Credit-Rating-Agency Reforms: As an Outgrowth of the Meltdown in the Mortgage-Backed Securities (MBS) Markets, the Securities and Exchange Commission Has Adopted New Rules to Tighten Oversight of the Credit-Rating Agencies

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The story of the credit-rating agencies is a story is a story of colossal failure. The credit-rating agencies occupy a special place in our financial markets. Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public."--Statement of Rep. Henry Waxman (D-California), chairman of the House Committee on Oversight and Government Reform, during the Oct. 22, 2008, Hearing on Credit Rating Agencies and the Financial Crisis. * "Since all opinions [about future events] are liable to error, and opinions based on models are liable to systemic error of vast proportion, why should the U.S. government want to enshrine the opinions [of certain preferred rating agencies] as having preferred, preferential--indeed mandatory--status? It shouldn't."--Testimony of Alex J. Pollock, resident fellow at the American Enterprise Institute, Washington, D.C., to the Joint Economic Committee of the U.S. Congress, May 14, 2008. * "[Analysts and managing directors] are continually 'pitched' by bankers, issuers, investors. [At times,] we drink the Kool-Aid."--Internal board presentation delivered by Raymond W. McDaniel Jr., chief executive officer, chairman of the board and director of New York--based Moody's Corporation, to Moody's directors in October 2007 and discussed as part of his testimony before the House Committee on Oversight and Government Reform's Oct. 22, 2008 hearing.

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On Feb. 2, 2009, the Securities and Exchange Commission (SEC) published the last of a series of final rules to reform federal regulatory oversight and registration of nationally recognized statistical rating organizations (NRSROs) to expand the list of prohibited conflict-of-interest activities. The rules' broader goals include maintaining separation of core functions from consulting services, minimizing conflicts inherent in issuer-based compensation, and enhancing record-keeping and disclosure requirements to better educate investors on methodologies used to initially rate a security class and ongoing monitoring processes used to ensure the integrity of the credit rating into the future.

Conflict-of-interest and NRSRO registration rules take effect on April 10, 2009; new record-keeping and disclosure rules take effect on Aug. 10, 2009.

The official name--nationally recognized statistical rating organization (NRSRO)--was adopted by the SEC in 1975. It was established solely for determining capital charges on different grades of debt securities under the Net Capital Rule--a rule requiring broker-dealers, when computing net capital, to deduct from their net worth certain percentages of the market value of their proprietary securities positions.

Over time, as marketplace and regulatory reliance on credit ratings increased, the use of the NRSRO concept became more widespread. Between 1975 and 2002, the SEC used the NRSRO designation as its "seal of approval" to select on an informal no action letter basis only a few national credit-rating agencies--Moody's Investors Service, Standard & Poors (S&P) and Fitch Ratings, all based in New York (collectively referred to as the Big Three); plus four other credit rating agencies that ultimately merged into the Big Three.

The 2009 SEC rules are designed to fully implement the Credit Rating Agency Reform Act of 2006 (the Reform Act), signed into law by President George W. Bush on Sept. 29, 2006. That's right--2006. The Reform Act came about as a result of the collapse of Enron Corporation in November 2001, and was to serve as a supplement to the Sarbanes-Oxley Act of 2002.

Well before the U.S. subprime mortgage collapse and collapse of financial markets worldwide, the Senate Committee on Governmental Affairs held hearings and issued a staff report in October 2002. The Senate committee was investigating how credit-rating agencies could have rated Enron a good credit risk right up until four days prior to the company declaring bankruptcy. …