On February 5, the United States Department of Justice (DOJ) and 13 states plus the District of Columbia sued Standard & Poor’s Financial Services LLC and its parent company, McGraw-Hill Companies Inc. alleging that the credit rating agency misled investors and knowingly assigned faulty ratings to investment products during the financial crisis. This suit is the first federal action against a credit rating firm related to the 2008 financial meltdown.
In the suit filed in the U.S. District Court for the Central District of California, the DOJ alleges that S&P engaged in a scheme to defraud investors by misrepresenting that its ratings of residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) were objective and independent. According to the DOJ, “the firm downplayed and disregarded the risks of the products it was rating in a bid to boost profits and to favor the interest of large banks and other issuers.” Moreover, the federal suit asserts that S&P was concerned over losing market share and revenue and it limited, adjusted and delayed updates to its ratings criteria and the models it used to measure risks posed by the products.
The DOJ claims that S&P violated the 1989 Financial Institutions Reform, Recovery and Enforcement Act and as such, the statute authorizes civil penalties up to the amount of losses allegedly suffered. In this case, the department identified more than $5 billion in losses resulting from CDOs that were rated by S&P between March and October 2007.
Consistent with our message of years past, AFP will continue to be a proponent of policies that encourage competition in the credit ratings market, increase transparency and control/eliminate potential conflicts of interest in the ratings process. We firmly believe that fundamental changes to the current business models of credit rating agencies must be enacted in order to correct the systemic problems plaguing the system.
Beginning in late 2002, AFP surveyed senior-level corporate practitioners and financial industry service providers on their views regarding the quality of the NRSROs’ ratings, the role the Securities and Exchange Commission (SEC) should take in regulating the agencies, and the impact additional competition may have on the marketplace for ratings information. In that survey, many financial professionals indicated that the ratings generated by the NRSROs were neither accurate nor timely.
Over the past 11 years, AFP has released additional surveys and data that assess the accuracy and timeliness of the NRSROs’ analyses and the potential role regulators may have in promoting competition among credit rating agencies. The results of our research have consistently shown several key findings which include:
- 87 percent of responding organizations with debt indicate that credit providers require them to obtain and maintain a rating from at least one of the four NRSROs.
- Many financial professionals believe that the ratings of their organizations are either inaccurate or are not updated on a timely basis.
- A third of corporate practitioners believe the ratings on their organization’s debt are inaccurate.
- 52 percent of financial professionals indicate that the cost of credit ratings has increased by at least 11 percent over the past three years, including 19 percent that indicate that costs have increased at least 25 percent over that time period.
Financial professionals believe the SEC should take a greater role in overseeing the credit rating agencies along with encouraging greater competition in the field.
In 2010, AFP suggested two proposals for credit rating agency reform to the SEC and members of Congress. These reforms would have significantly altered the way the ratings business is run.
AFP also commented on a number of proposals issued by the SEC. AFP supports the disclosure of additional information, but believes that the requirements for disclosure should be independent of model. Any disclosure requirements should be applied to all NRSROs regardless of their business model. Disclosing additional pieces of information will add transparency and credibility to the credit rating process, allowing investors to evaluate rating methodologies and the diligence with which each NRSRO scrutinizes existing ratings. As market events have reinforced, ratings that are not maintained based on an effective methodology cannot be considered credible and reliable. Market participants should have access to information that allows them to make a proactive assessment of an NRSRO’s surveillance process rather than discover that it is flawed through adverse events.
AFP generally supports increased regulation and oversight of NRSROs, but does not support interference with the rating methodologies used by NRSROs. Disclosure of and adherence to those methodologies are sufficient for a prudent investor to make an informed decision.
We will continue to pursue policies that promote real competition, greater credibility and reliability in ratings and the elimination of conflicts of interest. AFP will strenuously oppose efforts by the credit rating agencies to shift potential liability to issuers.