Speech by SEC Chairman:
Statement at Open Meeting on Rules for Credit Rating Agencies
Chairman Christopher Cox
U.S. Securities and Exchange Commission
June 11, 2008
Good morning. This is an open meeting of the U.S. Securities and Exchange Commission under the Government in the Sunshine Act on June 11, 2008.
Today we are beginning the consideration of a package of rules that would regulate the conflicts of interests, disclosures, internal policies, and business practices of credit rating agencies. This package of recommendations, the first two portions of which we will consider today, and the third of which we will consider on June 25, comes to us chiefly from the Division of Trading and Markets. But it also reflects the input of several of the Commission's other Divisions and Offices, as well as a number of international regulatory organizations that have studied these issues, including the Financial Stability Forum and the International Organization of Securities Commissions.
Importantly, the committees of Congress that were responsible for the recent Credit Rating Agency Reform Act have also contributed their thoughts and suggestions to our rulemaking initiatives in this area. That input has been very helpful in ensuring that our rules properly reflect the intent of Congress in the underlying legislation. The staff's recommendation before us today incorporates many of these thoughtful proposals.
All of the proposed rules that we are considering are born of the subprime mortgage crisis and the resulting credit crunch. These events of recent months have had a profound effect on our economy and our markets, and they have galvanized regulators and policymakers not only in this country but around the world to re-examine every aspect of the regulatory framework governing credit rating agencies.
At bottom in the subprime mess, of course, were the high-risk mortgages typified by lax loan underwriting, unverified borrower information, and even, in many cases, clear signs of fraud in the loan files. Because credit rating agencies relied on others to verify the quality of the assets underlying the structured products they rated, it is very likely those ratings were often based on incorrect information.
In many cases, the complexity of the structured products themselves combined with the lack of quality information about the underlying assets to make it exceptionally difficult for anyone to determine a credit rating at all.
Throughout the subprime crisis there was a marked absence of any clear, prominent explanation of these limitations of the ratings on structured products. And yet it is now unmistakable that there were additional risks associated with the credit ratings of those products. Investors weren't told, clearly and regularly, what the assumptions were that underpinned the ratings. Nor was it clear how structured finance ratings were likely to change based on changes in those assumptions.
There were other problems as well that were revealed by the subprime meltdown. When the Congress passed the Credit Rating Agency Reform Act a year and half ago, it was well understood that certain conflicts of interest were hardwired into the rating agency business model. But we have learned since then that the ratings of structured products in the subprime area made those conflicts of interest even more acute. That's because structured products were specifically designed for each tranche to achieve a particular credit rating — and the ratings agencies then made a lucrative business of consulting with issuers on exactly how to go about getting those ratings. Selling consulting services to entities that purchased ratings became a triple-A conflict of interest.
As if all of this weren't enough, the limited historical data available as a basis for judging the credit risk of subprime lending activities significantly increased the model risk in the rating process. The historical data on subprime loans were based on periods of rising home prices. As a result, the broad market downturn that actually occurred wasn't anticipated by the models.
All of these are serious problems. But they are problems in an industry that has in many other ways proven vital to the capital formation process in the United States and around the world. The Credit Rating Agency Reform Act, the rules the SEC has recently issued under that law, and the new rules that we are considering today are aimed not at constraining this important industry but at increasing its transparency and accountability. Their purpose is to create the conditions in which a multitude of firms can flourish in a healthy and competitive market that truly serves investors and issuers alike.
The nine credit rating agencies that have registered with the SEC since the law was passed already represent an 80% increase in the number of nationally recognized firms in the industry. (Before the law was passed, there were only five NRSROs: Moody's, Standard and Poor's, Fitch, Dominion Bond Rating Service, and A.M. Best.) Now there is more competition than ever before, and that is one important way to promote high-quality ratings and to provide a check against laxity and substandard practices.
Just as importantly, each of the newly registered firms — including the three largest firms, which rated most of the subprime-related products that raised so much concern over the last year — are now subject to the Commission's oversight and rulemaking authority. The fundamental purpose of the rules we are proposing today is to buttress this new level of competition with greater transparency and accountability.
Even though today's rulemaking is only at the proposal stage, it is already richly informed by empirical experience. Beyond the several governmental and non-governmental analyses that have been published in recent months, the SEC has been aggressively using its new authority to examine the details of how credit ratings have been created and disseminated.
Our examinations have extended even to issues that have only recently come to public light, such as the troubling reports that inaccurate ratings were assigned due to computer errors, and then persisted for months before they were corrected. It bears noting that not only can problems such as this provide the basis for remedial rulemaking, but if the underlying conduct constitutes a violation of the Credit Rating Agency Reform Act or its rules, the people and firms responsible would be subject to the full range of sanctions and penalties available to the Commission.
To promote transparency, accountability, and competition in the credit rating agency industry, the staff have recommended a package of new rules, in three parts.
The first part consists of rules that would do the following:
They would prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product were available.
They would prohibit credit rating agencies from structuring the same products that they rate.
To further strengthen competition in the ratings industry, they would require credit rating agencies to make all of their ratings and subsequent rating actions publicly available. This data would be required to be provided in a way that will facilitate comparisons of each credit rating agency's performance. Doing this would provide a powerful check against providing ratings that are persistently overly optimistic.
They would attack the practice of buying favorable ratings, by prohibiting anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for it.
They would prohibit gifts from those who receive ratings to those who rate them, in any amount over $25.
They would require credit rating agencies 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.
They would require disclosure by the rating agencies of the way they rely on the due diligence of others to verify the assets underlying a structured product.
They would require disclosure of 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.
The new rules would require credit rating agencies to make an annual report of the number of ratings actions they took in each ratings class, and they would require the maintenance of an XBRL database of all rating actions on the rating agency's web site. That would permit easy analysis of both initial ratings and ratings change data.
The rules would require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. That would permit broad market scrutiny, as well as competitive analysis by other rating agencies that are not paid by the issuer to rate the product.
And they would require documentation of the rationale for any significant out-of-model adjustments.
The second part of the proposal would require credit rating agencies to differentiate the ratings they issue on structured products from those they issue on bonds, either through the use of different symbols, such as attaching an identifier to the rating, or by issuing a report disclosing the differences between ratings of structured products and other securities.
This is an important proposal, because the experience of the subprime crisis has shown that many investors viewed the ratings of structured products as a seal of approval, and looked no further. Indeed, when the quality of the ratings came into question, those same investors were left with no independent means of assessing the risk of these products — and that, in turn, added to market illiquidity.
But structured finance ratings in fact differ from traditional corporate debt ratings in important ways. For one thing, they necessarily rely on models to a greater extent, with all of the unique risk that modeling entails. And to a much larger degree than ratings on traditional debt, they are driven by assumptions.
Another special characteristic of ratings on structured products is the potential for these products to experience significantly higher volatility when a systemic, economy-wide event affects the creditworthiness of many assets at once. So it is possible for a structured product to have more stable ratings than corporate bonds during times of overall economic and financial calm, while carrying a higher risk of a severe downgrade during difficult conditions.
These are important distinctions between structured products and corporate bonds, but credit rating agencies currently apply the same rating categories to both. The specific rule we are considering in this area would, if adopted, help ensure that investors fully appreciate the different risk characteristics of structured products, particularly under stress conditions. It would also help make clear that structured product ratings rely on qualitatively different kinds of information and ratings methodologies than do ratings for bonds.
That is the argument in favor of this proposed rule. But despite the obvious good that clarity and full disclosure can accomplish in this area, we are also aware that the mandated introduction of a new, separate rating symbology could also require fundamental changes to investment guidelines — and that this, in turn, could lead to other problems, such as the forced liquidation of products that no longer meet the old guidelines.
In many ways, of course, institutions updating their investment guidelines in light of the subprime crisis and re-considering how they use credit ratings for risk management and valuation is a good thing. Indeed, it is one of the fundamental purposes of the enhanced disclosure about ratings on structured products that would be required under other provisions of these proposed rules. It is precisely because some institutional investors have in the recent past relied too heavily on ratings in their investment guidelines — or even relied exclusively on ratings for purposes of valuation, independent risk assessment and due diligence — that this subject is now under discussion.
Nonetheless, I am firmly of the view (and I daresay to a greater or lesser extent so too are my fellow Commissioners) that we need to enter upon this particular subject of rulemaking with a weather eye to the fact that requiring these changes, simultaneously and across the board, could have unintended market impacts that need to be more fully understood before the Commission should be comfortable in embedding this requirement in a final rule.
As a result, not only is our proposed rule constructed in the alternative, with a disclosure option that could be used in lieu of separate symbols, but the proposing release asks abundant questions about the various possible implications of our proposed actions.
The symbology question is also relevant to the third part of the recommended rules package, which we will consider at our next Open Meeting on June 25 in order to give it the full time and attention that it deserves. At that time, we will consider whether to reform the Commission's many rules that make explicit reference to credit ratings, so as to provide a more thorough description of the basis for the SEC's use of ratings as a surrogate for compliance with various regulatory conditions and requirements.
There are many reasons that the subprime crisis should lead us to consider this course of action. To begin with, because the SEC's own rules do not distinguish between corporate and structured finance ratings for a variety of regulatory purposes, our own regulatory regime might be vulnerable to criticism on the same grounds as the ratings agencies' symbology. It is therefore incumbent upon us to examine, for example, the extent to which our regulations implicitly assume that securities with high credit ratings are liquid and have lower price volatility. As we have seen, structured finance and other rated instruments are in fact very different in these respects.
In addition, several observers, including the Financial Stability Forum, have made the observation that the official recognition of credit ratings for a variety of securities regulatory purposes may have played a role in encouraging investors' over-reliance on ratings. To the extent that the SEC's references to credit ratings in our rules are viewed by the marketplace as giving credit ratings an implied official seal of approval, they have argued, our own rules may be contributing to an uncritical reliance on credit ratings as a substitute for independent evaluation. Of course, it should go without saying that it should be neither the purpose nor the effect of any SEC rule to discourage investors from paying close attention to what credit ratings actually mean.
For that reason, we will consider recommendations in two weeks designed to ensure that the role we have assigned to ratings in our rules is consistent with the objective of having investors make an independent judgment of risks and of making it clear to investors the limits and purposes of credit ratings for structured products.
It is understatement to say that the preparation of this package of rule recommendations was a heavy lift by many men and women from Offices and Divisions across the SEC. I would like to express my thanks to the staff of the Division of Trading and Markets for their commendable work on this matter over a period of more than a year. Thanks especially to Director Erik Sirri, Deputy Director Bob Colby, Mike Macchiaroli, Tom McGowan, Randall Roy, Joe Levinson, Carrie O'Brien, Sheila Schwartz, and Rose Russo Wells.
I also would like to thank the leaders and professional staff in the Division of Corporation Finance and the offices of the General Counsel, the Office of Economic Analysis, the Office of International Affairs, the Division of Investment Management, the Office of Compliance Inspections and Examinations, and the Office of Investor Education and Advocacy for their contributions and collaborative efforts.
Finally, I would like to thank the other Commissioners and all of our counsels for their work and comments on this proposed rule.
I'll now turn the floor over to Erik Sirri for a more detailed discussion of these proposals.