SEC Hits Conflict of Interest at Credit-Rating Agencies

Moving to address one of the principal causes of the 2008 financial crisis, the Securities and Exchange Commission, in a split decision Wednesday, passed new rules designed to limit conflicts of interest at credit-rating agencies.

The rules, required by the 2010 revamp of financial regulation called the Dodd-Frank Act, follow in-depth reviews of the credit-rating agencies by SEC staff.

“While the reports from these reviews have catalogued a number of improvements, they have also identified concerns that persist, including ones related to the management of conflicts of interest, internal supervisory controls, and post-employment activities of former staff,” said SEC Chief Mary Jo White at the start of the SEC public meeting on the rule changes.

A number of congressional and regulatory investigations found that credit-rating firms such as Moody’s Investor Services and Standard & Poor’s allowed business considerations to influence the gold-plated AAA ratings they issued to complex mortgage bonds that proved to be junk.

These bonds, called mortgage-backed securities, were deemed the most creditworthy even though there was no history on which to judge the new financial instruments. The rating agencies sat at the table with Wall Street firms such as the defunct Bear Stearns and Lehman Brothers, and pooled together mortgages into complex securities.

Pension funds and other institutional investors snapped up these complex bonds, comfortable with the AAA rating that implied there was little chance of default. When the housing market cratered in 2007 and 2008, the complex securities were worth pennies on the dollar, and a global financial crisis ensued.

To address the conflict of interest, the new SEC rules would prevent the sales and marketing departments of credit-rating agencies from having anything to do with firms seeking a rating for their financial product. Among the provision of the new rules are tighter look-back requirements designed to discourage rating-agencies’ employees from going to work for companies whose product they’ve rated. Investigations by McClatchy Newspapers and subsequently regulators showed how Wall Street firms played rating agencies off each other, threatening to give competitors their business unless they got the AAA rating they sought.

The Justice Department is suing Standard & Poor’s for $5 billion, alleging it deliberately inflated ratings.

This article appeared in print in the August 28th, 2014 edition of Hamodia.