Roundtable to Examine Oversight of Credit Rating Agencies
The Commission originally adopted the term "NRSRO" in 1975 solely for determining capital charges on different grades of debt securities under the Commission's net capital rule for broker-dealers. Over time, however, the NRSRO concept was incorporated into a number of additional SEC rules and regulations, and used by Congress and other regulatory bodies, including banking regulators both at home and abroad. In 2006, Congress provided the Commission with authority to oversee credit rating agencies that seek to be treated as NRSROs for purposes of laws and regulations using the term. The Commission used that authority to establish a program for registration and oversight of NRSROs, effective in June 2007. The Commission adopted additional rules in February 2009, in part in response to the role that NRSROs played in rating structured products linked to subprime mortgages. Today's Roundtable is designed to assist the Commission in its continuing efforts to oversee the credit rating industry.
I. Current NRSRO Perspectives: What Went Wrong and What Corrective Steps Is the Industry Taking?
Background: The development of credit risk transfer markets gave rise to an "originate to distribute" model whereby mortgage loans are originated with the intent to securitize them. Under this model, arrangers earn fees from originating, structuring, and underwriting residential mortgage-backed securities (RMBS) and servicing the loans underlying the RMBS, as well as frequently a third set of fees from structuring, underwriting, and managing CDOs composed of RMBS. Moreover, the yields offered by subprime RMBS and CDO tranches (as compared to other types of similarly rated debt instruments) led to increased investor demand for these debt instruments. The originate to distribute model creates incentives for originating high volumes of mortgage loans while simultaneously reducing the incentives to maintain high underwriting standards for making such loans. The continued growth of the housing market through 2006, which led to increased competition among lenders, also contributed to looser subprime loan underwriting standards.
By mid-2006, however, the steady rise in home prices that had fueled this growth in subprime lending came to an end as prices began to decline. Moreover, widespread areas of the country began to experience declines whereas, in the past, poor housing markets generally had been confined to distinct geographic areas. The downturn in the housing market has been accompanied by a marked increase in delinquencies and defaults of subprime loans, including those underlying subprime RMBS. In addition, there has been an increase in the actual realized losses incurred after such loans are foreclosed.
The rising delinquencies and defaults in subprime loans backing the RMBS rated by the NRSROs exceeded the projections on which the NRSROs based their initial ratings. Furthermore, the defaults and foreclosures on subprime loans resulted in realizable losses to the lower RMBS tranches backed by the loans and, correspondingly, to the lower CDO tranches backed by those RMBS. In addition to directly impairing the affected tranche, the losses — by reducing the principal amount of these tranches — decreased the level of subordination protecting the more senior tranches. In other words, losses suffered by the junior tranches of an RMBS or CDO directly reduced the level of credit enhancement — the primary factor considered by NRSROs in rating tranched securities — protecting the senior tranches of the instrument. The result has been substantial ratings downgrades by NRSROs.
The extensive use of subprime RMBS in the collateral pools of CDOs has led to similar levels of downgrade rates for those securities as well. Moreover, the use of subprime RMBS as reference securities for synthetic CDOs magnified the effect of RMBS downgrades on CDO ratings. Surveillance of CDO credit ratings has been complicated by the fact that the methodologies used by the NRSROs to rate them relied heavily on the credit rating of the underlying RMBS or CDOs. Consequently, to adjust the CDO rating, the NRSROs first have needed to complete their reviews of the ratings for the underlying RMBS or adjust their methodologies to sufficiently account for the anticipated poor performance of the RMBS. Ultimately, the NRSROs have downgraded a substantial number of CDO ratings.
The scope and magnitude of these downgrades has caused a loss of confidence among investors in the reliability of RMBS and CDO credit ratings issued by the NRSROs. This lack of confidence in the accuracy of NRSRO ratings has been a factor in the broader dislocation in the credit markets. For example, the complexity of assessing the risk of structured finance products and the lack of commonly accepted methods for measuring the risk has caused investors to leave the market, including the market for AAA instruments, particularly investors that had relied primarily on NRSRO credit ratings in assessing whether to purchase these instruments. This has had a significant impact on the liquidity of the market for these instruments.
In the wake of these events, the NRSROs that rated subprime RMBS and CDOs have come under intense criticism and scrutiny. The NRSRO rules adopted by the Commission in June of 2007 preceded the full emergence of the credit market turmoil. The rule amendments proposed by the Commission in June 2008 and adopted in part and re-proposed in part in December 2008 were designed in response to the turmoil with the goal of further enhancing the utility of NRSRO disclosure to investors, strengthening the integrity of the ratings process, and more effectively addressing the potential for conflicts of interest inherent in the ratings process for structured finance products.
On July 8, 2008, the SEC released findings from extensive 10-month staff examinations of three major credit rating agencies that uncovered significant weaknesses in ratings practices and the need for remedial action by the firms to provide meaningful ratings and the necessary levels of disclosure to investors. The SEC staff's examinations found that rating agencies struggled significantly with the increase in the number and complexity of subprime RMBS and CDO deals since 2002. The examinations uncovered that none of the rating agencies examined had specific written comprehensive procedures for rating RMBS and CDOs. Furthermore, significant aspects of the rating process were not always disclosed or even documented by the firms, and conflicts of interest were not always managed appropriately.
The report summarized generally the remedial actions that credit rating agencies are expected to take as a result of the examinations, including that each NRSRO:
Evaluate whether it has sufficient staff and resources to manage its volume of business and meet its obligations under the Exchange Act and the rules applicable to NRSROs.
Review disclosure of the ratings process and the methodologies used to rate RMBS and CDOs to ensure full compliance with SEC rules. NRSROs should review whether policies governing the timing of disclosure of a significant change to a process or methodology are reasonably designed to comply with applicable SEC disclosure requirements.
Determine whether written policies and procedures used to determine credit ratings for RMBS and CDOs are fully documented.
Review current policies and practices for documenting the credit ratings process and the identities of RMBS and CDO ratings analysts and committee members.
Determine if adequate resources are devoted to surveillance of outstanding RMBS and CDO ratings.
Review practices, policies and procedures for mitigating and managing the "issuer pays" conflict of interest.
Review policies and procedures for managing the securities ownership conflict of interest to determine whether these policies are reasonably designed to ensure that employees' personal trading is appropriate and in compliance with applicable requirements.
(as to two of the NRSROs examined) Review whether internal audit functions, particularly in the RMBS and CDO ratings areas, are adequate and whether they provide for proper management follow-up.
II. Competition Issues: What are Current Barriers to Entering the Credit Rating Agency Industry?
Background: Ten credit rating agencies have applied for and been granted registration as NRSROs. The registered credit rating agencies and the dates of their registration are:
- A.M. Best Company, Inc. (September 24, 2007)
- DBRS Ltd. (September 24, 2007)
- Fitch, Inc. (September 24, 2007)
- Japan Credit Rating Agency, Ltd. (September 24, 2007)
- Moody's Investor Services, Inc. (September 24, 2007)
- Rating and Investment Information, Inc. (September 24, 2007)
- Standard & Poor's Rating Services (September 24, 2007)
- Egan-Jones Rating Company (December 21, 2007)
- LACE Financial Corp. (February 11, 2008)
- Realpoint LLC (June 23, 2008)
There are no applications for registration currently pending before the Commission. The Commission has not instituted any proceedings to determine whether the application of a credit rating agency for registration should be denied.
Of the ten credit rating agencies registered with the SEC as NRSROs, seven operate under the issuer-pay model.1 The remaining three operate under the subscriber-pay model,2 though one of these firms3 is a hybrid in that it also receives fees from issuers to rate structured finance products (a small percentage of its current extant ratings but the revenues have been a significant portion of its total revenues). The NRSROs operating under the issuer-pay model have determined over 98% of the total currently outstanding credit ratings issued by NRSROs.4 Additionally, two subscriber-paid NRSROs determine ratings for structured finance products that are funded primarily by subscriber fees. These firms account for approximately 2.6% of the total NRSRO ratings in structured finance products.5
One of the goals of the Rating Agency Act was to increase competition in the credit rating industry by lowering the barriers to becoming an NRSRO. One way to increase competition would be to make it easier for users of credit ratings to select the NRSROs that are performing best and have the highest quality processes for determining credit ratings. The SEC has adopted rules requiring NRSROs to disclose ratings performance statistics. Another approach is to create a mechanism for NRSROs that are not hired to rate a structured finance product to determine an unsolicited rating. In this regard, the SEC has proposed a rule to require disclosure to all NRSROs of the information used to rate structured finance products. Industry participants have suggested possible additional steps to increase competition,including:
Establishing a centralized global ratings database to facilitate comparisons of ratings.
Establishing a centralized global database of ratings performance statistics to facilitate comparisons of NRSRO accuracy.
Amending the Rating Agency Act to remove requirement that credit rating agency must have been in ratings business for three years before being eligible to register as an NRSRO.
III. Users' Perspectives
Background: The Commission first used the term NRSRO in 1975 in the net capital rule for broker-dealers (Rule 15c3-1) as an objective benchmark to prescribe capital charges for different types of debt securities. Since then, the Commission has used the designation in a number of regulations. Although the use of the term NRSRO was originated for a narrow purpose in the Commission's own regulations, ratings by NRSROs today are used widely as benchmarks in federal and state legislation, rules issued by other financial regulators, in the United States and abroad, and in private financial contracts and investment guidelines.
There is a risk that investors interpret the use of the term in laws and regulations as an endorsement of the quality of the credit ratings issued by NRSROs, which may have encouraged investors to place undue reliance on the credit ratings issued by these entities. Possible supervisory actions to discourage over-reliance on NRSRO ratings include removing the NRSRO concept from applicable statutes and regulations. In a series of three proposing releases issued in July 2008, the Commission proposed taking this step. The Commission received numerous comments on the proposals, many of which were negative.
Another approach may be to provide investors and market observers with the information necessary to perform their own analysis of the risks (credit, market, liquidity) of rated securities, most notably structured finance products. Coupled with this approach could be requirements that NRSROs disclose what their ratings are designed to assess (i.e., creditworthiness) and sufficient information about their methodologies to allow users of credit ratings and market observers to reach their own conclusions about the efficacy of the methodologies.
Other proposed approaches to increase investor understanding of credit ratings and credit rating methodologies that have been suggested by industry participants include:
Requiring that structured finance rating methodologies, including the models and assumptions underlying the models, be disclosed in full so users can replicate ratings.
Requiring independent analysis and validation of NRSRO models for structured finance ratings and publishing the results of the independent review.
Requiring NRSROs to disclose the type of information they review about the assets underlying a structured finance product (e.g., individual loan level information), including the extent to which they pierce layers of a structure to review information about the assets that are the fundamental source of payment streams (e.g., looking through the RMBS underlying a CDO to review information about the mortgage loans underlying the RMBS). Some have suggested that NRSROs be prohibited from rating a structure if they do not pierce all layers of the structure and review information about the ultimate assets.
Requiring that NRSROs differentiate ratings for structured products from ratings for corporate and municipal securities and/or publish measures of the uncertainty or potential volatility associated with ratings.
IV. Approaches to Improve Credit Rating Agency Oversight
Background: The Credit Rating Agency Reform Act of 2006 (Rating Agency Act) was designed to improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating industry. The Rating Agency Act defined the term NRSRO, provided exclusive authority to the Commission to implement registration, recordkeeping, financial reporting and oversight rules with respect to registered credit rating agencies, and directed the Commission to issue final implementing rules. The Rating Agency Act, however, expressly stated that the Commission has no authority to regulate the substance of the credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.
There are a number of self-operative provisions in the Rating Agency Act that directly impose requirements on NRSROs. These include requirements to establish and maintain procedures to prevent the misuse of material non-public information and address and manage conflicts of interest. The statute also requires an NRSRO to designate a compliance officer.
The operative provisions of the Rating Agency Act became applicable upon the Commission's adoption in June 2007 of a series of rules implementing a registration and oversight program for credit rating agencies that register as NRSROs. The initial round of rulemaking provisions related to registration, recordkeeping, filing of annual reports, procedures to prevent the misuse of material non-public information, procedures to disclose and manage conflicts of interest, and prohibitions against engaging in certain activities that are conflicts of interest or are unfair, abusive or coercive.
In June of 2008, in the first of three related actions, the Commission proposed a series of amendments to its existing rules to regulate the conflicts of interests, disclosures, internal policies, and business practices of credit rating agencies registered as NRSROs. The second action taken by the Commission was to propose a new rule that would require NRSROs to distinguish their ratings for structured finance products from other classes of credit ratings by publishing a report with the rating or using a different rating symbol. The third action was proposed to remove references to NRSRO credit ratings from Commission rules. The Commission received over 130 comment letters from a diverse group of market participants in response to the rulemaking proposals, addressing virtually every aspect of the proposed rulemakings.
With respect to the first action, the Commission adopted final rule amendments in December 2008. These new measures:
Require NRSROs to publish performance statistics for 1, 3, and 10 years within each rating category, in a way that facilitates comparison with their competitors in the industry.
Require disclosure by NRSROs of the way they rely on the due diligence of others to verify the assets underlying a structured product.
Require NRSROs to disclose how frequently credit ratings are reviewed; whether different models are used for ratings surveillance than for initial ratings; and whether changes made to models are applied retroactively to existing ratings.
Require NRSROs to make publicly available in Extensible Business Reporting Language ("XBRL") format a random sample of 10% of their issuer-paid credit ratings and their histories for each class of issuer-paid credit rating for which the NRSRO is registered and has issued 500 or more ratings.
Require NRSROs to make and retain records of all rating actions related to a current rating from the initial rating to the current rating.
Require NRSROs to document the rationale for any significant out-of-model adjustments used in determining a credit rating whenever a quantitative model is a substantial component of the credit rating process.
Require NRSROs to retain records of any complaints regarding the performance of a credit analyst in determining, maintaining, monitoring, changing, or withdrawing a credit rating.
Require NRSROs to provide the Commission with an annual report of the number of ratings actions they took in each ratings class for which they are registered as an NRSRO.
Prohibit NRSROs from structuring the same products that they rate.
Prohibit analysts who participate in determining credit ratings from negotiating the fees that issuers pay to be rated.
Prohibit gifts from those who receive ratings to those who rate them, in any amount over $25.
In conjunction with the adoption of these new measures, the Commission proposed an additional amendment which would require NRSROs to disclose ratings history information, in XBRL format, for 100% of all issuer-paid credit ratings determined after June 26, 2007 (the effective date of the Credit Rating Agency Reform Act of 2006). To mitigate concerns regarding the loss of revenues NRSROs derive from selling downloads and data feeds to their current outstanding issuer-paid credit ratings, the amendment would stipulate that a credit rating action would not need to be disclosed until 12 months after the action is taken.
Finally, in February 2009, the Commission re-proposed an amendment that would require NRSROs that are hired by arrangers to perform credit ratings for structured finance products to disclose to other NRSROs (and only other NRSROs) that they are hired to determine credit ratings for those deals and to obtain from such arrangers a representation that they will provide information given to the hired NRSRO to other NRSROs. NRSROs seeking to access this information would need to furnish the Commission an annual certification that they are accessing the information solely to determine credit ratings and will determine a minimum number of credit ratings using the information. In connection with this proposal, the Commission proposed to amend Regulation FD to accommodate this information disclosure program.
The final rule amendments and proposed rule amendments are available on the Commission's web site and were published in the Federal Register on February 9, 2009.