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Dec 22

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SEC Inspection of Credit Rating Agencies Shows Drastic Change Needed

Credit rating agencies (more formally known as Nationally Recognized Statistical Rating Organizations or “NRSROs”) have been under attack for what seems like forever. Yet the basic system remains unchanged. By way of example, this article describes the state of affairs around two years ago. The continuing criticism involves both the enormous conflicts of interest that exist in how credit rating work is obtained, and the genuinely poor job that the credit rating agencies have done in predicting serious problems

In November 2012, the SEC released its report regarding its second annual inspection of the NRSROs. The report summarizes its finding regarding the following entities, as listed by the SEC:

 

 

  1. A.M. Best Company, Inc.
  2. DBRS, Inc.
  3. Egan-Jones Ratings Company
  4. Fitch, Inc.
  5. Japan Credit Rating Agency, Ltd.
  6. Kroll Bond Rating Agency, Inc.
  7. Moody’s Investors Service, Inc.
  8. Morningstar Credit Ratings, LLC
  9. Standard & Poor’s Ratings Services (“S&P”)

Of these, Moody’s S&P and Fitch collectively perform practically all of this work, and are market dominant.

The SEC report provides a parade of horribles in terms of how the credit rating agencies conduct themselves. For example, the SEC reported on eight areas. The first of these areas involved whether the credit rating agencies conducted their work in accordance with own policies. Here are the SEC’s conclusions:

1. Each of the larger NRSROs and two of the smaller NRSROs did not appear to follow their methodologies and certain policies and procedures in determining certain credit ratings.

2. One of the larger NRSROs and two of the smaller NRSROs appeared to have inadequately disclosed portions of their ratings methodology, or changes to such methodology.

3. One of the larger NRSROs failed to adhere to policies and procedures by delaying certain rating actions and one of the larger NRSROs and two of the smaller NRSROs failed to adhere to policies and procedures or have unclear policies regarding the surveillance of existing credit ratings.

4. All of the NRSROs had weaknesses in record retention and recordation of rating actions and committee procedures.

5. All of the NRSROs failed to follow their procedures in some instances and the Staff identified weaknesses in certain policies and procedures.”

Congress needs to give more authority to the Securities and Exchange Commission to reform the credit rating agencies, or else pass new laws to solve the problems. Although the SEC describes the regulations that it has done, the SEC describes its authority as follows:

In 2006, Congress passed the Credit Rating Agency Reform Act (the “Rating Agency Reform Act”) that provided the Commission with the authority to establish a registration and oversight program for credit rating agencies. The Rating Agency Reform Act added Section 15E to the Exchange Act, which established Commission oversight of those credit rating agencies that register with the Commission as Nationally Recognized Statistical Rating Organizations (“NRSROs”). The Rating Agency Reform Act also amended Section 17 of the Exchange Act to provide the Commission with recordkeeping, reporting, and examination authority over registered NRSROs.

Importantly, Section 15E(c)(2) expressly prohibits the Commission from regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.”

About the author

David Nolte

I am a founding principal of Fulcrum Inquiry, an accounting and economic consulting firm that performs damage analysis for commercial litigation, forensic accountings, financial investigations, and business valuations. I am a Certified Public Accountant (CPA) and an Accredited Senior Appraiser (ASA), as well as having other professional credentials. I regularly serve as an expert witness involving damages measurement. My litigation-oriented resume is on Fulcrum's website.

Permanent link to this article: http://betweenthenumbers.net/2012/12/sec-inspection-of-credit-rating-agencies-shows-drastic-change-needed/

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