ATTORNEY: Anna Karin F. Manalaysay
POMERANTZ MONITOR, MARCH/APRIL 2015
Anyone compiling a list of culprits in the U.S. subprime residential mortgage debacle of 2007-2008 would have to include the credit rating agencies at or near the top. Meant to provide investors with reliable information on the riskiness of various kinds of debt, the agencies have instead been accused of defrauding investors by giving triple-A ratings to mortgage-related securities so risky they were even considered doomed to fail by the banks that created them.
Why did this happen? Probably because the financial incentives for the ratings agencies have changed dramatically. In the past, credit rating agencies charged a subscription fee to subscribers to cover their rating activity. Then the practice changed, and the company or issuer being rated pays the fee. By switching to this business model, the ratings agencies assumed a crippling conflict of interest; for if they did not deliver high ratings regardless of the circumstances, issuers would shop around for a more compliant ratings agency the next time around.
The best-known credit rating agencies in the United States are Moody’s Investor Services, Standard and Poor’s, and Fitch. S&P issues nearly half of all credit ratings and together with Moody’s and Fitch, the so-called “Big Three” issue ninety-eight percent of the total ratings. On February 3, 2015, S&P agreed to pay $1.375 billion to settle lawsuits brought by the U.S. Department of Justice and 20 attorneys general concerning ratings S&P gave to certain mortgage securities just before the 2008 financial meltdown. So far, this has been the largest settlement involving a credit rating agency.
The press release issued by the Justice Department said the ratings at issue were given to residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) during the period 2004 to 2007. RMBS are created when a bank or other financial institution pools together mortgage loans. CDOs pool together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors.
The lawsuit filed by the Justice Department in 2013 alleged that S&P had engaged in a scheme to defraud investors by knowingly inflating the credit ratings it gave to RMBS and CDOs which resulted in substantial losses to investors and ultimately contributed to the worst financial crisis since the Great Depression. The Justice Department claimed that S&P’s rating decisions were not independent and objective as they were required to be but, rather, based in part, on its business concerns.
As a part of the settlement, S&P agreed to a statement of facts that contained an admission that its ratings for CDOs were partially made based on the effect they would have on S&P’s business relationship with issuers. It also admitted that, despite knowledge within the S&P organization in 2007 that many loans in RMBS transactions it was rating were delinquent and losses were probable, it continued to issue and confirm positive ratings.
As credit rating agencies were being blamed for feeding a subprime mortgage frenzy, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010. Among its various provisions, Dodd-Frank outlined a series of broad reforms to the credit rating agencies market. Despite Dodd-Frank, however, some signs of trouble have re-emerged. In January 2015, for example, S&P paid nearly $80 million to settle accusations of the SEC that it orchestrated similar fraud in 2011, years after the financial crisis took place. S&P also agreed to take a one-year “timeout” from rating certain commercial mortgage investments at the heart of the case, an embarrassing blow to the rating agency. The pact is the SEC’s first-ever action against a major ratings firm.
The SEC has since issued new rules aimed to enhance governance, protect against conflicts of interest, and increase transparency. These rules, which went into effect January 1, 2015, require rating agencies such as S&P to:
- provide records of their internal control policies and rating methodology;
- prohibit their sales teams from participating in the rating process;
- review, and revise if needed, ratings for companies that later hire one of the agency’s employees; and
- file annual reports showing how the agencies monitor ratings, how ratings changed over time and whether evaluated companies eventually defaulted.
If a credit rating agency violates these rules, the SEC will suspend or revoke the agency’s registration — disciplinary action that may be effective in preventing further violations. However, while the regulations do attempt to keep rating activity under strict surveillance, they do not restructure the way rating agencies solicit business or receive payment. Thus, the inherent conflict of interest still exists since the agencies are paid by the same banks and companies they rate.
The SEC has thus far failed to maintain control and ensure rating agencies follow proper rating methodologies — the multiple accusations against S&P attest to these failures — but only the health of the future financial market will tell whether the recent regulations, coupled with the hefty consequences credit rating agencies such as S&P have had to face, will have a long-term stabilizing impact.