DealBook: Rating Agencies Face Crackdown

Alex Wong/Getty ImagesMary Schapiro, the Securities and Exchange Commission chairman.

Securities regulators are out to tame the credit rating agencies, crucial Wall Street players at the center of the financial crisis.

The Securities and Exchange Commission proposed sweeping new rules on Wednesday to overhaul the rating business – regulations that would force tougher internal controls, potentially curb conflicts of interest and even mandate that the agencies periodically test the competence of their employees.

“These rules are intended to help investors and other users of credit ratings better understand and assess the ratings,” Mary L. Schapiro, chairman of the S.E.C., said at a public meeting on Wednesday. “It is a massive proposal,” she said of the plan, which spans more than 500 pages.

The S.E.C.’s five commissioners unanimously agreed to advance the proposals, which are now open for public comment for 60 days.

The agency’s Republican commissioners indicated, however, that they would push for some changes. The proposals “could be life threatening” to small rating agencies,” Kathleen L. Casey, a Republican commissioner, said at the public meeting.

A rating agency, for instance, would have to take on the costs of periodically administering performance exams that would “test its credit analysts on the credit rating procedures and methodologies it uses,” according to a summary of the proposal.

The proposals stem from the Dodd-Frank Act, the financial overhaul law enacted last year. The S.E.C. has already proposed new policies under Dodd-Frank that would strip references to credit ratings from rules that govern securities offerings.

The rating agencies in recent years became a target in Washington, as regulators and lawmakers blamed them for feeding the mortgage bubble by awarding top grades to bonds backed by subprime mortgages. The investments later soured, driving the economy to the brink.

A Congressional panel that chronicled the crisis called the largest rating agencies — Standard Poor’s, Moody’s Investors Service and Fitch Ratings — “essential cogs in the wheel of financial destruction.”

The problems, critics say, stem from an inherent conflict of interest plaguing the rating agencies’ business model.

Banks and corporations that issue debt must pay the rating agencies to assign their bonds a letter grade. In the lead up to the crisis, the rating agencies had a heavy hand in the mortgage bond business, as they advised big banks how to earn a top triple-A grade. In a quest for profits, the critics say, the agencies compromised the integrity of their ratings.

The S.E.C.’s proposal intends to mitigate some of those conflicts that have long hurt the industry’s reputation.

The plan would prohibit analysts from issuing a rating if they also marketed their rating agency’s products or services. Small rating agencies can apply for an exemption from this rule.

The proposal also takes aim at the revolving door between the rating agencies and Wall Street firms that seek the grades.

Under the plan, the rating agencies would have to examine whether their former analysts awarded overly rosy ratings to a firm that later hired that person. In such cases, the rating agencies would have to “promptly determine whether the credit rating must be revised.”

Ms. Casey warned that this proposal “threatened to cross the line” into dictating the substance of credit ratings. “I am concerned that this is such a slippery slope,” she said.

Still, the proposals do not go as far as some had expected.

In the final days of negotiations over Dodd-Frank, lawmakers stopped short of eliminating the so-called issuer pays model that causes potential conflicts of interest. Instead, lawmakers opted for a compromise. The S.E.C. must now study whether to create an independent body that will randomly assign ratings to different agencies.

The rating agencies fiercely oppose this plan, among other Dodd-Frank rules. Some rating agencies also may target an S.E.C. proposal that would require the industry to disclose how well their ratings have performed over time.

“One significant concern is whether the S.E.C. will follow up on this rule-making by actively pushing back at rating agencies if these attempts at mandating greater rating agency transparency turn out to produce opaque or formalistic disclosures in practice,” said Jeffrey Manns, a professor at George Washington University law school, who is an expert in credit rating agencies.

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