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Statement At Open Meeting

Commissioner Kara M. Stein

Aug. 27, 2014

I would also like to thank each of the many staff members involved for their diligent and thoughtful work in finalizing these rules.  I am especially grateful to Randall Roy, Christian Sabella, Liban Jama, and Harriet Orol for your helpful and considerate engagement with my office throughout this process. 

Separately, I want to acknowledge the efforts of the many public commenters throughout this process whose careful analyses, recommendations, and creative thinking helped to substantially improve the rules before us today.

We are a long way from 1909 when an entrepreneur named John Moody issued the first so-called “rating manual” containing ratings for railroad company bonds.[1]  Over the next two decades, the ratings industry grew with Poors Publishing, Standard Statistics, and Fitch Publishing joining the ranks.[2]

In 1936, federal banking regulators gave the industry a boon by requiring bonds held by banks to be “investment grade” per “recognized rating manuals.”[3]   State insurance and other regulators followed suit, and eventually the Securities and Exchange Commission (SEC) gave certain rating agencies a seal of approval in 1975 as part of its net capital rule for broker-dealers, creating a new category now known as “nationally recognized statistical rating organizations” or “NRSROs.”[4]

For better or worse, with help from various regulators, including the SEC, these organizations became embedded into the capital markets landscape.  And for better or worse, we must now address the myriad of consequences that have resulted.

Indeed, the rules before us today are long overdue and sorely needed.  It has been seven years since credit rating agencies began their massive downgrades of residential mortgage-backed securities (RMBS) and played a role in the global financial crisis -- a crisis that decimated the retirement assets of hundreds of thousands of Americans and eventually caused a $19.2 trillion drop in household wealth.[5]

The assurances these agencies provided regarding the quality of RMBS investments were vital to the meteoric growth of the securitization markets.  Everyone needed the rating agencies to make their businesses work.  Issuers needed ratings to sell the securities, and many investors could not purchase or hold them without this seal of approval.  Rating agencies were in high demand, and business was booming.

Over a three-year span from 2004-2007, two credit rating agencies alone issued ratings for more than 11,000 RMBS and collateralized debt obligation (CDO) transactions.[6]  Fees for individual ratings ranged from roughly $40,000 on the lower end to a whopping $750,000 for some CDO ratings.[7]  Not surprisingly, revenues skyrocketed.  From 2002-2006, revenues from these transactions tripled at one firm, and quadrupled at the other.[8]  Eventually, as we all know, the bubble burst, and massive downgrades, beginning in July 2007, plunged the highest-rated investments to “junk” status.  In fact, over 90% of the AAA ratings given to subprime RMBS issued in 2006 and 2007 were later downgraded to junk.[9]

The credit rating agencies, that should have been on the front line, sounding the alarm to warn against the coming financial firestorm, instead helped fan the flames.  Why? For the simple and predictable reason that it was in their financial interest, at least in the short term, to do so.  This fundamental truth must be addressed head on.  It must be addressed with clear and strong rules regarding conflicts of interest.  It must be addressed with comprehensive and thoughtful rules regarding internal controls, financial reports, ratings disclosures, policies surrounding rating methodologies, and standards of competence for analysts.  The rules we adopt today accomplish some, but not all, of these goals.     

Today’s rules, most of which are specifically mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, contain many provisions, too numerous to mention here, which hold the promise of promoting more sound, rigorous, transparent, and independent ratings by NRSROs. 

For example, the rules will now require a significant amount of information to be disclosed with the publication of each credit rating – both quantitative and qualitative.  This information should provide users of credit ratings with much greater transparency into the methods, assumptions, limitations and reliability of each rating. 

I am also pleased to see that the final rule requires a CEO attestation regarding management’s assessment of internal controls, as well as an attestation by the person responsible for each rating confirming that the rating is free from improper influence.  I am a firm believer in attestations, and as I have said before:  nothing focuses the mind like signing your own name. 

In my view, the Commission also is right to prescribe factors that NRSROs must consider in establishing, maintaining, enforcing, and documenting effective internal controls.  As written, the rule provides reasonable and sufficient flexibility; and the factors listed, while not exhaustive or a “safe harbor,” can provide a needed and useful guide for current NRSROs, as well as potential new entrants.

As to the conflicts of interest section of today’s rule, I believe it appropriately addresses the Commission’s specific statutory mandate to issue rules to prevent sales and marketing from influencing the production of ratings.  It is good as far as it goes, but our work is far from complete in getting at the fundamental conflicts of interest present in both the issuer-pay and subscriber-pay business models.  I look forward to further analysis, dialogue and, importantly, action to address this overarching and continuing concern. 

Finally, I believe that further work should be done to ensure that rating symbols are applied consistently.  The failure of NRSROs to do this during the financial crisis has been well-established,[10] and the results, as we all know, were disastrous. I hope our examiners in the Office of Credit Ratings will carefully analyze and monitor how well NRSROs are doing in creating and maintaining policies, as we are requiring today, designed to ensure this consistency.  I also would encourage credit rating agencies to voluntarily consider whether it is appropriate to create different ratings symbols for different asset classes in order to more accurately reflect the fundamental differences in risk characteristics between and among certain assets, such as, for example, municipal bonds, corporate bonds, and asset-backed securities.

While I am hopeful that the rules we adopt today will help make significant progress toward a better, more transparent, and more competitive marketplace for credit rating agencies, I am well aware that more work must be done in this regard, and I look forward to engaging with the public and my fellow Commissioners as we continue these important efforts.  Thank you.

[1] See Lawrence J. White, Credit Rating Agencies:  An Overview, Annual Review of Financial Economics, Vol. 5, p. 10 (2013); Richard Sylla, A Historical Primer on the Business of Credit Ratings, presented at Conference on The Role of Credit Reporting Systems in the International Economy, p. 9,  (March, 2001).

[2] See White, pp. 10-14. 

[3] Id.

[4] IdSee also Adoption of Uniform Net Capital Rule and an Alternative Net Capital Requirement for Certain Brokers and Dealers, Exchange Act Release No. 11497 (June 26, 1975), 40 FR 29795 (July 16, 1975); 17 CFR 240.15c3-1.  Pursuant to Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commission has since begun to remove from its rules references or requirements of reliance on credit ratings.  See, e.g., Proposal for Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification Requirement in the Money Market Fund Rule, Rel. No. IC-31184, July 23, 2014.

[5] See Wall Street and the Financial Crisis:  Anatomy of a Financial Collapse, Majority and Minority Staff Report, Permanent Subcommittee on Investigations, United States Senate, April 13, 2011, p. 243 (the “PSI Report”); The Financial Crisis Inquiry Report, Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, submitted by the Financial Crisis Inquiry Commission, pursuant to Public Law 111-21, January 2011, pp. 206-212,; The Financial Crisis Response in Charts, United States Department of the Treasury, April 2012; slide 1;; Financial Regulatory Reform,  Financial Crisis Losses and Potential Impacts of the Dodd-Frank Act, United States Government Accountability Office Report to Congressional Requesters; p. 23, fig. 6,    

[6] See PSI Report, p. 30.

[7] Id.

[8] Id. pp. 30-31.

[9] Id. p. 31.

[10] See generally Jess Cornaggia, Kimberly J. Cornaggia, & John Hund, Credit Ratings Across Asset Classes: AA? (2011),; see also Report to Congress, Credit Rating Standardization Study, United States Securities and Exchange Commission, September 2012, pp. 34-36.

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