Speech by SEC Staff:
Opening Remarks before the Commission Open Meeting
Erik R. Sirri
Director, Division of Trading and Markets
U.S. Securities and Exchange Commission
June 11, 2008
Thank you Chairman Cox.
You have before you proposed rule amendments that would further implement the Credit Rating Agency Reform Act of 2006. The proposed rules are designed both to address concerns about the role that NRSROs played in the market turmoil related to subprime loans, and to strengthen to robustness and transparency of the ratings process generally. In mid-2006, there was an increase in subprime loan delinquencies and defaults, which caused substantial adverse effects on the markets for RMBS backed by subprime loans and on CDOs linked to such loans. These impacts extended beyond RMBS and CDOs to the broader credit markets and the economy as a whole. Homeowners, employees, investors, local governments, and financial institutions have all suffered substantially from this credit market turmoil. As a result, the parties, including NRSROs, which played a substantial role in the origination, securitization, and sale of subprime RMBS and CDOs, have come under increased scrutiny.
The rules proposed today will address additional conflicts of interest, some of which will be prohibited outright, to protect the integrity of the ratings process. In addition, the proposed rules would require enhanced disclosures by NRSROs that we believe will increase the transparency of the ratings process. I would now like to describe each of the proposed amendments.
1. Additional Conflicts of Interest — Amendments to Rule 17g-5
As currently written, Rule 17g-5 identifies a series of conflicts arising from the business of determining credit ratings. Some of these conflicts must be disclosed and managed, while others are specifically prohibited. The Commission is proposing to amend Rule 17g-5 to require disclosure and establishment of procedures to manage one additional conflict of interest and to prohibit certain other conflicts outright.
In the case of structured finance products, we believe that the "issuer/underwriter pay" model creates a specific conflict because certain arrangers of structured finance products repeatedly bring ratings business to the NRSROs. As sources of constant revenue, active arrangers have the potential to exert great influence over an NRSRO relative to a corporate issuer that brings fewer ratings business to the NRSRO. To address this concern, we would identify the following as a new conflict of interest that must be disclosed and managed: issuing or maintaining a credit rating for a structured finance transaction that was paid for by an issuer, sponsor, or underwriter of a security or money market instrument. An NRSRO would need to manage this conflict by requiring as a condition of rating a structured finance product that certain specified information about the assets underlying the instrument would be disclosed through a means designed to provide reasonably broad dissemination of the information.
We believe that this disclosure would create an opportunity for other NRSROs to rate the product, and these "unsolicited ratings" could be used by market participants to evaluate the ratings issued by the NRSRO that was hired to rate the product. In addition, we believe that this proposal will foster competition by making it easier for NRSROs that are not contracted by an arranger to rate structured finance products and establish a track record for rating such products.
We are also proposing to add three new prohibited conflicts of interest to Rule 17g-5. First, an NRSRO would be prohibited from issuing a credit rating with respect to an obligor or security where the NRSRO or person associated with an NRSRO made recommendations to the obligor or the issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the obligor or the issuer of the security. Second, a person within an NRSRO who has responsibility for participating in determining credit ratings or for developing or approving procedures or methodologies used for determining credit ratings may not participate in any fee discussions or arrangements. Finally, the amendments to Rule 17g-5 would prohibit an NRSRO from allowing a credit analyst who participated in determining or monitoring a credit rating, or a person responsible for approving a credit rating, from receiving gifts, including entertainment, from the obligor being rated, or from the issuer, underwriter, or sponsor of the securities being rated, other than the items provided in the context of normal business activities such as meetings, if such gifts have an aggregate value that exceeds $25. We believe these prohibitions are appropriate because they address potential practices at an NRSRO that could impair its objectivity and quality of its rating.
2. Records of Rating Actions — Amendments to Rule 17g-2
We are also proposing amendments to Rule 17g-2 relating to the records of rating actions. The first proposed amendment would require an NRSRO to make and retain records of all rating actions and make such records publicly available in an Interactive Data format. The records should include the rating action performed, the name of the security or obligor and, if applicable, the CUSIP for the security or the CIK number for the rated obligor, and the date of the rating action. Ratings actions such as the initial rating, upgrades, downgrades, and placement on watch for upgrades and downgrades should be included in the records. We believe that having this data publicly available will foster greater accountability of the NRSROs by making it easier for persons to analyze the actual performance of each NRSRO and compare this performance across NRSROs.
The second proposed amendment to Rule 17g-2 requires that if a quantitative model is a substantial component of the ratings process, the NRSRO will need to keep a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued. We believe that this proposal will enhance the recordkeeping processes of the NRSROs, which will help Commission examiners reconstruct the analytical process by which a credit rating was determined.
Finally, the Commission is proposing to amend Rule 17g-2 to require than an NRSRO retain records of any complaints regarding the performance of a credit analyst in determining credit ratings. We believe that requiring an NRSRO to keep such records will assist the Commission in reviewing how NRSROs address conflicts of interest that could impair the integrity of the ratings process.
3. Amendments to the Instructions for Form NRSRO
We are proposing a number of amendments to the instructions of Form NRSRO to enhance the disclosures that NRSROs must provide to the Commission. Currently, the instructions to Exhibit 1 of Form NRSRO require NRSROs to disclose performance measurement statistics over the short-term, mid-term, and long-term periods, as reflected in the statute. The proposed amendments to these instructions would require the disclosure of separate sets of default and transition statistics for each asset class of credit ratings for which an applicant is seeking registration as an NRSRO and would require that these disclosures be broken out over 1, 3, and 10 year periods. In addition, we are proposing to change the language of the instructions in Exhibit 1 of Form NRSRO. Currently, the instructions require an NRSRO to provide "downgrade and default rates" as its performance measurement statistics. We are proposing to change this language to "ratings transition and default rates" to clarify that the upgrades as well as downgrades should be included in the statistics. Finally, we are proposing to amend the instructions to Exhibit 1 to specify that the default statistics must show defaults relative to the initial rating and incorporate defaults that occur after a credit rating is withdrawn. We believe these enhanced disclosures will allow investors to improve their evaluations of how credit ratings of an NRSRO perform on a class-by-class basis.
The proposed rules also amend the instructions to Exhibit 2 of Form NRSRO to require enhanced disclosures about the procedures and methods an NRSRO uses to determine credit ratings. We are proposing enhanced disclosures in three additional areas. First, an NRSRO will need to disclose whether and, if so, how much verification performed on assets underlying or referenced by the structured finance transaction is relied on in determining the credit rating. Second, an NRSRO will need to disclose whether and, if so, how assessments of the quality of originators of structured finance transactions play a part in the determination of the credit ratings. The third part of this rule will address the surveillance process of ratings. An NRSRO will need to disclose how frequently credit ratings are reviewed, and whether different models or criteria are used for ratings surveillance than for determining initial ratings, whether changes made to models and criteria for determining initial ratings are applied retroactively to existing ratings, and whether changes made to models and criteria for performing ratings surveillance are incorporated into the models and criteria for determining initial ratings. We believe that these additional disclosures will provide greater clarity to investors and other market participants about the NRSROs' rating process.
4. Reporting Requirements — Amendments to Rule 17g-3
We are proposing to amend Rule 17g-3 to require an NRSRO to provide the Commission with an annual report of the number of credit rating actions during the fiscal year in each class of security for which the NRSRO is registered. We believe this proposed amendment is necessary or appropriate in the public interest because it will help the Commission in its examination function. An increase in the number of ratings actions could be the result of a process for monitoring ratings that has been compromised by improper practices such as having prohibited conflicts, or engaging in unfair, coercive or abusive conduct. These results could be fleshed out during the examination process.
5. Special Reporting of Symbols for Structured Finance Products — New Rule 17g-7
For the second part of the staff proposal, the Commission is proposing new Rule 17g-7 to help ensure that investors understand that the risk characteristics for structured finance products are different than the risks for other types of similarly rated instruments. This new rule would require an NRSRO to publish a report to accompany every structured finance credit rating that describes the ratings methodology used to determine the credit rating and how it differs from a rating for any other type of obligor or debt security and how the risks associated with structured finance securities are different from the risks associated with other types of rated obligors or debt securities. An NRSRO could choose not to publish the report if it instead used ratings symbols for structured finance products that differentiated them from the credit ratings for other types of debt securities. We believe that proposed Rule 17g-7 will encourage investors to perform greater levels of internal risk assessment of structured finance products by putting them on notice that these products have different characteristics than other types of rated debt instruments. We recognize, however, that many market participants do not believe that the symbology approach will be effective, particularly from a cost-benefit analysis. We have asked the public to comment on such a proposal in the proposing release.
I would like to thank Deputy Director Bob Colby, Mike Macchiaroli, Tom McGowan, Randall Roy, Joe Levinson, Carrie O'Brien, Sheila Schwartz, Rose Russo Wells and Catherine Moore for their hard and diligent work on this project as well as our colleagues within the Commission.
We are happy to answer any questions you have on the proposed rules.