The Securities & Exchange Commission (SEC) published its ‘Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies’ [NRSROs]. The SEC concluded (in a year-long study released on July 8th), that rating agencies improperly managed conflicts of interest and violated internal procedures in granting top ratings to structured securities. The SEC report lists eight major areas of deficiencies in processes, procedures and conflict of interest, including:
- The massive volume and complexity of deals overwhelmed NRSROs’ resources, leading to errors and short cuts in procedures and documentation.
- Aspects of the rating process were not always disclosed. There was a lack of consistency in documentation on rating processes, models and rating committee meetings.
- As to the quality of information underlying the ratings, there was no obligation for rating agencies to verify the information provided by arrangers.
- Significant aspects of the rating process, including rationale for rating committee actions and decisions, were not always documented.
- No due diligence on information was provided to NRSROs.
- The surveillance process used appears to have been less robust than it should have been.
- There were issues in the management of conflicts, for instance, with analysts taking part in pricing
- Internal audit process varied significantly between rating agencies and were ineffective in part due to lack of documentation.
Implications: Tighter regulations are now inevitable, but rating agencies are pushing back stating that some of the recommendations are too costly and beyond the current mandate of the SEC. However it is important to note that the NRSROs are proceeding with the implementation of many of the recommendations made by the SEC. There are many proponents for a tighter regulatory regime, here in the USA and on the other side of the Atlantic at the European Commission. But there are others who caution that the NRSROs are not the only participants in the value chain of bringing financial securities to the market. There is a long route from origination to investors all of which have to be part of a ‘credit system overhaul’. In regard to entrusting NRSROs to European regulators the Financial Times wrote recently: “If the world’s best-paid financiers did not spot subprime, is it fair to entrust this tasks to Europe’s supervisors?”
BIIA suspected all along that there was a disconnect with regard to the use of consumer information. The USA has the highest penetration of credit due to the availability of reliable information, and based on this fact the subprime debacle should not have happed. It is now evident that there was wholesale misrepresentation, misuse of information and outright fraud in the origination process of subprime mortgages. FICO scores appeared to have been imprecise because the absence of underlying credit performance of subprime candidates (no loan history). Experts are now questioning the reliability of credit scores. Others counter by proposing a greater use of non financial data (for example utility payments etc.) to compensate for the absence of previous credit performance data from the financial sector) to improve the performance of ‘subprime credit scores’.
Deven Sharma, President of S&P stated recently in a speech at a conference of the Federal Deposit Insurance Corporation (FDIC): “… an important conversation is underway about the way securities are evaluated and rated in addition to the way securities are originated, sold, invested and priced…” BIIA hopes that the credit information industry will be included in such conversations.
BIIA Newsletter July / August 2008 Issue