Speech by SEC Commissioner:
"In Search of Transparency, Accountability, and Competition: The Regulation of Credit Rating Agencies"
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
Remarks at "The SEC Speaks in 2009"
February 6, 2009
Good morning. I appreciate the opportunity to be with you. Before I continue, I must remind you that my remarks today are my own and do not represent the views of the SEC or my fellow commissioners.
To state the obvious, these are tumultuous times for our markets, financial institutions, and investors. The bursting of the housing bubble and the ensuing credit and liquidity crises have posed formidable challenges to policymakers and regulators alike as we have sought to identify, analyze, and respond effectively to some of the causes, contributors, and drivers of the financial crises.
Over the course of the past year, there have been several reports — including those issued by the President's Working Group on Financial Markets, the Financial Stability Forum, the International Organization of Securities Commissions, and the Group of 30 — identifying some of these factors. One of the causes cited in all of these reports is the role of, and reliance on, credit rating agencies and credit ratings. This morning, I would like to focus my remarks on this area and discuss the Commission's efforts to enact necessary reforms to this critical part of our market.
For many years, and increasingly after the fall of Enron and WorldCom, there have been widespread concerns about the rating industry, including inherent conflicts of interest relating to compensation arrangements, oligopolistic pricing and practices, mediocre ratings quality, failure to issue timely upgrades or downgrades, lack of transparency as to how ratings are determined, and a virtual absence of any accountability to investors, markets, and regulators.
In many respects, the current financial crisis has validated these longstanding concerns. The large rating agencies helped promote the dramatic growth in structured finance over the past decade, and profited immensely by issuing ratings that pleased the investment banks that arranged these pools of securities, but betrayed the trust of investors who were led to believe that investment grade bonds were relatively safe.
Make no mistake — the rating agencies' conduct and performance was entirely rational, and quite similar to the market dominance and behavior of other companies that have enjoyed a similar "most favored" status from the government, such as Fannie Mae and Freddie Mac. Although many of their ratings turned out to be catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade. And even today, in the aftermath of these costly mistakes, issuers or underwriters almost invariably turn to the large rating agencies.
They do so for a very simple reason — because there is nowhere else for them to go. For those who still believe in free-market capitalism, the continued dominance of a critically important industry by just a few firms is an unfortunate reality.
While rating agencies are not poised to win any popularity contests these days, and they have much to account for to be sure, I nevertheless don't believe that demonizing them serves a constructive purpose. Instead, we need to seize this opportunity to build on the significant reforms that have recently been adopted by Congress and the Commission, and lead the rating industry to serve investors and the markets more effectively.
Although the industry traces its roots back to 1909, when John Moody published his "Analyses of Railroad Investments," it is important to remember that Commission supervision of rating agencies is less than two years old. In the face of strenuous opposition and a high-powered lobbying campaign waged by the largest two rating agencies, Congress passed the Credit Rating Agency Reform Act of 2006, ending a century of industry self-regulation and providing the Commission authority for the first time in this space.
The Act's overriding purpose was to promote competition in this famously concentrated industry by establishing a transparent and rational registration system for rating agencies seeking "nationally recognized statistical rating organization," or NRSRO, status. Along with increasing competition, the Act also was designed to enhance industry transparency, address conflicts of interest, and prohibit abusive practices. As a result, rating agencies now are required to make a series of disclosures on a variety of matters including policies and procedures for determining ratings and preventing the misuse of material non-public information, conflicts of interest, and performance measurement statistics.
The Act also mandated that the Commission prohibit conflicts of interest, or require their disclosure and management, particularly any conflicts relating to "compensation of the NRSRO for ratings and other services." Importantly, the Act gave the Commission authority to conduct a robust inspection, examination, and investigation program to ensure that the rating agencies are operating in a manner consistent with their disclosures and the federal securities laws.
We promulgated initial rules implementing the legislation in the spring of 2007. In August 2007, the SEC staff initiated in-depth examinations of the three major rating agencies and over the ten-month investigation uncovered significant deficiencies in the rating agencies' policies, procedures, and practices. The examinations found that:
- the rating agencies struggled significantly with the increase in the number and complexity of subprime RMBS and CDO deals since 2002;
- none of the rating agencies examined had specific, comprehensive written procedures for rating RMBS and CDOs;
- significant aspects of the rating process were not always disclosed or even documented by the firms;
- conflicts of interest were not always managed appropriately; and
- processes for monitoring ratings were less robust than the processes used for initial ratings.
In June 2008, consistent with these findings and the earlier findings and recommendations of the President's Working Group on Financial Markets, IOSCO, and the Financial Stability Forum, the SEC voted to issue proposals designed to address the role of rating agencies in the troubled structured finance market and to advance the Rating Agency Act's goals of enhancing transparency, competition, and accountability. The Commission adopted most of these proposals last December.
The Rating Agency Act was necessary, struck careful balances, and has worked well so far, in my view. Although the Act did not take effect before the largest rating agencies issued the structured finance ratings that contributed significantly to the financial sector meltdown, I nevertheless believe that it provides the Commission with the necessary authority to appropriately oversee rating agencies. To date, the Act and subsequent Commission actions have paved the way to a doubling of the number of NRSROs, and provide clear and well defined rules for those contemplating registration.
So it's pretty clear that progress has been made. But make no mistake — the rating industry is not yet competitive. Of course, it's unrealistic to expect legislation permitting new entrants into an industry to overcome in less than two years a century of branding and reputational development by the dominant incumbents, as well as decades of federal, state, and international regulatory actions benefiting them, not to mention the thousands of private financial contracts that require ratings be obtained from the large firms.
One way for new entrants in the rating industry to increase competition is by distinguishing themselves from the largest firms. And they can do so by issuing ratings that prove to be more credible and reliable. In order for them to do so, it is crucial for the Commission to foster an environment, as envisioned and required by Congress, which is unapologetically pro-competitive, because until there is a market penalty for being wrong, the industry will not serve investors as effectively as it would otherwise.
Let's be very clear: the longstanding, deeply entrenched incumbents in this space, which have some of highest profit margins in the U.S., or anywhere in the world for that matter, have not retained their outsized market share by virtue of issuing high-quality ratings. In the past, quality has never been necessary.
As noted earlier, I believe Congress has given the Commission the authority that we need to effectively oversee this industry and we have already adopted two major releases in this area in 2007 and 2008. But important work still needs to be done. There are several proposals that the Commission should act upon in the near future. I will briefly highlight what I consider to be the two most important initiatives.
It is imperative that the Commission adopt its proposal to address the oligopoly in the rating industry and the overreliance on NRSRO ratings by removing the regulatory requirements embedded in numerous SEC rules. These requirements — which accord privileged status only to ratings from certain firms — have served to elevate NRSRO ratings to a status that does not reflect the actual purpose, much less the limitations, of credit ratings.
This evolution in the use of ratings has been recognized by numerous commentators and market participants, including the rating agencies themselves, who have emphasized what a credit rating is intended, and not intended, to represent. To remove the NRSRO references from SEC rules will require a reassessment of our longstanding uses of NRSRO ratings. But, in my view, doing so is absolutely essential to the Commission's efforts to faithfully implement the clear congressional intent of enhancing transparency, accountability, and competition in this industry.
The Commission has referred to NRSRO ratings in its rules for over three decades. Although it is quite understandable why they were first incorporated into the Net Capital Rule, for example, and in subsequent rules here and elsewhere, it has become evident over time that there are considerable unintended consequences to the regulatory use of ratings.
The purpose was not to establish and preserve a valuable franchise for the large rating agencies, while simultaneously inoculating them from market competition. Nor was it intended to serve as a substitute for adequate due diligence on the part of investors, managers, directors, and others, which could have served as a critical check on the rating agencies. Unfortunately, as recent events have demonstrated, it appears to have led to just such results in too many cases.
I was pleased to see that the Group of Thirty's recent report on financial reform recommends that "users of risk ratings, most importantly regulated users, should be encouraged to restore or acquire the capacity for independent evaluations of the risk of credit products in which they are investing." Removing NRSRO references from our rules is a particularly significant step toward this necessary change, and I strongly believe any reforms would not be complete without doing so.
Another proposal — actually, a re-proposal — that we should adopt this year is the information disclosure program for structured financial products. This would require the disclosure of the information an NRSRO uses to issue a structured finance rating. The re-proposal is a pro-competitive amendment that reflects substantial modifications that were necessary and advisable. The Trading and Markets staff, led by Erik Sirri, and with the tireless efforts of Randall Roy and others, did an outstanding job drafting this re-proposed rule that should make it workable in practice.
Specifically, it would require that arrangers (that is, issuers or underwriters) disclose all of the information that is provided to the hired NRSRO to determine the credit rating. It limits the disclosure to other NRSROs and makes appropriate modification to Regulation FD.
The re-proposal would permit analysis by other NRSROs that are not paid by the issuer to rate the product. These other NRSROs could then issue unsolicited ratings, and the marketplace could then decide whose performance is superior. This is exactly the type of pro-competitive reform contemplated by the Rating Agency Act.
I do not expect the firms with a stranglehold on the industry to applaud these proposed reforms, but that should not surprise anyone. More importantly, these are critical actions that I believe the Commission is obligated to take in order to fulfill the regulatory mandate Congress has set for us.
Thank you, and I hope that you all enjoy the rest of the conference.