New York- A report released last Tuesday by the Securities and Exchange Commission (SEC) revealed deficiencies in the credit-rating practices of the three major rating agencies, which agreed to implement the SEC’s recommendations in an effort to ensure the credibility of their ratings.
The SEC report identified issues related to disclosure, documentation, surveillance, internal policies, and conflict of interests, among others, across the practices of the firms reviewed. Furthermore, the agency intercepted communications such as e-mails and instant messages revealing the analysts’ knowledge of the diminished quality of the ratings.
“We’ve uncovered serious shortcomings at these firms, including a lack of disclosure to investors and the public, a lack of policies and procedures to manage the rating process, and insufficient attention to conflict of interest,” said SEC chairman Christopher Cox in a press release .
This news did not come as a surprise to us. In our article “A Bug in the Moody’s Black Box?,” posted on May 23, we commented on the fact that Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product, which, according to that rating firm, was due to a “bug” in its computer models. In that opportunity we stated that “it seems indisputable at this point that Moody’s failed to exercise sufficient quality control over its model.”
Just a few weeks after the “bug” buzz, we are hearing again about the lack of quality control at the major rating agencies. The SEC’s 10-month examinations of S&P’s, Moody’s, and Fitch Ratings revealed that these firms have failed in various stages in their processes rating subprime RMBS and CDOs.
The report concludes that comprehensive reforms are needed in order to overcome the deficiencies found. While the firms agreed to implement the SEC’s recommendations in an attempt to restore credibility for investors, the picture is darker.
The Wall Street Journal disclosed yesterday, in an article titled “SEC Says Debt-Rating Firms Sacrificed Quality for Profit”, parts of the intercepted e-mails and instant messages by analysts at the reviewed firms. These messages might reveal the dimension of the struggles these companies are having in keeping up with high-quality ratings. E-mails sent by analysts in 2006 and 2007, show their awareness of the diminished quality of the ratings. One analyst, whose identity was not revealed by the SEC, was quoted in the WSJ saying, in 2006 right before the subprime market crisis, “Let’s hope we are all wealthy and retired by the time this house of cards falters.”
The content and the development of this particular investigation are reminiscent of a certain settlement. Without attempting to make predictions, it is worth to note some similarities. The Global Settlement reached in 2003 was preceded by an investigation where the SEC participated, which uncovered conflicting interests and other irregularities. Beyond generating a scandal, the e-mails and other communications by analysts provided a lead in the investigation. Such communications ended up being a good thermometer of the situation underlying securities research.
In the particular case of the rating agencies, their willingness to adopt the SEC’s recommendations is a first encouraging step in retaining their credibility. We will now witness whether this expressed willingness translates in reality.