SEC Allegations Against Rating Agencies Keep Piling Up

In a recently released report, the SEC alleges that Moody’s, S&P, and Fitch have, on multiple occasions, engaged in improper actions and had failures strikingly reminiscent to those that they engaged in and suffered from prior to the Great Recession.  It further alleges that a majority of the smaller Rating Agencies have engaged in similar improper actions and had similar failures.

These shocking allegations are contained in the SEC’s 2015 Summary Report examining the Rating Agencies’ activities in 2014, released on December 28, 2015 together with their 2015 Annual Report on Nationally Recognized Statistical Rating Organizations (NRSROs) that focused on the period from June 26, 2014 to June 25, 2015.[1]

The SEC alleges a host of violations by Moody’s, S&P, and Fitch and by at least 5 of the 7 smaller Rating Agencies. Among the many allegations in the 2015 Reports: claims of misapplication of RMBS criteria in numerous ratings, lack of necessary policies and controls concerning ratings methodologies and modeling, insufficient policies and controls to manage the issuer-paid conflict, and failure to adhere to internal policies and procedures with respect to the issuance, surveillance, or withdrawal of ratings by one or more of the Rating Agencies.

What happened after these alleged events occurred, or continued unabated from previous years?   The reports don’t say, and we don’t know.  What we do know is that, incredibly, despite the continued and on-going severity of these allegations, the SEC has not used its enforcement powers. There have been no administrative proceedings to adjudicate these allegations against the Ratings Agencies.

[pullquote align=”full” cite=”” link=”” color=”” class=”” size=””]What will it take for the SEC to act to use its enforcement powers to punish these alleged violators of its rules?[/pullquote]

The lack of follow-up on its own allegations is troubling, but there are also issues with the report itself. The SEC should also have been much timelier in its reporting. An examination report for the year 2014 should not take 362 days to prepare.

Transparency is an issue. The SEC Reports have historically been released between the day before Christmas Eve and New Year’s Day, perhaps to ensure that they draw little attention[2].

Moreover, we don’t know which Rating Agency is being accused of what violation because the SEC chooses to camouflage the name of the accused, referring to it as “a larger NRSRO” or a “smaller NRSRO” rather than stating its name. Whose interests does it serve to know only that a big 3, or smaller 7 NRSRO has been accused of fraudulent or merely sloppy acts, instead of identifying them by name? Concealing Ratings Agencies’ names in this way only serves to raise doubts about the whole group and does not benefit the financial market. The SEC should be much more transparent in this area.

The 2015 SEC Reports demonstrate that the SEC has failed to act on what it sees as new, and continuing, issues with respect to the Rating Agencies’ operations and performance.  It’s time to address the elephant in the room: What will it take for the SEC to act to use its enforcement powers to punish these alleged violators of its rules?

Putting Things in Perspective

Let’s get some perspective.  Moody’s, S&P, and Fitch were key drivers of the mortgage market bubble that resulted in the Great Recession.[3]  Wildly Inflated ‘AAA’ ratings they issued on trillions of dollars of mortgages packaged and repackaged in residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs), primarily in the 2003-2007 period, —and the scores of downgrades of these securities by Moody’s, S&P and Fitch in 2007-2008—inflicted destruction across the financial markets and broader economy.

The ratings fiasco of those years has been widely attributed to flawed computer models, internal pressures to build or maintain market share, lack of devoted resources despite extraordinary profits, and a lack of transparency and oversight at Moody’s, S&P, and Fitch.

Reforms enacted under Dodd-Frank[4] were supposed to deal with these types of issues.  They were designed to encourage a more competitive ratings market, improve its transparency, and help ensure that Rating Agencies meet the highest standards.  Dodd-Frank also strengthened the SEC’s ability to enforce these regulations and directed it to adopt new rules about conflicts of interest, fines and penalties and other matters.

But the shocking alleged violations described in the 2015 Examination Report occurred in 2014, long after the Great Recession and long after Dodd-Frank was enacted.  Six years later, serious issues continue to occur.

Action Required

Enforcement mechanisms work best when they are utilized, or when those subject to them believe that they will be utilized aggressively.  As it stands, if the SEC’s allegations are true, the Ratings Agencies as a group (and Moody’s, S&P, and Fitch individually) don’t meet reasonable standards and continue to improperly deal with inherent conflicts of interest.[pullquote align=”right” cite=”” link=”” color=”” class=”” size=””]If the SEC’s allegations are true, the Ratings Agencies as a group don’t meet reasonable standards and continue to improperly deal with inherent conflicts of interest.[/pullquote]

The SEC highlights its settlement of four administrative cases against the Rating Agencies (three against S&P and one against a smaller Rating Agency, DBRS) in the 2015 SEC Reports.

It might appear that by settling these administrative cases, the SEC is actively using its enforcement powers over the Ratings Agencies. But the long lag between the occurrence of the alleged violations in those cases (one of the S&P cases occurred between 2009 and 2012, a second in 2011, and a third in 2012)  and their resolution, and the expanding number of shocking Rating Agency violations alleged by the SEC, demonstrates a clear lack of aggressiveness and timeliness of action on its part.

The SEC needs to use its powers forcefully, prosecuting any Rating Agency that fails to meet its regulatory requirements, and referring allegations criminal in nature to the Department of Justice for appropriate investigation and prosecution.  The SEC’s administrative court moves quickly and most, if not all, of the allegations in the SEC Reports should have been adjudicated or resolved by now.

With the SEC having failed in its vital regulatory activities vis-à-vis the Rating Agencies, it would be wise for the Senate Committee on Banking, Housing, and Urban Affairs or the House Committee on Financial Services to focus on how to address these matters properly.

By Avi Oster

Managing Director

Judicious Advisors LLC

[1]  The 2015 Summary Report of Commission Staff’s Examinations of Each Nationally Recognized Statistical Rating Organization and the 2015 Annual Report on Nationally Recognized Statistical Rating Organizations were prepared by the SEC’s Office of Credit Ratings (OCR) together with other members of the SEC’s staff.  The 2015 SEC Reports, together with similar reports issued at the end of 2013 and 2014, are referred to in this post as “the SEC Reports.”  The SEC refers to the Ratings Agencies as NRSROs.  A NRSRO is a Nationally Recognized Statistical Rating Organization (i.e., a Rating Agency) as determined by the SEC.  There are 10 NRSROs.  In this post I refer to the 3 largest Rating Agencies (Moody’s, S&P, and Fitch) by name and to the other 7 as the smaller Rating Agencies.  In the SEC Reports they are referred to as “larger NRSROs” and “smaller NRSROs” respectively.

[2] The 2015 SEC Reports, given their release date, appear to have drawn perfunctory press attention, with the notable exception of the incisive Gretchen Morgenstern’s column, The Stone Unturned: Credit Ratings, in the Sunday New York Times on January 10, 2016.

[3] While Fitch was a key driver of this bubble, given its much smaller share of outstanding ratings at that time, it was less of a leading force than Moody’s and S&P.

[4] The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), signed into law in July 2010.

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