(Updates with Stein comment in sixth paragraph.)
Aug. 27 (Bloomberg) -- Credit-rating firms, whose lapses played a central role in the 2008 financial crisis, face broader restrictions on conflicts of interest under rules adopted by the U.S. Securities and Exchange Commission.
The rules, approved on a 3-2 vote today, require firms including Moody’s Investors Service, McGraw Hill Financial Inc.’s Standard & Poor’s and Fitch Ratings Ltd. to ensure they insulate analysts from pressure to please bond issuers, who pay for the ratings. The rules include a strict prohibition on allowing sales motives to influence grades.
Firms also will have to reveal more about the accuracy of ratings, including a common method for disclosing default and downgrade rates of bonds. Credit-rating analysts who leave to join a firm whose product they have graded will have their work immediately re-examined.
“This package of reforms will improve the overall quality of credit ratings and protect against the re-emergence of practices that contributed to the recent financial crisis,” SEC Chair Mary Jo White said in a statement before today’s vote.
The Financial Crisis Inquiry Commission said in its January 2011 report that debt graders led by S&P and Moody’s helped ignite the credit squeeze that began in August 2007 by lowering standards to win business. Investors who bought the complex bonds often relied on ratings that indicated the securities had a very low probability of default.
“The credit-rating agencies, which should have been on the front line sounding the alarm to warn against the coming financial firestorm, instead helped fan the flames,” SEC Commissioner Kara M. Stein said today.
The Dodd-Frank Act of 2010, enacted in response to the crisis, directed the SEC to prevent conflicts of interest from creeping into ratings decisions. The law also required that rating symbols -- such as Moody’s Aaa or S&P’s AAA -- are applied consistently among the different kinds of bonds that credit raters examine.
The rules require that firms establish controls to ensure they follow their own criteria for rating bonds. SEC examinations over the past several years have found that some rating firms didn’t follow their own methodologies while others failed to separate analytical and business functions.
Moody’s “believes that a modernized oversight regime will help increase confidence in the ratings process as well as instill greater discipline in the industry,” said Anthony Mirenda, a company spokesman. “While we have yet to digest the SEC’s new rules fully, we intend to implement and abide by them as published.”
David Wargin, an S&P spokesman, said the company is evaluating the rules to “determine what changes to our operations may be required.”
“We are committed to the highest standards in our ratings activities and complying with the new requirements,” he said.
The rules also create a process for suspending or revoking the registration of credit raters if a rating is found to have been tainted by sales and marketing motives.
The SEC said seven other smaller credit rating firms, including Morningstar Inc. and Kroll Bond Rating Agency Inc., may apply for exemptions from the conflict-of-interest rules.
Michael Piwowar, a Republican commissioner who opposed the rules, said the agency’s plan is too prescriptive, while the wall between sales and analysis may restrict the ability of ratings firms to grow.
Any ratings firm “that grows its business in any asset class could be suspected of having the ratings determination process ‘influenced by’ sales and marketing considerations,” he said.
The SEC also unanimously approved a separate set of rules that enhance protections for investors who buy bonds backed by mortgages, auto loans and leases, and commercial buildings. Sellers of the bonds will have to provide investors with loan- level data that can be used to judge the riskiness of the securities. The details include the borrowers’ debt levels and credit scores as well as information about loan balances and payments.
The new requirements cover part of the market for mortgage- backed securities that aren’t guaranteed by the government, a market which imploded in 2008. The rules don’t apply to offerings of asset-backed securities that are sold to investors in private placements.
Banks eligible to accelerate sales of asset-backed bonds with minimal SEC review will have to provide an executive’s certification that investor disclosures are accurate. They also will have to provide a process for reviewing soured assets that may be eligible to be repurchased.
“The reforms before us today will add critical protections for investors and strengthen our securities markets by targeting products, activities and practices that were at the center of the financial crisis,” White said in a statement before the vote. “Investors will have powerful new tools for independently evaluating the quality of asset-backed securities and credit ratings.”
--With assistance from Matt Robinson in New York.