings forms by the end of the year and that the new forms provide comprehensible, consistent, and useful ratings information to investors, including by testing the proposed forms with actual investors.

    6. Reduce Ratings Reliance. Federal regulators should reduce the federal government's reliance on privately issued credit ratings.


1221. 1/2003 "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets," prepared by the SEC, at 5. [Back]

1222. 10/8/2002 "Financial Oversight of Enron: The SEC and Private- Sector Watchdogs," prepared by the U.S. Senate Committee on Governmental Affairs, at 6. See also "Rating the Raters: Enron and the Credit Rating Agencies," before the U.S. Senate Committee on Governmental Affairs, S.Hrg. 107- 471 (3/20/2002). The Committee has since been renamed as the Committee on Homeland Security and Governmental Affairs. [Back]

1223. 10/8/2002 "Financial Oversight of Enron: The SEC and Private- Sector Watchdogs," prepared by the U.S. Senate Committee on Governmental Affairs, at 6, 108. [Back]

1224. Id. at 122. [Back]

1225. Id. at 6. [Back]

1226. Section 702 of the Sarbanes- Oxley Act of 2002. [Back]

1227. 1/2003 "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets," prepared by the SEC, at 4. [Back]

1228. Id. at 19 . [Back]

1229. 9/3/2009 "Credit Rating Agencies and Their Regulation," report prepared by the Congressional Research Service, Report No. R40613 (revised report issued 4/9/2010). [Back]

1230. Id. [Back]

1231. 7/2008 "Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies," prepared by the SEC, at 1. The CRAs examined by the SEC were not formally subject to the Credit Rating Agency Reform Act of 2006 or its implementing SEC regulations until September 2007. [Back]

1232. Id. at 1- 2. [Back]

1233. Id. at 14, 17- 18, 23- 29, 31- 37. [Back]

1234. See Title IX, Subtitle C – Improvements to the Regulation of Credit Rating Agencies of the Dodd- Frank Act. [Back]

1235. See id. at §§ 931- 939H; "Conference report to accompany H.R. 4173," Cong. Report No. 111- 517 (June 29, 2010). [Back]

1236. See Section 931 of the Dodd- Frank Act. [Back]

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