February 22, 2016
Rating Agencies: SEC’s Annual Report Reveals Ongoing Concerns
The seemingly positive SEC press release touting improvements in credit rating agency processes based on 2015 annual examinations (summary report) and reporting (annual report) notwithstanding, this NY Times article portrays the progress of the Big 3 rating agencies (S&P, Moody’s and Fitch) in particular in a much less favorable light based on a close read and analysis of the same underlying information contained in the SEC’s December 2015 reports.
By way of background, in August 2014, in response to the alleged role of flawed credit ratings on asset-backed and other securities in the financial crisis, the SEC adopted Dodd-Frank-mandated rules aimed at improving the quality of credit ratings by addressing, e.g., agency internal controls, conflicts of interest, procedures designed to protect the integrity of rating methods, and their transparency/accountability.
Contrary to the outwardly reassuring picture conveyed by the SEC release, the NY Times recounts these concerning findings from the SEC reports:
- Two of the larger companies “failed to adhere to their ratings policies and procedures, methodologies, or criteria, or to properly apply quantitative models.” These failures occurred on numerous occasions.
- Errors seem common. Because of a coding mistake, a structured finance deal made by one larger ratings agency didn’t reflect its actual terms. It took some time for this error to be detected and when it was, the transaction’s rating took a substantial hit.
- A larger ratings agency employee noticed an error in the calculations used to determine certain ongoing ratings, but in subsequent publications, the company disclosed neither the mistake nor its implications. This ratings agency also inaccurately described the methodology it used to determine some of its official grades.
- The analysts at one larger ratings agency learned of flaws in outside models used to determine ratings. But no one at the company assessed the impact of the errors or told others about them as required under its procedures. The SEC also identified instances where substantive statements made by this agency in its rating publications directly contradicted its internal rating records.
- Policies and procedures at one larger credit ratings agency did not prevent “prohibited unfair, coercive or abusive practices.” As a result, the agency gave an unsolicited rating to an issuer that was “motivated at least in part by market-share considerations.” Such a practice would allow an agency to gain an issuer’s business by offering a better rating than a competitor.
- At the same agency, two grades assigned by ratings committees were changed at the urging of “senior ratings personnel.” This not only violated the unnamed firm’s policies and procedures, but also resulted in a misapplication of the company’s ratings criteria.
Consumer Federation of America’s Micah Hauptman made these remarks: “These failures are eerily familiar, right? Sales and marketing concerns influencing the production of ratings. Credit ratings agencies that didn’t have policies and procedures in place to manage issuer-pay conflicts. These are the exact same deficiencies that caused the 2008 financial crisis, and that the Dodd-Frank Act was supposed to address.”
See these August 2014 statements from SEC Chair White and Commissioner Stein upon adoption of the new credit agency requirements.
Credit Rating Agencies: Random Selection
Under Presidential candidate Bernie Sanders’ plan to reform Wall Street, companies would no longer be allowed to select their rating agency:
Reforming Credit Rating Agencies
We cannot have a safe and sound financial system if we cannot trust the credit agencies to accurately rate financial products. And, the only way we can restore that trust is to make sure credit rating agencies cannot make a profit from Wall Street. Investors would not have bought the risky mortgage backed derivatives that led to the Great Recession if credit agencies did not give these worthless financial products triple-A ratings – ratings that they knew were bogus. And, the reason these risky financial schemes were given such favorable ratings is simple. Wall Street paid for them. Under my administration, we will turn for-profit credit rating agencies into non-profit institutions, independent from Wall Street. No longer will Wall Street be able to pick and choose which credit agency will rate their products.
Senators Al Franken (D-Minn.) and Roger Wicker (R-Miss.) reportedly offered a proposed amendment during the deliberation of Dodd-Frank to effect random assignment of rating agencies to companies – with an incentive for more business based on ratings accuracy, but the proposal morphed into a study. The two since have continued to push for reform.
Moody’s Evaluation of Cyber Risk: Credit Rating Impacts
In this podcast, Christian Plath, VP – Corporate Governance Analyst at Moody’s, discusses the credit rating impacts associated with companies’ cyber risks with reference to Moody’s recent cyber risk report (see this overview), including:
– How has Moody’s view of cyber risks vis a vis its credit analysis evolved over the past few years?
– How does Moody’s evaluation of cyber risk in its analysis differ from its evaluation of other types of risks – if at all?
– What can companies do to mitigate the potential for cyber risk to adversely affect their rating?
– Could a lack of preparedness or an acute vulnerability for a cyber attack ever be a justification to downgrade an issuer?
– by Randi Val Morrison