US regulator publishes damning report into three ratings agencies

The SEC has issued a damning report into practices at ratings agencies Standard and Poor's, Fitch and Moody’s.

Back in August 2007 the US regulator began an investigation into the agencies’ handling of the rating of sub-prime securities in the wake of the turmoil in those markets that began early in 2007.

The report raised a number of questions about ratings agencies’ handling of residential mortgage-back securities and collaterised debt obligations.

Quoting emails garnered by the report, the SEC cited one analyst, who “ expressed concern that her firm’s model did not capture “half” of a particular deal’s risk, stating that ‘it could be structured by cows and we would rate it.’”.

In another document, an analytical manager in the CDO ratings part of the agency said that the ratings would create “an even bigger monster – the CDO market.”

He added: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

The SEC added that low resources at the agencies impacted the timeliness of surveillance efforts, finding that managers were constantly asking senior managers to hire more staff to cope with the influx of business.

The regulator also discovered a lack of surveillance procedures at two rating agencies: “Two rating agencies do not have internal written procedures documenting the steps that their surveillance staff should undertake to monitor RMBS and CDOs.” It also added that “significant aspects of the ratings process were not always disclosed.”

The SEC added that there was a conflict of interest “inherent” in the ratings agencies’ business models, saying that they “have an interest in generating business from the firms that seek the rating, which could conflict with providing ratings of integrity.”

The regulator added that one ratings agency allowed “senior analytical managers to participate directly in fee discussions until early 2007 when it changed its policy.”

The report also said that ratings agencies “do not appear to take steps to prevent considerations of market share and other business interests from the possibility that they could influence ratings or ratings agencies.”

It quoted one senior analytical manager in the Structured Finance group at an agency, saying: “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision [on assigning separate ratings to principal and interest] and if so, how much? Essentially, [names of staff] ended up agreeing with your recommendations but the CDO team didn't agree with you because they believed it would negatively impact business.”

In another email, following a discussion of a competitor’s market share, an employee of the same firm stated that aspects of the firm’s ratings methodology would have to be revisited to recapture market share from the competing rating agency, the report said. “An additional email by an employee stated, following a discussion of losing a rating to a competitor, ‘I had a discussion with the team leaders here and we think that the only way to compete is to have a paradigm shift in thinking, especially with the interest rate risk,’” the report said.

The report concluded; “while the various rating agencies had differing practices and, as to each, the staff identified a range of issues to be addressed, each of the examined firms can take steps to improve their practices, policies and procedures with respect to rating RMBS and CDOs, and other structured finance securities. Each credit rating agency was cooperative in the course of these examinations and has committed to taking remedial measures to address the issues identified.”

Standard and Poors responded in a statement: “S&P is fully committed to increased openness and transparency and is implementing globally a wide ranging set of actions to further strengthen our credit ratings process, enhance our analytics and provide more transparency to the market.

“Building on these actions, we will continue to take any further steps needed to improve our processes and ensure they are of the highest quality. We remain dedicated to helping restore confidence in capital markets and ratings, and we will continue to work with regulators, policymakers and market participants worldwide on the measures necessary to achieve this.”

Fitch said: "Fitch continues to view a number of the SEC's recently proposed rules regarding the practices of credit rating agencies as a positive step forward. The SEC has not informed Fitch of any finding that Fitch acted in a manner inconsistent with Fitch's code of conduct, which is published on the Fitch website and modeled on that of IOSCO.

"From its beginning, Fitch's code of conduct was designed to maintain the integrity of Fitch's analytical processes and to manage conflicts of interests. Fitch is currently in the process of updating its policies, procedures and code consistent with the recent amendments to the IOSCO code and the SEC proposals."

Moody’s reaction was : "Moody's has initiated a wide range of reforms that refine our analytical methodologies, improve transparency and enhance our overall independence. The ultimate aim of our actions is to enhance ratings performance quality and expand the usefulness of our ratings, research and analytical tools for all market participants. We will continue these initiatives and welcome additional recommendations from the SEC and market participants