SEC On "The Issuer Pays": Ratings Agency Facelift Falls?

SEC Staff Report on Credit Rating Agencies, July 2008

Rating agencies do not appear to take steps to prevent considerations of market share and other business interests from the possibility that they could influence ratings or ratings criteria.

The SEC (PDF) report on the ratings agencies classified as NRSROs — nationally recognized statistical ratings agencies — tells a pretty simple story.

1. The major rating agencies — Fitch, Moody’s and Standard & Poor’s — were told to develop and enforce policies to prevent conflicts of interest from potentially throwing a bias into analyst rating reports.
2. The major ratings agencies developed those polices.
3. But they do not enforce them.

The issue acquires particular poignancy at a time when the public is looking carefully at the performance of these agencies to determine their “failed prognostication rate” (FPR) — which is actualy just a piece of pseudoterminology I made up myself, but you get what I mean, right?

Freedonia sovereign debt is as solid as the Rock of Groucho, they say.

The Rock of Groucho turns out to have feet of clay. Citibank fires 20,000 employees. Goldman Sachs ponders vacating its Death Star building on Pearl Street and decamping for Tony Sopranoland.  The mayor of New York City — who is in the information and numbers business himself, and is actually quite good at it — looks at his tax revenue projections for the next five years and contemplates jumping out the window.

Each of the NRSROs examined uses the “issuer pays” model, in which the arranger or other entity that  issues the security is also seeking the rating, and pays the rating agency for the rating. The conflict of interest inherent in this model is that rating agencies have an interest in generating business from the firms that seek the rating, which could conflict with providing ratings of integrity. The Commission’s rules specify that it is a conflict of interest for an NRSRO being paid by issuers or underwriters to determine credit ratings with respect to securities they issue or underwrite. They are required to establish, maintain and enforce policies and procedures reasonably designed to address and manage conflicts of interest.35 Such policies and procedures are intended to maintain the integrity of the NRSRO’s judgment, and to prevent an NRSRO from being influenced to issue or maintain a more favorable credit rating in order to obtain or retain business of the issuer or underwriter

The SEC asked the agencies to design a scheme of effective self-regulation to avoid such conflicts or apparent conflicts.

They did.

Each of the NRSROs has policies that emphasize the importance of providing accurate ratings with integrity. To further manage the conflicts of interest arising from the “issuer pays” model, each of the examined NRSROs established policies to restrict analysts from participating in fee discussions with issuers.

They just do not enforce those policies:

While each rating agency has policies and procedures restricting analysts from participating in fee discussions with issuers, these policies still allowed key participants in the ratings process to participate in fee discussions.

For example:

One rating agency permits an analytical manager to participate in internal discussions regarding which considerations are appropriate for determining a fee for a particular rated entity.

And:

Only one rating agency actively monitors for compliance with its policy against analysts participating in fee discussions with issuers, and, as a result was able to detect and correct certain shortcomings in its process.

The long, slow wrestling match with the SEC recalls in many ways the issue of investment banking research independence. At the end of the day, when the dust had settled, the investment houses simply decided that rules to protect the integrity of equities research — the mythical “Chines wall” — made the whole enterprise not worth undertaking.

As a result, Henry Blodget no longer studies stocks for a living. Instead, he blogs.

The same argument is to be heard from proponents of Journalism 2.0.

Playing the game of news reporting by the old rules, which guarantee its integrity and responsibility to the public interest, is simply no longer profitable (enough).

The result: News media that, like the fabled Rio de Janeiro newspaper editor, is constantly jumping up on the desk and screaming, “I need a front page headline! Somebody find me a bleeding corpse!”

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