The SEC’s Misleading Take On Its Own Rating Agency Report

Despite Its Own Findings, It Claims Success and Congratulates Itself

Despite the SEC‘s allegations of rampant bad ethics, widespread noncompliance with internal standards, insufficient controls, and little change in Moody’s, S&P’s, and Fitch’s dominance over the industry, the SEC declared victory in a recent press release[1] announcing its latest reports on its oversight of the Rating Agencies.

Given the findings of those reports[2], the truth is that the SEC and its Office of Credit Ratings (OCR) have been far less than successful in overseeing the NRSROs: they have utterly failed in their responsibilities.

One of the cornerstones of the SEC’s duties is its mission to protect investors. Its Office of Credit Ratings (OCR) was established as part of Dodd-Frank[3] to strengthen the SEC’s ability to “..promot[e] accuracy in credit ratings…to ensure that credit ratings are not unduly influenced by conflicts of interest…” and to fortify its ability to enforce its new regulations vis-a-vis the Rating Agencies.[4]

The press release misrepresents the SEC’s lack of success in improving the quality of credit ratings.  It presents a completely contrary story and, with self-congratulatory wording, suggests that the SEC actually deserves praise for improvements to Rating Agency quality and competition due to its efforts.

Continued Allegations of Widespread Faults at the Rating Agencies

In the Reports, the SEC alleges[5] that both the Big 3 and the Smaller Rating Agencies, have continually and repeatedly failed to a) manage conflicts of interest, b) adhere to their individual policies, procedures, and methodologies, c) avoid widespread insufficiencies in their internal control structures, d) comply with reporting requirements, and e) maintain proper governance structures and performance.

The multitude and types of specific – and shocking – allegations against the Rating Agencies that are presented in the latest Examination Report will be all too familiar to readers of the previous SEC Reports.[6]

The alleged behavior is essentially the same as that which led Moody’s, S&P, and Fitch to issue wildly inflated ‘AAA’ ratings to RMBS and CDOs, primarily in the 2003-2007 period.  The bulk of these securities – scores of which they dramatically downgraded in 2007-2008 – defaulted; they were key drivers of the mortgage market bubble that resulted in the Great Recession.

While individual alleged violations of acceptable behavior and standards appear to be cured from examination period to examination period, remarkably similar instances of mismanaging conflicts of interest, failing to meet their own standards, misapplying ratings criteria and/or ratings models, and other violations or deficiencies, turn up again and again in the SEC Reports.

Why doesn’t the SEC use its enforcement powers to prosecute Rating Agencies that fail to meet regulatory requirements?

This should raise obvious questions. If these findings are at all correct, why is so difficult for the Rating Agencies to fix these problems once and for all, to simply ensure the quality and integrity of their own ratings, and put in proper controls over possible conflicts of interest?  If the Rating Agencies don’t want to, or can’t, fix these problems and comply with their regulations, why doesn’t the SEC act? Why doesn’t the SEC use its enforcement powers to prosecute Rating Agencies that fail to meet regulatory requirements? Why doesn’t it refer findings criminal in nature to the Department of Justice for appropriate investigation and prosecution?

Unfortunately it’s easier for the SEC to ignore its own findings and falsely declare victory than to take appropriate action.

The SEC Ignores the Overwhelming Bad News and only Reports the Limited Good News

Despite dozens of severe new findings in its report, in its press release the SEC actually commends the Rating Agencies:

…compliance and competition continue to increase among the credit rating agencies under SEC oversight….
As a result of our efforts, NRSROs are redoubling their focus on policy and procedure adherence to achieve enhanced transparency quality, and integrity….

To support these conclusions, the press release focuses just on the 11th and 12th pages of the 39-page 2016 SEC Examination Report. This section of the report discusses the issues that the Rating Agencies have improved.

The core of the 2016 Examination Report, which describes the dozens of violations by the Rating Agencies that the SEC allegedly found during the report’s examination period, is not discussed in the press release at all.  This lack of disclosure is misleading.

The statement in the press release that “…all of the staff’s findings from prior examinations have been appropriately addressed” is also misleading.  By not mentioning any of the dozens of findings of similar violations in the 2016 Examination Report, this press release paints a completely false picture that the SEC finds the Rating Agencies to be in compliance with their requirements.

Minimal Reduction in Moody’s, S&P’s, and Fitch’s Market Dominance

The press release states that, “…competition continue[s] to increase among the rating agencies…” but this statement is contradicted by the 2016 Annual Report itself. It notes that, even with inroads being made by the smaller Rating Agencies in U.S. structured finance (in ABS, RMBS, and CMBS), “…S&P, Moody’s, and Fitch in the aggregate account for 96.5% of all the ratings outstanding as of December 31, 2015—slightly higher than 95.8% as of December 31, 2014.”[7]

It even notes that, “..the NRSRO industry constitutes a “highly concentrated” market….”[8]

NRSRO Revenue Information[9]
S&P, Fitch, & Moody’s All Other NRSROs
2015 93.2% 6.8%
2014 94.5% 5.5%

The 2016 Annual Report does note larger relative headcount increases at the Smaller Rating Agencies, but fails to say that management and senior management of the Smaller Rating Agencies who have made the greatest inroads is dominated by veterans of Moody’s, S&P and/or Fitch.[10]

These are hardly signs of a market that has truly diversified away from Moody’s, S&P, and Fitch.

These facts and numbers demonstrate that the claims by the SEC in the press release that there is significant increased competition in ratings misrepresents reality and its reporting in the 2016 Annual Report.  These are hardly signs of a market that has truly diversified away from Moody’s, S&P, and Fitch and belie the press release’s claims regarding increased competition.

A Year Too Late

While the tone of the press release suggests that all of the “improvements” are happening now, this is also misleading.

The 2016 Annual Report actually covers June 2015 to June 2016, and the 2016 Examination Report covers January 2015 through December 2015.  As noted in my previous post on this subject, this lack of timeliness is an additional cause for concern.

Why does it take until December 21 to issue a report for a period ending on December 31 of the previous year? Is that considered to be timely reporting?

Continuing Mystery of Who Is Accused of What

Also noted in my previous post on this subject, the reports remain less than transparent. In 2016, the SEC continues its puzzling practice of camouflaging the names of Rating Agencies accused of violations. It refers to them as a “larger NRSRO” or a “smaller NRSRO” rather than stating their names.  Whose interests does it serve to know only that a larger NRSRO or a smaller NRSRO has been accused of fraudulent or merely sloppy acts, instead of identifying the accused 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.

This glaring lack of transparency is totally at odds with the SEC’s mission of promoting transparent capital markets and the Office of Credit Rating’s (OCR’s) charge to increase Rating Agencies’ transparency.

In Case You Didn’t Notice

Perhaps the market’s expectations regarding the Rating Agencies are so low that even if the SEC Reports hadn’t been released on Christmas Eve, together with an innocuously titled press release (which has the effect, even if it is not the intention, of drawing as little attention as possible to them), their content  wouldn’t have mattered much to the market.

Nevertheless, the Rating Agencies continue to have an important presence and influence on the markets.  Part of the SEC’s mission is to, “…enhance the regulation, accountability, and transparency of nationally recognized statistical rating organizations or “NRSROs,”[11] and it is important that it carry out that function.

Lack of Sufficient Action By The SEC

We should expect, and we should demand, much more from the SEC. Despite self-aggrandizing statements to the contrary, the job of Rating Agency reform – over 10 years since their missteps in RMBS and CDO ratings leading up to the Great Recession – appears to be far from done.

The job of Rating Agency reform – over 10 years since their missteps in RMBS and CDO ratings leading up to the Great Recession – appears to be far from done.

The SEC seems to be confused about their mission with respect to the Rating Agencies.  The conclusion to the 2016 Examination Report begins with its identification of “findings and recommendations for the NRSOs”  and ends with the line “…the Staff will continue to assess the NRSROs’ compliance with the new and amended SEC rules, and expects enhanced compliance by the NRSROs with these rules.”

This conclusion is misguided. The SEC is a regulatory agency, not a consulting firm. According to its allegations and its findings, the SEC has found rampant patterns of repeated and continuing misbehavior and compliance failures by the Rating Agencies over many years. Despite this, the SEC remains in discussion and expectation mode with the Rating Agencies. The alleged misbehaviors are neither proven nor punished.

These allegations have been going on for far too long and are of such quantity and severity that the SEC’s use of its enforcement power to move against the alleged violators is way overdue.

The SEC has powerful enforcement tools at its disposal should it choose to use them. It should have been clear to the SEC for a long time that pointing fingers at anonymous parties in an annual report, issued a year after the fact, with no prosecution, will not result in the reforms necessary to ensure the integrity and impartiality of NRSROs.

By Avi Oster

Managing Director

Judicious Advisors LLC


[1] SEC Issues Annual Staff Reports on Credit Rating Agencies (Press Release 2016-276).

[2] As similarly noted in my previous post on this subject, SEC Allegations Against Rating Agencies Keep Piling Up, the 2016 Summary Report of Commission Staff’s Examinations of Each Nationally Recognized Statistical Rating Organization (the “2016 Examination Report”) and the 2016 Annual Report on Nationally Recognized Statistical Rating Organizations (the “2016 Annual Report” and, together with the 2016 Examination Report, the “2016 SEC Reports” and, together with previous annual versions of these reports, the “SEC Reports”) were prepared by the SEC’s Office of Credit Ratings (OCR) together with other members of the SEC’s staff.  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 or as “the Big 3”, to the other 7 as “the smaller Rating Agencies”, and all 10 as the “Rating Agencies”.  In the SEC Reports they are referred to as “larger NRSROs” and “smaller NRSROs” respectively.

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

[4] See “About the Office of Credit Ratings”

[5] The SEC uses the terms “findings” and “essential findings” to describe the allegations that it makes based on their examinations. I similarly use these terms in this post.

[6] New Examination Reports and Annual Reports have now been issued annually for 6 years and 9 years, respectively.

[7] Annual Report, page 11.

[8] Annual Report, page 14.

[9] Annual Report, Page 17.

[10] For example, DBRS’s Group Managing Director of Global Structured Finance and its Managing Director, Head of RMBS Structured Finance came directly from Fitch; 2 of the 5 members of Kroll Bond Rating Agency’s (“KBRS”) Executive Leadership, including its President & CEO, have roots at S&P and Fitch, the heads of its CMBS, RMBS, and Project Finance Groups  came directly from S&P, and its Chief Compliance Officer came directly from Moody’s; and Morningstar Credit Rating’s (“Morningstar”) President was at McGraw-Hill for 30+ years, including serving as the Head of Structured Finance and the Head of Global Ratings for its S&P unit for 5 years and 10 years, respectively, and the heads of its CMBS, RMBS & ABS, and Operational Risk Assessments, Groups, as well as its Designated Compliance Officer all came from S&P.

[11] Ibid., footnote 5.

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