A major cause of the recent financial crisis was the failure of the residential mortgage-backed securities market. Investors relied in great measure on the ratings rendered by Moody”™s Investors Service, Standard & Poor”™s and Fitch Ratings, which gave AAA ratings to these securities.
Unbeknownst to most investors was that the ratings were tainted by ignorance of the very complex offerings and, most importantly, by the inherent conflict of interest that these services possessed.
Bond holders needed reliable rating agencies
Rating agencies initially came about in the early part of the 20th century in response to the need of potential bond holders for a reliable guide to the safety and risk assessment for the offerings. Beginning with Moody”™s in 1909, these services sold ratings manuals of various bonds to investors. In 1936, in the midst of the Great Depression, the government forbade banks from investing in speculative investment securities, restricting them to the purchase of investment grade securities.
Thus, banks were compelled to ascertain whether their investments were in accordance with government regulations. To do so, banks were obligated to use the then-recognized publishers of ratings to determine the relative risk of these securities rather than exercising their own judgment.
In 1975, the Securities and Exchange Commission, fearing the growth of unregulated ratings agencies, created the requirement that they be recognized as a “nationally recognized statistical ratings organization” (NRSRO). The requirement greatly restricted the number of potential ratings organizations and, de facto, gave almost exclusive reign to the three major ratings organizations that continue to operate to this day.
Problem: Securities issuers paying rating costs
The problem arose when these organizations transferred the cost of their services from investors to the issuers of the securities. Inasmuch as an issuer had the choice of selecting from the limited number of ratings services, it could seek out the organization which would give it the highest rating.
These NRSROs thus competed with each other for the business of particular issuers, which paid for their services. There was clearly an inherent conflict of interest when a ratings service rates the issuer that pays for its services. This is not to suggest that the organizations were necessarily corrupt but that, according to scholarly studies, the ratings tended to be “a race to the bottom.”
Testimony before congressional committees highlighted the fact that these services ignored significant data showing that the loans in the securitized mortgage pools were of poor quality, while simultaneously giving them their highest rating. In testimony before the House Oversight and Government Reform Committee, former executives of major ratings services testified of the use of outdated models to maximize their profits.
Moreover, these services offered advice for substantial sums concerning how to upgrade one”™s securities. In addition, there was substantial evidence that personnel preparing reports concerning these securities did not fully understand the incredible complexity of the securitization instruments.
Dodd-Frank Act improved rating regulations
Congress addressed the problem of the inaccuracies and mismanagement of risks by the ratings services. As part of the massive legislation, known as the “The Dodd-Frank Act,” it set forth improvements to regulating these entities.
Specifically, and analogous to the requirements under the Sarbanes-Oxley Act, it requires that each recognized rating organization must establish, maintain and document an effective control structure to assure the implementation of policies and procedures for determining credit ratings. Each of them must provide, in its annual internal controls report to the SEC, a description of management”™s establishment and maintenance of an effective internal control structure and an assessment of its effectiveness, coupled with the attestation of its chief executive officer, or equivalent person.
The SEC is to promulgate rules to assure that the ratings emanating from these NRSROs are not influenced by sales and marketing considerations. The NRSRO must designate an individual responsible to assure compliance with the act, whose compensation is not linked to the firm”™s financial performance. Failure to do so may cause the debarment of the organization and its members. The act also creates an Office of Credit Ratings within the SEC to promote accuracy of the ratings and to ensure that the ratings are not influenced by conflicts of interest. The SEC is to promote transparency of the ratings and assure that models and methodologies used by the NRSROs are approved by a national board of statistical rating organizations and are applied consistently to all credit ratings.
Investors may now have the assurance that the “opinions” of the NRSROs will no longer be influenced by external factors that will impede their gatekeeper role in the debt market.
Roy Girasa, J.D., Ph.D., a professor of law at Pace University”™s Lubin School of Business in Pleasantville. Reach him at rgirasa@pace.edu.
