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Sunday, February 28, 2010

Credit Rating Agencies and Their Regulation

Gary Shorter
Specialist in Financial Economics

Michael V. Seitzinger
Legislative Attorney

Credit rating agencies (CRAs) are expected to provide investors with an informed and unbiased view on securities' debt risk (also referred to as credit risk), the risk that issuers will fail to make promised interest or principal payments when they are due. The agencies provide judgments ("opinions") on the creditworthiness of bonds issued by a wide spectrum of entities, including corporations, nonprofit firms, special purpose entities, sovereign nations, and state and municipal governments. They take the form of ratings that are usually displayed in a letter hierarchical format: AAA being the highest and safest, with lower grades representing an increasing scale of risk to the investor. The three dominant CRAs are Moody's, Standard & Poor's, and Fitch. 

CRAs have been a fixture of securities markets since the 19th century; they predate federal regulation of the markets. The Securities and Exchange Commission (SEC) issues a designation of Nationally Recognized Statistical Rating Organization (NRSRO), which is important because a variety of laws and regulations reference their use. (For example, the amount of risk-based capital that banks must hold against a portfolio of securities is linked to ratings; and thrift institutions are not allowed to own bonds rated below investment grade.) 

In recent years, many assert that the performance of the dominant rating agencies has been marked by a number of spectacular failures. Companies like Enron and WorldCom retained their high credit ratings until a few days before they filed for bankruptcy. More recently, many mortgage-backed securities initially rated AAA have defaulted or have been sharply downgraded. In both situations, investors who relied on the ratings suffered heavy losses. The SEC and other observers have criticized the failings of the three dominant CRAs in their ratings of mortgage backed securities. Subsequently, Moody's, Standard & Poor's, and Fitch have adopted a number of voluntary reforms intended to address their perceived shortcomings. 

Between December 2008 and September 2009, the SEC adopted several reforms aimed at enhancing NRSRO disclosures, and mitigating NRSRO conflicts of interest, including a prohibition on NRSRO personnel involved in rating determination participating in fee discussions, negotiations, or arrangements; a requirement that each NRSRO and NRSRO applicant provide rating change statistics for each asset class of credit ratings for which it is registered or is seeking registration; an authorization for competing NRSROs to offer unsolicited ratings for structured finance products by granting them access to the necessary underlying data for structured products; and an elimination from federal securities regulations and laws certain references to credit ratings by NRSROs. On December 11, 2009, the House passed H.R. 4173. In November 2009, the Senate Banking, Housing, and Urban Affairs Committee released a legislative draft that also contains rating agency reform provisions. Both would require NRSROs to have established internal controls over the processes used to determine credit ratings, enhance the rights of entities to bring private actions against rating agencies for certain knowing or reckless failures in research with respect to rating determinations, and disclose the primary assumptions used in constructing the procedures and methodologies for arriving at credit ratings. Separately, H.R. 4173 would strike references to "not investment grade" or to "ratings" or similar language in a number of federal statutes, including the Federal Deposit Insurance Act; replace the term ''nationally recognized statistical rating'' with ''nationally registered statistical rating'' in the Securities Act of 1933 and the Securities Exchange Act of 1934; and require the removal of references by federal financial regulators and in certain federal laws. Other bills that would also provide for rating agency reforms include S. 927 (Pryor), S. 1073 (Reed), H.R. 1181 (Ackerman), H.R. 1445 (McHenry), and H.R. 2253 (Delahunt).  

Date of Report: February 18, 2010
Number of Pages: 29
Order Number: R40613
Price: $29.95

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