SEC Chair Mary Jo White's Upcoming Test

The indications we've been given -- although no one is willing to state definitively what the final rule is likely to include -- suggest that we shouldn't get our hopes up that our chief concerns will be comprehensively or even meaningfully addressed. We hope we are reading those indications wrong.
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Remember credit rating agencies? Those trusted financial gatekeepers that slapped AAA ratings on junk mortgage backed securities and collateralized debt obligations in the run-up to the 2007-2008 financial crisis? The ones that conveniently ignored or overrode their rating methodologies to issue those high-quality ratings merely because they earned record profits from doing so? The ones that, according to the U.S. Senate Permanent Subcommittee on Investigations, "caused the most immediate trigger to the financial crisis" when they finally acknowledged those securities were actually incredibly risky investments and were going to incur severe losses?

It's now more than seven years after credit rating agencies helped trigger the financial crisis and, believe it or not, we're just as susceptible now to credit rating agencies' potentially destructive rating practices as we were then.

That's because, while Congress provided in the Dodd-Frank Act powerful tools to the Securities and Exchange Commission (SEC) to clean up rating agencies' practices, the SEC has not shown an eagerness to use those tools. Not only has the SEC yet to act, but the rules that the SEC proposed in 2011 to implement rating agency provisions of Dodd-Frank ironically wouldn't curtail many of the perverse activities that credit rating agencies engaged in during the years leading to the crisis.

In an effort to get the rulemaking process back on track, CFA and others have repeatedly raised concerns with the SEC's proposals and provided concrete, simple, and targeted fixes that could make a real difference in the ways credit rating agencies function. Those proposals include:
•adopting an over-arching principles-based rule prohibiting ratings agencies from allowing marketing and sales considerations to influence ratings decisions (and then enforcing it);
•setting standards designed to ensure that credit rating agencies adhere to their rating policies, procedures, and methodologies instead of ignoring or overriding them when it suits them; and
•creating an enforcement mechanism that requires ratings to be applied consistently across asset classes so that, for example, a AAA means the same thing regardless of whether it is assigned to a municipal bond or a synthetic collateralized debt obligation.

Just to provide some context regarding the third point, credit rating agencies use the same symbols across different asset classes despite the fact that different asset classes tend to perform very differently based on their different risks. For example, over an average ten year window, issuers of asset backed securities that Moody's assigned AAA ratings to defaulted more than 20 percent of the time, compared to AAA-rated corporate and municipal bonds, which never defaulted within the same time frame. In response to criticism that such a lack of uniform performance undermines the intended consistent application of ratings, the rating agencies say they "strive" to "broadly" achieve ratings comparability across assets, but offer no guarantees. They claim that "creditworthiness is a multi-faceted phenomenon," for which "there is no formula." So their approach is to boil down all the complexity and issue overly simplistic symbols that apply across asset classes because, according to them, that "conveys the clearest message." In reality, this process allows rating agencies to issue ratings that mean everything and nothing at the same time.

Credit rating agencies get away with this because they "define" their rating symbols so vaguely as to render them meaningless. For example, S&P states that a AAA-rated borrower has an "extremely strong capacity to meet its financial commitments," whereas a AA-rated borrower has a "very strong capacity to meet its financial commitments." What distinguishes "extremely strong" from "very strong" is not explained. The real world impact is rating agencies are free to issue ratings without any substance and that bear no rational relationship to their actual performance. It also means there is no mechanism for anyone to hold them accountable. Ratings from the other major rating agencies are no clearer.

The SEC's 2011 proposed rule largely accepts credit rating agencies' current practices, taking no concrete steps to ensure that ratings agencies issue ratings that mean the same thing when they are applied across asset classes. The SEC staff is also on record recommending that the Commission not take additional steps at this time to ensure ratings are in fact applied consistently.

We're now hearing that that the SEC is about to finalize its credit rating agency rules. The indications we've been given--although no one is willing to state definitively what the final rule is likely to include--suggest that we shouldn't get our hopes up that our chief concerns will be comprehensively or even meaningfully addressed. We hope we are reading those indications wrong.

Chair Mary Jo White, who controls the SEC's agenda, has said recently that the Commission's responsibility in implementing its congressional mandates is much greater than simply "checking the box" and declaring the job done. Faced with a rule that is both so clearly lacking and so easily fixed, this is the easiest test of whether Chair White is truly prepared to put that principle into practice. If she fails to deliver, her legacy on Wall Street reform will be seriously tarnished.

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