Policing 2,611,582 credit ratings

November 16, 2012

The SEC is out with its second annual examination of “Nationally Recognized Statistical Rating Organizations,” otherwise known as credit rating agencies. A little known 2006 law, the Credit Rating Agency Reform Act, gave broad authority to the SEC to inspect raters as if they were broker dealers, and is what empowers the SEC to annually inspect raters. According to the law, raters must:

[M]ake certain public disclosures, make and retain certain records, furnish certain financial reports to the Commission, establish and enforce procedures to manage the handling of material non-public information, and disclose and manage conflicts of interest. The Commission’s rules also prohibit an NRSRO from having certain conflicts of interest and engaging in certain unfair, abusive, or otherwise coercive practices.

In other words raters must follow the rules, keep very good records and undergo something akin to an annual proctology exam by the SEC. Rating crimes were committed in the past and now the police are on the scene.

Part of the SEC summary report lists the number of ratings outstanding from nine NRSROs. As of December 31, 2011, the number was 2,611,582, with the three top raters, Fitch, Moody’s and Standard & Poor’s creating 96% of them. It is a very concentrated and some say non-competitive industry. Page 6 of the report does a great job showing which raters have what percentage of each asset class. For example a small rater, A.M. Best, concentrates on insurance ratings, and has 23% of that space.

The annual report detailed some bad infractions of the rules, although for the most part, does not identify the rater, merely referring to the three largest and smaller raters. Sometimes, though, you guess which rater the report is referring to. In one of the most stunning allegations (page 12):

The Staff also found that the [smaller] NRSRO did not appear to conduct the analyses and request the documents required by its policies and procedures when it issued a short-term investment grade rating of the same issuer, contrary to the NRSRO’s own rating policies. Approximately two weeks after the NRSRO published these ratings and the press release, the issuer petitioned for bankruptcy.

Whoops! That is a ratings disaster. Pity that we don’t know the name of the rater involved.

The report also details one of the most contentious issues about who pays for ratings (page 8):

Six of the NRSROs operate primarily under the “issuer-pay” model. Two of the NRSROs, KBRA and Morningstar, previously operated primarily under the “subscriber-pay” model, but in recent years have begun issuing ratings under the issuer-pay model. Only EJR operates fully under the subscriber-pay model. The NRSROs operating primarily under the issuer-pay model account for almost 99% of the total NRSRO credit ratings reported by NRSROs as of December 31, 2011.

The ratings business runs on an issuer pay model. The perennial question is whether issuers (or their underwriters) shop for the best rating first. That is an unanswered question.

Kudos to the SEC on their second annual examination of raters. Markets now have a lot more information about these powerful entities.

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