The following is an excellent article written by Gretchen Morgenson on January 8, 2016 in the New York Times titled “Ratings Agencies Still Coming Up Short, Years After Crisis” and I quote:
The mistakes that led to the 2008 mortgage crisis can’t happen again, right?
Not so fast, particularly if you’re talking about credit ratings agencies like Moody’s Investors Service and Standard & Poor’s. Eight years after these companies were found to have put profits ahead of principle when they assigned high grades to low-quality debt securities, some of the same dubious practices continue to infect their operations. That’s the message in the most recent regulatory report on the companies from the Securities and Exchange Commission.
The credit ratings agencies played an enormous role in generating billions of dollars in losses during the debacle. Internal emails that emerged in congressional investigations were especially revealing of the problems at these companies. “We rate every deal,” one Standard & Poor’s employee famously wrote. “It could be structured by cows and we would rate it.”
There’s an entertaining — and illuminating — scene in the movie “The Big Short” that perfectly captures the pathology. As a Standard & Poor’s employee played by Melissa Leo replies when asked why the ratings agency didn’t insist on higher standards: “They’ll just go to Moody’s.”
But like many of those responsible for the mess, credit raters largely escaped accountability. They were allowed to maintain their conflicted business models, in which issuers pay the agencies to rate their securities. And their ratings remain deeply embedded in our financial system: bank capital requirements are still based in part on the grades assigned to securities these entities hold.
Ten credit ratings agencies are currently registered and operating in the United States. As their overseer, the S.E.C. must conduct examinations of them every year and issue an annual report of its findings.
The most recent such report came out on Dec. 28, easily missed in the holiday crush. But its contents are a potent reminder that absent strong enforcement of the rules, questionable behavior is not likely to change.
The S.E.C. report doesn’t identify which agencies ran afoul of what rules. That’s unfortunate. But it does separate the companies into two groups based on size. So when the regulator describes a problem at one of the “larger” credit ratings agencies, you know it means one of the big three — Fitch Ratings, Moody’s or Standard & Poor’s.
Some of the problems uncovered by the S.E.C. are frighteningly basic. For example, 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, the report noted.
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.
In another example, 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 S.E.C. said.
Then there were the analysts at one larger ratings agency who 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 S.E.C. also identified instances where substantive statements made by this agency in its rating publications directly contradicted its internal rating records.
Even more alarming, policies and procedures at one larger credit ratings agency did not prevent “prohibited unfair, coercive or abusive practices,” the report found. 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,” the S.E.C. found. This not only violated the unnamed firm’s policies and procedures, but also resulted in a misapplication of the company’s ratings criteria, the report said.
“These failures are eerily familiar, right?” said Micah Hauptman, financial services counsel to the Consumer Federation of America. “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,” he added, “and that the Dodd-Frank Act was supposed to address.”
Ratings agency rules from 2007 and 2010 were intended to diminish potential conflicts of interest at these companies, improve their internal controls and create new standards of training, experience and competence.
But rules work only if companies that violate them are punished for doing so.
The S.E.C.’s report comes from its Office of Credit Ratings; officials in this unit conduct exams and collect data on how the agencies are adhering to the rules.
The task of cracking down on violators falls to members of the S.E.C.’s enforcement staff. And it seems from this report that they have their work cut out for them.
“The S.E.C. is going to have to be extraordinarily tough if they want to change the internal practices of the credit ratings agencies,” Mr. Hauptman said. “There are legitimate concerns about the S.E.C.’s willingness to go that route.”
The first case brought by the S.E.C. against a major credit ratings agency came a year ago when it accused Standard & Poor’s of fraud. The ratings agency “elevated its own financial interests above investors by loosening its rating criteria to obtain business and then obscuring these changes from investors,” the agency said. Standard & Poor’s settled the case, paying $58 million to the agency and $19 million more to two state attorneys general.
In October, the S.E.C. also took action against DBRS, a smaller ratings agency, for misrepresenting its ratings methodology on certain securities; the firm paid $6 million to settle the case. But these cases stem from activities several years ago. And the numbers in those matters aren’t much when set against the profits ratings agencies generate. For example, Moody’s earned almost $1 billion in 2014, the most recent annual figure available.
“We’ve always been optimistic about the potential that the new rules had,” Mr. Hauptman said. “Now we have to wait and see how vigorously the S.E.C. enforces them.”