Addressing Conflicts of Interest In the Credit Ratings Industry
Commissioner Luis A. Aguilar
May 14, 2013
Good morning. I am very pleased to be here at the Roundtable on Credit Ratings. I strongly support the Commission’s effort to evaluate ways to improve our credit ratings system.1 Effective oversight of Nationally Recognized Statistical Rating Organizations (“NRSROs”) is critical to ensuring accurate ratings and promoting investor confidence. Before I begin, however, let me issue the standard disclaimer that the views I express today are my own, and do not necessarily reflect the views of the U.S. Securities and Exchange Commission (“SEC” or “Commission”), my fellow Commissioners, or members of the staff.
As an SEC Commissioner, I have focused singularly on how the SEC can best serve the needs of investors. It is clear that the role played by credit rating agencies can have an impact on the integrity of our markets and investor confidence.2
Today’s roundtable and the Commission’s December 2012 Report to Congress on Assigned Credit Ratings are direct outgrowths of industry practices that permitted inaccurate ratings to undermine the securities market and the integrity of the credit ratings industry.3
A number of studies have concluded that inflated credit ratings, among other factors, contributed to the financial crisis by masking the true risk of many mortgage-related securities.4 For example, prior to the financial crisis, NRSROs issued credit ratings for tens of thousands of U.S residential mortgage backed securities (“RMBS”) and collateralized debt obligations (“CDO”).5 A majority of the products received AAA and other investment-grade credit ratings despite their risky features. Although AAA-rated securities have historically had less than 1% probability of incurring defaults, over 90% of the AAA ratings given to subprime RMBS securities that originated in 2006 and 2007 were later downgraded by the NRSROs to junk status.6
These large numbers of downgrades resulted in great harm and requires that we make sure they don’t reflect a faulty systemic process. Too that end, one of the key concerns raised by commentators regarding the current structure of the credit ratings process is the issue of conflicts of interest associated with the “issuer-pays” model.7 This model allows the party planning on issuing a financial instrument to pay an NRSRO for assigning the rating. A number of commentators have argued that this business model encourages ratings shopping by the issuers and investment banks selling the securities, and results in undue pressure for NRSROs to give favorable ratings to attract business.8
Investors use credit ratings to make investment decisions, generally opting for “investment-grade” products – those rated as AAA to BBB-.9 Products that carry a greater risk are labeled “below investment grade.” Obviously, products that receive an investment grade rating have a much broader market in which to sell. As a result, there can be a great deal of incentive to have a product rated at investment grade level. Therefore, it is important to establish processes to ensure that a product receive the appropriate rating level. A faulty system of assigning credit ratings can devastate the best financial planning and destroy financial security, particularly for investors that are retired or nearing retirement. Given the importance of credit ratings, it is critical that credit ratings be issued with integrity and transparency.
It is clear that the past cannot be repeated. The financial crisis cost Americans $3.4 trillion in retirement savings and it triggered the worst crisis since the Great Depression.10 The Financial Crisis Inquiry Committee concluded that “the failures of the credit rating agencies were essential cogs in the wheel of financial destruction … [and] were key enablers of the financial meltdown.”11
I want to thank all of the panelists for being here today to share your views. All of you have important information to share with us about the credit ratings system, and I appreciate that you’ve taken the time to be with us.
As today’s discussion unfolds, we should remember the needs of investors, who deserve a credit ratings system that is transparent, orderly, and that is not derailed by conflicts of interest.
1 Today’s Roundtable will consist of three panels. The first panel will discuss the potential creation of a credit rating assignment system for asset-backed securities. The second panel will discuss the effectiveness of the SEC’s current system to encourage unsolicited ratings of asset-backed securities. The third panel will discuss other alternatives to the current issuer-pay business model in which the issuer selects and pays the firm it wants to provide credit ratings for its securities.
2 “Report to Congress on Assigned Credit Ratings, As Required by Section 939F of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (December 2012), http://www.sec.gov/news/studies/2012/assigned-credit-ratings-study.pdf.
4 United States Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Government Affairs, “Wall Street and the Financial Crisis: An Anatomy of a Financial Collapse” (April 13, 2011), http://www.hsgac.senate.gov//imo/media/doc/Financial_Crisis/FinancialCrisisReport.pdf?attempt=2; and The Financial Crisis Inquiry Commission, “The Financial Crisis Inquiry Report” (January 2011), http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.
5 United States Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Government Affairs, “Wall Street and the Financial Crisis: An Anatomy of a Financial Collapse (April 13, 2011), http://www.hsgac.senate.gov//imo/media/doc/Financial_Crisis/FinancialCrisisReport.pdf?attempt=2.
6 Id. (Financial instruments bearing below BBB- (or Baa3) ratings are referred to as “below investment grade” or as having “junk” status).
7 Supra note 2.
10 Maurico Soto, Urban Institute, “How Is the Financial Crisis Affecting Retirement Savings?” (March 9, 2009), http://www.urban.org/publications/411847.html; and Government Accounting Office, “Financial Regulatory Reform: Financial Crisis Losses and Potential Impacts on the Dodd-Frank Act” (January 16, 2013), http://www.gao.gov/products/GAO-13-180.
11 The Financial Crisis Inquiry Commission, “The Financial Crisis Inquiry Report” (January 2011), http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.