On July 8, 2008, the SEC announced the results of its investigation of the three major rating agencies, Fitch Ratings Ltd., Moody’s Investor Services Inc. and Standard & Poor’s.  The investigation uncovered “significant weaknesses in ratings practices.”

First, the report asserts that the ratings agencies suffered from several inherent conflicts of interest, including an “issuer pays” model that puts pressure on the agencies to issue favorable ratings in order to generate return business.

Second, the report notes that the ratings agencies seemed fundamentally unable to deal with the increased growth and complexity of Residential Mortgage-Backed Securities (“RMBS”) and Collateralized Debt Obligation (“CDO”) deals beginning in 2002.  In this regard, the SEC asserts that some of the firms failed to disclose “significant aspects of the ratings process” and/or had inadequate documentation of policies and procedures for rating RMBS and CDOs.  Specifically, the report finds that: (1) “[n]one of the rating agencies examined had specific written procedures for rating RMBS and CDOs”; (2) some of the ratings agencies failed to document significant steps in the ratings process (including deviations from their standard models); and (3) at least one firm, without disclosure, “regularly reduced loss expectations on subprime second lien mortgages” which sometimes resulted in a reduction of expected loss.  The SEC report specifically notes one internal communication in which an analyst “expressed concern that her firm’s model did not capture ‘half’ of the deal’s risk” but stated that “it could be structured by cows and we would rate it.”

Finally, the SEC report finds that the ratings firms overworked their analysts and did not have enough staff for their volume of work.  In particular, the SEC notes that some of the ratings agencies had failed to keep up with internal surveillance of ratings and, due to the increased number and complexity of the RMBS and CDO’s, the agencies were not able to verify whether their models were accurate.

The Proposed Rule changes deal with enhanced disclosure of procedures and methodology in determining credit ratings, additional record keeping, making rating actions publicly available, sending an additional annual report to the SEC, disclosing information about the securities being offered beginning on the date the offering price is set and attaching to the ratings an explanation of how ratings of structured financial products differ in methodology from those for other securities.  Notably, all of these rules and changes apply only to rating agencies registered with the SEC.  Such registration is voluntary.

For a copy of the SEC report, click here.  For a copy of the Proposed Rules, click here.

Reacting to the report, Senator Charles Shumer reportedly commented that although “the SEC doesn’t name names, these findings show searing abuse by the rating agencies” and suggested that the next appropriate step was the filing of enforcement actions.