This is a whitepaper prepared for Members of Congress concerning creating more transparency and accountability in the credit ratings process. It details events related to the Credit Crisis of 2007-2008.
Creating transparency and competition in
the credit markets
The Chairmen and Members of the Subcommittee on Securities and Insurance, Senate Banking
Committee and the Subcommittee on Capital Markets, Insurance and GSEs, House Financial Services
To propose legislative solutions to increase competition and transparency in the credit markets
Grant the SEC authority to revoke NRSRO status
Create a central repository of default statistics at the SEC
Designate oversight of the NRSRO relationship to issuer audit committees
Proposals to Congress 3
The 2007 credit crisis 5
What do credit rating agencies do? 9
Quis custodiet ipsos custodes? 12
Credit rating agency market practice issues 14
Equivalent Disclosure and proposed legislative solutions 24
Background - Legislative & SEC reviews 27
Background - Regulation Fair Disclosure 31
Summary of proposed legislative and regulatory solutions 33
January 15, 2008
Prepared by Cate Long, Multiple-Markets
Proposals to Congress:
Equivalent disclosure would increase the volume of issuer information available to all Nationally
Recognized Statistical Rating Organizations (NRSROs). This will greatly enhance transparency in the
fixed income markets.
Equivalent disclosure will require issuers to share material non-public information with all NRSROs if
they share this information with one NRSRO. This will eliminate “ratings shopping” and ensure
competition among NRSROs for the most accurate and predictive ratings. This is the expansion of
Regulation Fair Disclosure to the fixed income markets.
Grant the SEC authority to revoke NRSRO status:
The Credit Rating Agency Reform Act of 2006 does not include a grant authority to the SEC to revoke
the NRSRO status of agencies who do not abide by the disclosure which they make to the Commission.
This leaves the Commission without a method of disciplining NRSROs who are not using accurate and
reliable methodologies when issuing ratings, have conflicts of interest which are not managed or who no
longer have the capital resources to continue as an independent entity.
Create a central repository of default statistics at the SEC:
The Congress and the SEC have required NRSROs to publish their default statistics as one of the
schedules required in Form NRSRO. The intent was to require the NRSROs to demonstrate the
predictive value of their ratings for securities and to allow a comparative understanding between the
rating symbology of NRSROs.
The SEC Final Rule requires NRSROs to publish this data on their website for access by investors.
Although the intent of this requirement is very positive unfortunately the placement of these default
statistics is difficult to access and the NRSROs are copyrighting the statistics so they cannot be reused
It would especially useful for Congress to require that this information be aggregated and published in a
central location. This central location could be the SEC EDGAR system. EDGAR’s stated purpose is to
increase the efficiency and fairness of the securities market for the benefit of investors, corporations,
and the economy by accelerating the receipt, acceptance, dissemination, and analysis of time-sensitive
corporate information filed with the agency.
Designate oversight of the NRSRO relationship to issuer audit committees:
There is concern that NRSROs and issuers do not maintain an independent relationship that minimizes
or eliminates conflicts of interest. It is vital that NRSROs evaluate issuers without the influence of
ratings revenue or other consulting income. It is it critical that issuers do not shop for the highest
ratings rather than the most accurate ratings.
The oversight of the NRSRO-issuer relationship should be assigned to the audit committees of the
Boards of Directors of issuers or equivalent oversight entity. Additionally, the total amount of fees paid
to NRSROs by the issuer should be disclosed in public filings.
US and global bond markets have been in deep distress and lawmakers have been examining issues in
the subprime and structured finance areas.
Central in these examinations has been the role of credit rating agencies. This marks the third
Congressional review of credit rating agencies in five years. The Credit Rating Agency Reform Act of
2006 had just been fully implemented when the credit markets seized up.
The credit rating agencies, statutorily recognized as quot;Nationally Recognized Statistical Rating
Organizationsquot; (NRSROs) are being questioned concerning the accuracy of their rating
methodologies and their potential conflict of interests. Our regulatory framework embodies the
expectation that NRSROs will consistently and accurately judge the relative creditworthiness of issuers
and securities. Members of Congress are concerned that the regulatory framework may have flaws
which inhibit the proper functioning of NRSROs.
Market participants rely on the information implied by ratings to measure the risk, price, and
trade fixed income securities. Hundreds of federal and state laws rely on the analysis of NRSROs to
determine the suitability of securities for various investors, fiduciaries and institutions. The stability of
the financial system is predicated on NRSROs providing accurate analysis and rating
methodologies. Stability also requires transparency and a free flow of information.
The 2007 credit crisis is due, in part, to a dramatic reassessment and rerating of subprime and
structured products. Extraordinary rerating and repricing of securities such as CDOs, CDOs squared,
ABCP vehicles, RMBS and other highly structured and levered products has been happening since July,
When NRSROs misjudge the creditworthiness of a security, or an entire class of securities, risk can be
unknowingly concentrated and mispriced. Investors and institutions can be exposed to severe losses
when NRSROs reassess methodologies and rerate securities. Recent events have raised the issue
if NRSROs have failed in assessing risk in a similar manner to their performance in the Enron and
Financial institutions, public retirement funds, mutual funds, hedge funds, foreign entities and investors
have suffered severe strains as securities have been reevaluated and repriced. The dislocation is of an
unprecedented magnitude. The Federal Reserve and other central banks have taken exceptional
measures to maintain ample liquidity in the banking system.
The SEC is conducting in depth examinations of the NRSROs under the new statutory authority
conferred by the Credit Rating Agency Reform Act of 2006 (CRARA) to understand if conflicts of
interest, poor methodologies, lax analysis or other factors impeded the ability of NRSROs to accurately
rate large classes of securities. Congress continues its oversight role and reviews the
statutory framework that NRSROs, issuers and investors work within.
This whitepaper was prepared for Members of Congress to recommend the adoption of
quot;Equivalent Disclosurequot; and other measures to increase competition and transparency in credit
Ratings are information. They represent the opinion of a credit rating agency about the relative
creditworthiness of an issuer or security. Markets thrive when information is available and when
transparency is linked with competition. For the stability of global financial markets we need more
disclosure, transparency and competition in the ratings business.
The 2007 Credit Crisis
Over the past 40 years, the global financial system has evolved from a slow paced world of fixed
exchange rates, capital controls, bank-dominated financial flows and modest domestic and international
capital markets into one in which capital flows freely across borders, investors and borrowers invest and
borrow globally, and capital is allocated by the securities market rather than by banks.
Deregulation, disintermediation and financial innovation have created a financial system that is vastly
more efficient than before, and which allows excess savings in one country or region to finance
investment in a completely different location. Such free flow of capital has contributed significantly to
the growth of the global economy.
Prior to the disintermediation of the markets, credit crunches occurred when a central bank brought the
official rate above the time deposit interest rate ceiling to slow the economy. This action caused funds
to flow out of the banking system, which in turn forced banks to restrict lending.
Modern credit crunches are caused by unexpected shocks that destroy market confidence e.g.:
A geopolitical event – the Iraq conflict (1990-1)
A sovereign default and the near-collapse of a big hedge fund (Russia and Long-Term Capital
Major accounting frauds and associated defaults – the technology bubble (2001-2)
The revaluation of a large asset class – U.S. sub-prime bubble (2007)
Last July the credit crisis of 2007 erupted when Moody’s and Standard & Poor's downgraded several
billion dollars worth of mortgage-backed collateralized debt obligations (“CDOs”). The general view is
that these downgrades were long overdue. Why were the rating agencies slow to downgrade?
This is a difficult question to answer without direct investigation into the practices of the major credit
rating agencies. The SEC is currently undertaking this review within the authority granted to the
Commission by the Credit Rating Agency Reform Act of 2006. The results of this review will be central
to our outstanding of the events and practices which lead to the credit crisis of 2007.
The 2007 crisis has invited comment about the role, function and performance of credit rating
agencies. These events have again proven that markets can change rapidly and dramatically. The
opportunity to improve market practices, including credit analysis and credit-ratings processes, must be
pursued vigorously and transparently if confidence in, and the healthy operation of, credit markets are
to be restored.
Press descriptions of the 2007 Credit Crisis
A Sinking Sensation for Subprime Loans >> February 14, 2007 (Business Week) ---
...quot;But credit deterioration poses pitfalls for investors. Total delinquencies for RMBS transactions issued
in 2006 averaged 12.61%, and loans considered seriously delinquent averaged 5.97%, according to
research by Standard & Poor's Credit Markets. And there are reports that jitters are hitting the
derivatives market as buyers and sellers of mortgage credit protection battle it out, says Action
Delinquencies and foreclosures may get worse. One out of five subprime mortgages issued in the past
two years is projected to end in foreclosure, according to a study released in December by The Center
for Responsible Lending, a Durham (N.C.)-based research group. The group also noted that even when
home prices were rising, subprime home loans fared poorly, with as many as one in eight, or 13%, of
these loans ending in foreclosure within five years of origination.quot;...
Subprime Losses Drub Debt Securities >> July 11, 2007 (Bloomberg) ---
More than a few investors would like to know what took the New York-based rating companies so long
to discover a U.S. liability of Iraq-sized proportions.
quot;I track this market every single day and performance has been a disaster now for months,'' said
Steven Eisman, who helps manage $6.5 billion at Frontpoint Partners in New York, during a conference
call hosted by S&P yesterday. ``I'd like to understand why you made this move now when you could
have done this months ago.''
Eisman was referring to the rise in borrowing costs that has forced thousands of Americans to default
on their mortgages. A total of 11 percent of the loan collateral for all subprime mortgage bonds had
payments at least 90 days late, were in foreclosure or had the underlying property seized, according to
a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May
2005, that amount was 5.4 percent.
Investors depend on guesswork by Wall Street traders for valuing their bonds because there is no
centralized trading system or exchange for subprime mortgage securities. Credit rating companies
supported high prices because they failed to downgrade the debt as delinquencies accelerated.
Rate Agencies Move Toward Downgrading >> July 11, 2007 (New York Times) --
...quot;The slumping housing market
again rattled the bond market
Standard & Poor’s, the credit rating
firm, said that it would tighten the
standards it used to rate bonds
backed by subprime mortgages, a
tacit acknowledgment that it might
have been too optimistic about the
At the same time, Standard &
Poor’s said that it would probably
downgrade bonds totaling a
relatively small $12 billion, a move
that surprised investors with its
tone and timing. A rival agency,
Moody’s Investors Service, followed
suit later in the day, saying that it would downgrade 399 bonds with a face value of $5.2 billion and put
another 32 bonds on watch.
Yesterday’s actions are expected to draw further attention to the role of credit agencies in the market
for mortgage securities, which helped fuel the housing boom by extending credit to people who may not
have otherwise qualified for loans.
Investors and policy makers are increasingly asking whether Standard & Poor’s, Moody's and a third
agency — Fitch Ratings — were lax in their evaluations of the mortgage bonds that Wall Street banks
sold to investors like pension funds, insurance companies and endowments.
James Grant Says World Credit Market Has Yet to Reach Bottom >> Jul 16, 2007
(Bloomberg TV) --
James Grant, editor of Grant's Interest Rate Observer, talked with Bloomberg's Pimm Fox in New York
on July 13 about the outlook for the credit market amid U.S. subprime mortgage troubles, credit ratings
of residential mortgage-backed securities.
This is a video... running time = 19:27 minutes
00:00 quot;We are not at the bottom in credit.quot;
01:28 Mortgage-backed securities' ratings, pricing
06:08 quot;Opacityquot; of subprime mortgage market
08:53 Credit market, impact on private equity
Ohio Attorney General Says Raters quot;Likely Aided and Abettedquot; Fraud
(Bloomberg TV) This is a video. Running time = 7:11 minutes
Ohio Attorney General, Marc Dann, discusses his agencies civil and criminal investigations of the credit
rating agencies and their role in mortgage fraud committed on Ohio homeowners.
Florida's Pension Fund Holds Same `Suspect' Debt >> Dec 4, 2007 (Bloomberg)
quot;Florida's pension fund owns more than $1 billion of the same downgraded and defaulted debt that
sparked a run on a state investment pool for local governments and forced officials to freeze
The State Board of Administration, manager of $37 billion in short-term assets, including the pool, also
oversees the $138 billion Florida Retirement System. The board purchased $3.3 billion of debt whose
top ratings were reduced following the collapse of the subprime mortgage market, according to
documents obtained by Bloomberg News through an open records request.
Like the hundreds of school districts and towns unable to access $14 billion frozen in the Local
Government Investment Pool, Florida's 1.1 million current and retired state workers rely on the board's
management to boost returns on the funds that pay their pensions. That has left them vulnerable to the
same potential for losses. A state-created home insurer and the treasury are also at risk.
quot;These were highly inappropriate investments for taxpayers' money,'' said Joseph Mason, a finance
professor at Drexel University in Philadelphia. ”This is the tip of the iceberg for pension funds. We know
the paper is sitting there. There are substantial subprime-related losses that haven't shown up yet.''
Florida Fun Run >> Nov 30, 2007 (The Financial Times) --
...quot;Not much unites the Arctic outpost of Narvik and the sunshine state of Florida. Except their troubled
finances – courtesy of the US housing bust.
On Thursday, Florida temporarily froze redemptions from its state-run Local Government Investment
Pool, a $17 billion money market-like facility for local districts, to prevent a run on deposits.
It followed news that Narvik and three other remote Norwegian towns had lost a bundle on investments
in complex securities sold by Wall Street and undone by the credit turmoil.quot;...
Mr. Josh Rosner of Graham Fisher discusses credit rating agencies >> Bloomberg TV
Mr. Rosner discusses the role of credit rating agencies on the credit markets.
This is a video. Running time = 10:59 minutes
See additional news accounts in the quot;Resourcesquot; section at the end of this whitepaper.
What do credit rating agencies do?
Credit rating agencies are public or private companies who are compensated to evaluate securities
issued by companies, financial institutions, governments and structured finance sponsors. Credit rating
agencies are staffed by analysts who are trained to evaluate the quality of fixed income securities. The
analysts assign quot;credit ratingsquot; to the securities.
Ratings are opinions expressed by rating agencies about the relative creditworthiness of issuers and
securities. Credit ratings help investors understand the risk of default (default = not receiving interest
and principal payments for the security). The higher the credit rating the less chance of a security
Credit rating agencies that go through the quot;recognitionquot; process at the SEC are known as quot;Nationally
Recognized Statistical Rating Organizationsquot; (NRSROs). The SEC recognition allows their ratings to be
used in many federal, state and local rules and laws.
The credit rating agencies derive their revenue in two ways. The dominant agencies charge the issuer of
the bond for a rating. This is known as the quot;issuer payquot; model of rating agencies.
The rating fees for issuers are listed below:
Asset type Moody's S&P
Corporates 4.25 bp 4.25 bp
$ 50k $ 65k
$ 1k $ 2k
Sovereigns $ 50-200k
Structured finance up to 12 bp
Bp = basis point or 1/100th of a percent
The other method of revenue for rating agencies is when users pay for the ratings and the
accompanying commentary. This is the quot;user payquot; model. The dominant agencies charge both issuers
and users for their ratings.
US Treasury securities (Treasuries) are the quot;gold standardquot; of fixed income securities. The probability
of US Treasuries defaulting is considered to be zero. This chart shows the rating scales of the current
dominant NRSROs. All the ratings in the green section are quot;investment gradequot;. The yellow and red
sections denote speculative or quot;junkquot; grade securities.
Definition Moodys S&P Fitch
10.0 US Treasuries *** *** ***
9.5 Prime, maximum safety Aaa AAA AAA
9.0 Very high grade/quality Aa1 AA+ AA+
8.5 quot; Aa2 AA AA
8.0 quot; Aa3 AA- AA-
7.5 Upper medium quality A1 A+ A+
7.0 quot; A2 A A
6.5 quot; A3 A- A-
6.0 Lower medium grade Baa1 BBB+ BBB+
5.5 quot; Baa2 BBB BBB
5.0 quot; Baa3 BBB- BBB-
Number Definition Moodys S&P Fitch
4.5 Speculative Ba1 BB+ BB+
4.0 quot; Ba2 BB BB
3.5 quot; Ba3 BB- BB-
3.0 Highly speculative B1 B+ B+
2.5 quot; B2 B B
2.0 quot; B3 B- B-
1.5 Substantial risk Caa1 CCC+ CCC+
1.0 In poor standing Caa2 CCC CCC
0.5 quot; Caa3 CCC- CCC-
0.0 Extremely speculative Ca CC CC
Maybe in or extremely
0.0 C C+,C,C- C+,C,C-
close to default
0.0 Default D D
Multiple-Markets Patent pending
Credit rating agencies use different types of methodologies to evaluate securities. Generally these
methodologies are classified as quot;qualitativequot; and quot;quantitativequot; methods. The Credit Rating Agency
Reform Act allows rating agencies to use either quot;qualitativequot; or quot;quantitative” methods or a combination
Qualitative methodologies involve the rating agency analyst reviewing the financials and capital
structure of the issuer, talking to the management, and reviewing the industry, interest rate and
Quantitative methodologies used by rating agencies vary but generally rely on a model through which
the issuer’s variables are computed.
Most agencies use a combination of qualitative and quantitative methodologies. One of the provisions of
the Credit Rating Agency Reform Act of 2006 is a requirement that the NRSRO detail the procedures
and methodologies that are used in the determination of credit ratings.
Number of ratings outstanding by NRSRO by asset type as reported to the SEC in 2007:
Financial Insurance Corporate Asset Issuers of NRSRO paid
institutions companies issuers backed government by issuer or
& BDs securities securities obligor
AM Best 1 6,068 2,439 53 ---
DBRS, Inc. 870 30 720 610 40
Egan-Jones 60 46 800 --- ---
Fitch, Inc. 65,621 4,024 13,791 70,731 765,699
Japan Credit Yes
154 32 551 64 73
Moody's Investor 78,000 6,000 29,000 108,000 154,000
Rating and Yes
100 35 609 235 88
Standard & Yes
42,800 6,800 28,300 187,600 976,000
Quis custodiet ipsos custodes?
quot;Quis custodiet ipsos custodes?quot; A Latin phrase from the Roman poet Juvenal, variously translated as:
quot;Who will guard the guards?quot;
quot;Who watches the watchmen?quot;
quot;Who shall watch the watchers themselves?quot;
Rating agencies are the quot;gatekeepersquot; or quot;watchmenquot; of the financial system. They play a critical role in
evaluating the securities sold by companies, governments, financial institutions and structured
finance entities. Their assignment of a quot;ratingquot; to a security is a quot;signalquot; to market participants of the
risk of owning a fixed income instrument.
This quot;gatekeeperquot; role is statutorily granted through recognition as a quot;Nationally Recognized Statistical
Rating Organizationquot; (NRSRO).
(The following is taken from the testimony of Professor John Coffee to the Senate Banking Committee)
When a debacle occurs in the financial markets—whether it be the crisis triggered by the failure of
Enron and WorldCom in 2002, the contemporary mortgage meltdown, or earlier problems in the junk
bond market—one can usually identify a “gatekeeper” in whom investors have lost confidence.
By the term “gatekeeper,” I mean those professionals on whom investors necessarily depend to provide
certification and verification services: auditors, securities analysts, credit rating agencies, investment
banking firms and sometimes corporate attorneys.
These professionals develop “reputational capital” over many years and many clients that leads
investors to rely on them, in part because investors know that the gatekeeper will suffer a serious
reputational injury if it is associated with a fraud or unexpected insolvency. Because this injury should
be greater than any amount the issuer can pay the gatekeeper to acquiesce in fraud, it should deter the
gatekeeper from involvement in fraud.
From this perspective, “reputational capital” is in effect “pledged” by the gatekeeper in support of the
issuer’s statements. But when the market learns that the gatekeeper failed to uncover fraud or related
problems (or that it blinked at them), the resulting loss of confidence, both in the gatekeeper and the
market’s mechanisms generally, can produce a sharp decline in stock market values, a liquidity crisis as
buyers flee the market, or even, in an extreme case, a panic. Recent market developments suggest
that there has been such an erosion in investor trust and confidence.
Thus, when accounting irregularities and financial statement restatements soared in the period between
1998 and 2002, and eventually culminated in the Enron and WorldCom insolvencies, investors lost
confidence in audited financial statements, and stock market prices collapsed. As a result, Congress
enacted the Sarbanes-Oxley Act to eliminate conflicts of interest and restore confidence in the auditing
profession. Controversial as that statute may have been, it basically worked.
Today, attention has shifted to the performance of a different gatekeeper: the credit-rating agency.
Functionally, it plays much the same role for debt purchasers that auditors and securities analysts
perform for equity investors.
Structured finance particularly relies on the credit-rating agency because investors have no ability to
evaluate on their own the securitized pools of financial assets that structured finance creates.
That is, while a sophisticated debt purchaser might be able to evaluate the creditworthiness of the
bonds of a major corporation by examining the corporation’s financial statements, the debt purchaser
has no corresponding ability to assess the risk level of a mortgage pool backing an issue of
collateralized debt obligations (“CDOs”) and so must rely on a “gatekeeper”—here, the credit rating
The major change that destabilized rating agencies appears to have been the rise of structured finance.
Not only are the process and criteria for rating a securitized pool of financial assets opaque, but major
investment banks that assemble these pools bring them to the rating agency for advance negotiation
over the rating before they are marketed.
The process can become one of extended negotiation, because if an investment grade rating is initially
denied, the investment bank can seek to supplement and/or improve the quality of the asset pool.
This is a qualitatively different process than the evaluation of the financial statements of a corporate
issuer, whose financial statements cannot be changed or improved in response to criticism in the short
As a consequence, the rating agency is no longer facing an atomized market of clients who each come
to it only intermittently (and thus lack market power), but instead large repeat clients who have the
ability to take their business elsewhere.
Today, structured finance accounts for a major share of some rating agencies’ total revenues; equally
important, these amounts are paid by a small number of investment banks that know how to exploit
their leverage—and get the rating just over the line and into the promised land of investment grade.
Moody's Investors Service ratings revenue by asset type (data from Moody's 3Q '07 10Q pg. 17)
9 months 9 months
In millions $ 9/30/7 9/30/6
Structured finance $ 611 $ 505
Corporate finance 285 238
Fin inst/Sovereigns 196 189
Public finance 61 71
$ 1,154 $ 1,004
Total ratings revenue
$ 1,344 $ 1,162
Credit rating agency market practice issues...
The process of rating a security begins when an issuer (company, government,
structured finance sponsor) begins to work with rating agencies (NRSROs) and
a lead underwriter to structure a fixed income offering.
Currently issuers can meet with various NRSROs, receive a preliminary rating
and then choose which NRSROs to compensate. This is called “rating shopping”
and is used to find the NRSROs that will award the highest rating to the
offering. By using the highest ratings the cost of borrowing is lower.
Generally, NRSROs that are not compensated by the issuer do not receive
access to the issuer and material non-public information of the issuer. This
limits the non-compensated NRSROs from having equivalent information upon
which to conduct its analysis. It creates information asymmetry for users
because some ratings incorporate management’s input and material non-public
information and some ratings do not.
How securities are issued and rated:
The current credit crisis has illuminated certain market practices that are impeding the operation of the
Two of these issues relate to practices of issuers of fixed income securities:
Issuer selective disclosure of material non-public information
Three issues relate to practices of the dominant credit rating agencies:
quot;Issuer payquot; business model
NRSROs participating in structuring securities
Differential default rates between asset classes
The legislative and regulatory frameworks for the credit markets assume that NRSROs are providing
accurate and unconflicted ratings. NRSROs have stated in the credit crisis of 2007 that their
methodologies did not incorporate adequate information and their modeling was not especially
predictive for certain asset classes especially mortgage back securities (MBS) and structured finance
products that bundled MBS securities.
The credit crisis of 2007 demonstrated that market participants were not always receiving accurate and
unconflicted credit analysis. Investors lost confidence in the ratings assigned by NRSROs and the value
of securities and were unwilling to trade them. In essence the credit markets “froze”.
Many of these market practices lead to reduced transparency and inhibited competition between credit
rating agencies to provide the best methodologies and analysis. These practices caused market
participants to be unable to measure and price risk.
Issuer selective disclosure of material non-public information
Issuer selective disclosure occurs when an issuer shares with select NRSROs the documents underlying
a transaction and/or access to the material non-public information of the issuer. This provides chosen
NRSROs with broader information to judge the creditworthiness of securities. Other NRSROs, not
favored by the issuer, must rely on publicly available information to develop a rating for the security or
are unable to rate the security because they don’t have the underlying information.
The issuer has full control of the adequacy of disclosure to the NRSROs. Issuers do not face any
legislative or regulatory requirement to disclose information equally with NRSROs. The right of issuers
to selectively disclose material non-public information comes from an exemption granted to
communications between issuers and NRSROs in Regulation Fair Disclosure.
This selective disclosure restricts many NRSROs from evaluating the creditworthiness of an issuer and
issuing ratings. And selective disclosure undermines the intent of the CRARA to increase competition
and transparency in rated fixed income securities.
Many NRSROs simply do not have access to the information needed to evaluate a security or issuer.
This limitation constrains the market from making informed decisions about the creditworthiness of
securities because only a small number of ratings might be available on a security or issuer.
The following is a comparison between the number of equity analysts and NRSROs covering several
very large corporations who have large amounts of debt outstanding. (Note that NRSROs who are not
compensated to rate this issuers may generally rely on the public filings of the issuer available on
EDGAR and other financial documents published by the issuer.)
Debt # of NRSRO
Equity market # of equity NRSROs rating
Issuer outstanding rating the
cap ($B) analysts the issuer
Citigroup 170 20 558 5 D, F, M, R, S
Ford 17 14 137 5 D, F, M, R, S
General Electric 398 13 491 3 F, M, S
For NRSROs: D = DBRS, F = Fitch, M = Moody’s, R = Rating & Investment Information, S = S&P
Issuer selective disclosure is intimately connected with issuer “rating shopping”. This is the process of
issuer sharing material non-public information and the underlying documents with NRSROs who they
believe will give them the highest ratings. There is no evidence that all issuers are selectively
disclosing information to NRSROs that award them the highest ratings. But there is plenty of evidence
in the public record that points to some issuers “rating shopping”.
The credit crisis of 2007 suggests that issuers were not choosing and compensating the NRSROs with
the most rigorous or predicative methodologies. Issuers were choosing and compensating NRSROs who
awarded the highest ratings to their securities.
We have a three tier system of NRSROs.
Compensated by Access to material
the issuer non-public information
First tier NRSRO Yes Yes
Second tier NRSRO Maybe Maybe
Third tier NRSRO No No
The first tier of NRSROs is paid by the issuer to rate its securities and as part of that
compensated relationship is given access to material non-public information. Typically the issuer
compensates only two NRSROs. Moody’s and Standard & Poor’s are the NRSROs most often
compensated by issuers. Fitch is a minor third player in this tier as is AM Best in the “insurance
company” asset class. These NRSROs also sell subscriptions to their ratings.
The second tier of NRSROs can be paid by the issuer to rate their securities but are not often
chosen by an issuer and are not given access to material non-public information. The following
NRSROs are in this category DBRS, Japan Credit Rating Agency, and Rating and Investment
Information. These NRSROs occasionally receive fees from issuers to rate securities and they sell
subscriptions to users of ratings.
The third tier of NRSRO is paid by subscribers and/or other market participants and do not
accept compensation from issuers of securities. Generally these NRSROs must rely on publicly
available information to conduct their credit analysis. These NRSROs generally have no access to
the material non-public information of the issuer. Egan-Jones appears to be the only NRSRO that
has stated in their Form NRSRO that they do not receive fees from issuers.
The existence of three tiers of NRSROs, with substantively different access to the information of issuers,
has limited the transparency of the credit market. It has also limited competition between the NRSROs
in their race to conduct the most accurate and timely credit analysis. Some NRSROs are provided
broader access to the material non-public information as part of a compensated relationship with
issuers. As we have seen recently this has significant consequences for the financial markets.
Professor John Coffee of Columbia Law School stated in his testimony of September 26, 2007 to the
Senate Banking Committee the following,
“Although I doubt that subscription-funded agencies will displace the traditional rating agencies,
subscription-funded rating agencies are less conflicted, and they could play an important watchdog role.
But such new entrants face barriers, as issuers may not wish to deal with them or disclose sensitive
information. Indeed, the issuer may withhold access to non-public information for precisely the same
reason that public companies use to withhold data from securities analysts who were skeptical of them:
to punish them. Thus, some have sensibly proposed that an equivalent of Regulation Fair Disclosure
(“Reg FD”) should be adopted to require “equivalent disclosure” to all NRSROs of any information that is
given by an issuer to any NRSRO. “
Rating shopping happens when an issuer reviews the preliminary ratings of NRSROs to determine which
rating agencies will assign the highest rating to its securities. The issuer then chooses the NRSROs with
the highest rating to work with and compensate.
This is another dimension of “selective disclosure” discussed in the previous section. Brian Clarkson,
President of Moody's Investors Service and Chief Operating Officer, described “rating shopping” as the
following in a letter to the SEC:
… “In the asset-backed market, rating shopping describes instances where a sponsor refuses to engage
in discussions with and provide information to a rating agency that may give a less favorable
perspective on the issuance’s creditworthiness and instead the sponsor “takes its business” to other
agencies that provide higher ratings. Therefore, and to put it bluntly, in the ABS market:
The issuer could take its business elsewhere unless the rating agency provides a
As the Commission is likely aware, over the past several years, investors and the market as a whole
have responded to some extent to the problem of rating shopping. While securities have grown
increasingly more complicated, and investors have become increasingly more sophisticated and
demanding, most sponsors presently obtain two ratings and publish in the prospectus the lower of the
two ratings attained. This development has helped curtail the sponsor’s ability to shop for the single
highest investment grade rating available and thereby satisfying its regulatory requirement.”
The Wall Street Journal describes how Moody’s loses business when it tightens its requirements for
commercial mortgage back securities. (Moody's Says It Is Loses Business As Issuers 'Rate Shop', July
…”Moody's Investors Service says it is paying a high price for its tough stance on lax lending standards
for commercial mortgage-backed securities.
In a new report that assesses the status of the market, the Moody's Corp. unit said it was passed over
and not hired for 75% of the commercial mortgage-backed securities rating assignments issued in the
past few months as a result of its requirement that issuers add an extra layer of credit enhancement.
Moody's said issuers are quot;rating shoppingquot; -- meaning they were hiring competitors that would hand out
higher ratings on securities. Because Moody's makes money rating the creditworthiness of bond
issuances, blacklisting could potentially eat away at the firm's bottom line if the trend continues.
On a recent CMBS offering issued by Morgan Stanley, which included 225 fixed-rate loans on 268
multifamily, commercial, and manufactured housing community properties, S&P and Fitch issued the
ratings. Morgan Stanley didn't return calls seeking comment on why it selected these two rating outlets.
Moody's says it cannot comment on the details of a specific deal or issuer, but suspects its higher
subordination levels are the reason it isn't in on most of the deals.
Analysts say the rejection of Moody's by some issuers -- typically investment banks -- is a direct result
of its April announcement. Since the lower-rated bonds needed to increase subordination levels are
more expensive, Moody's move could trim profit margins for CMBS issuers.”
Professor John Coffee discussed the following implications of “rating shopping” in his testimony to the
Senate Banking Committee (page7),
“An important dimension of “rating shopping” is the ease with which issuers can move their ratings
business from NRSRO to NRSRO. They are not required to report publicly which NRSRO they are
compensating for ratings or whether they have requested that an NRSRO withdraw ratings. In contrast,
firing an auditor is difficult because SEC rules require full disclosure of the circumstances surrounding
the termination and permit the auditor to comment.
Also, when the auditor is fired, there is great uncertainty about what the incoming auditor will do;
perhaps, it will be even tougher, and certainly, it has leverage over the client. Precisely because issuers
usually hire multiple rating agencies, they can drop one with less visibility or adverse consequences. In
any event, the evidence clearly shows that there is a market penalty for downgrading one’s ratings.
Moody’s has reported that since it downgraded a series of structured finance offerings in July, 2007, its
market share in the relevant market for mortgage-backed securitizations has dropped from 75% to
25%. In short, business in the market for ratings is mobile, retaliation is relatively costless, and hence
the gatekeeper can become compromised, particularly with regard to structured finance products.”
quot;Issuer payquot; model
When Congress passed the Credit Rating Agency Reform Act of 2006 (CRARA) there was much debate
about the conflicts of interest inherent in the “issuer pay” model. “Issuer pay” is where the issuer or
sponsor of securities pays the NRSROs to rate their securities. This is the current predominant method
of compensation for NRSROs. Seven of the eight NRSROs now recognized state that they receive fees
from issuers for rating securities.
If NRSROs receive compensation from issuers then CRARA requires the NRSRO to disclose this conflict
of interest and state how it is managed. CRARA also directs NRSROs to report to the SEC, in a
confidential manner, revenue from their twenty largest clients. This provides the SEC with a roadmap to
the sources of revenue for the NRSRO. If an NRSRO receives a significant portion of their revenues from
a concentrated group of issuers or sponsors then the Commission can look more closely at the
interaction between those parties and the NRSRO. And examine how well the NRSRO is managing the
conflicts of interest.
The credit ratings industry is an oligopoly dominated by two NRSROs (Moody’s and Standard & Poor’s)
with Fitch having a significant but much smaller market share.
The CRARA does not mandate a business model for NRSROs. NRSROs are free to develop any method
of compensation and ratings distribution that leverages the capability and resources of their firm.
Rather the CRARA mandates two requirements about how NRSROs distribute their ratings into the
financial markets. One requirement is to provide ratings to market participants for “free or a reasonable
fee” and the other is to make their ratings “readily available”.
“Free or a reasonable fee”
The CRARA directs the SEC to require NRSROs to distribute rating symbols for “free or a reasonable
fee”. The SEC has not stated a definitive view on the concept of “reasonable fee” although comments
were sought on this issue in the Proposed Final Rule.
We believe that “reasonable fee” should vary by fixed income classification. For example due to the
complexity of structured finance, and their exclusive use by institutional investors, a “reasonable fee”
for those ratings could be considerably more expensive than ratings for corporate issuers or municipal
If new NRSROs want to charge more than the current NRSROs, ratings subscribers would be in the best
position to determine if the bundle of services offered (number and quality of ratings, distribution
method, and syndication opportunities, etc.) provides better value.
We do not encourage the SEC or Congress to adopt an approach that could be viewed as “rate setting”
for access to ratings published by the NRSROs.
We believe that the fee issue is best addressed by creating a regulatory environment where the highest
quality and most competitive NRSROs are able to create the best analytic methods and tools. Further,
we encourage the Congress and Commission to be flexible and allow NRSROs to distribute their ratings
in unique, low cost ways that best fits their business model and the varied sectors of the investment
If Congress or the Commission attempts to proscribe a set of specific distribution methods and pricing
models for firms applying for NRSRO status it is likely that firms would adopt business models and
analytic methods that already exist and do not leverage new streams of information and distribution.
NRSROs should be able to develop various approaches to their fee models. For example, NRSROs could
provide ratings to large financial portals for distribution into the market and share advertising revenue
with the portal. Alternatively NRSROs could distribute ratings for a fixed fee, fee per rating, a fee based
on the number of trades within a platform, or by sharing market data revenues with a vendor. Ratings
are information and their use and packaging should evolve as information processes and platforms
We believe that NRSROs that want to create increased market share will compete against other
NRSROs by increasing the predictive quality and accuracy of their analysis and reducing the cost to
users of this information.
For some NRSROs the free distribution of their ratings is of value to demonstrate to issuers that the
fees they are paying are being used to broadly inform the market of the creditworthiness of the issuer’s
securities. Other NRSROs believe that restricted distribution of their ratings is beneficial for their
business model. We believe that NRSROs will have various views on the value of distributing ratings
into the financial markets.
The second requirement for NRSROs is to make their ratings “readily available” to market participants.
The following information is drawn from the Form NRSROs.
NRSRO Method of making ratings “readily available”
AM Best Best's credit ratings can be accessed free of charge on Best's web site at
DRBS With the exception of private ratings and ratings for certain private placement
transactions, DBRS distributes its ratings publicly at no cost through its website,
www.dbrs.com. Ratings are also publicly distributed through Bloomberg, Reuters,
First Call, ABSNet and other electronic and print service providers.
Egan-Jones A reasonable fee will be charged; that is rates approximating S&P’s and Moody’s or
Fitch Fitch publishes all public ratings and related rating actions and opinions free of
charge on a non-selective basis on its website, www.fitchratings.com
Japan Credit Internet web site (for free), JCR-RatingEye (web for JPY300,000/User ID/Year), J-
Rating Agency CRIS (database service communicated to customers electronically for
JPY960,000/user/Year plus initial cost JPY2,500,000) Monthly report (publication for
JPY1,800/copy), E-mail service (for free) and facsimile service (for
Moody’s All public credit ratings are available free of charge on our website,
Rating and The credit ratings in the classes indicated in Item 7A are readily accessible for free
Investment on R&I’s website at http://www.r-i.co.jp/eng/
Standard & Public ratings and rating actions are made available at no charge on the S&P
Poor’s website, www.standardandpoors.com, and through various subscription based
products, such as RatingsDirect.
NRSROs often met the requirement for “readily accessible” by publishing rating assignments or changes
on their websites. The public notification is done simultaneously with the notification to their
subscribers. The rating symbol they assign to a security remains available for free on their website. But
for vendors or other users to redistribute ratings most of the dominant NRSROs charge a redistribution
These two requirements embodied in the CRARA work well for NRSROs that are compensated by issuers
to rate their securities. The compensation from the issuer allows NRSROs to hire staff and management
and to pay for infrastructure and ratings distribution.
The two CRARA requirements (“free or a reasonable fee” and “readily available”) can pose problems for
NRSROs who are funded by subscribers or users of their ratings. The challenge for “user pay” NRSROs
is to provide ratings to their subscriber for a fee and also comply with the two requirements of the
CRARA, “for free or a reasonable fee” and “readily available”.
The primary thrust of these requirements is to insure that market participants (particularly retail
investors) not be disadvantaged. Because rating changes affect the value of securities there is
importance in the entire market having access to rating actions taken by NRSROs.
The process of making ratings “readily available” is similar to the way that equity ratings are managed.
Equity ratings are published by the broker-dealer simultaneously to the public, their brokerage force
and their clients. The equity “rating symbol” becomes available in the public for free use and
redistribution. The underlying rational developed by the equity analyst is shared only with clients of the
firm and others that compensate the broker-dealer for the research.
CRARA recognizes that credit ratings are critical to the functioning of the credit markets and attempts
to insure that some market participants are not disadvantaged.
NRSROs participating in structuring securities
There has been much discussion and media attention paid to the issue of NRSROs participating with
sponsors of securities in structuring products. We believe that the examination and review of NRSROs
by the SEC will shed appropriate light on this issue.
Additionally at the end of 2007 the Committee of European Securities Regulators (CESR) asked credit
rating agencies active in the European markets to respond to a set of questions about structured
finance. CESR has published the responses on the credit rating agencies.
On this topic CESR asked the following questions (Question number 34):
“Is the analyst assigned to a certain Structured Finance rating deal allowed to give advice to the
participants (before the rating is issued) about how to structure the deal in order to raise the rating? Is
the analyst allowed to give feedback to the participants of a deal if the initial rating does not meet
expectations? Are there limits to which elements of the deal can be addressed and to what extent (i.e.
does the analyst provide suggested changes to the structure)? Is this covered in any internal policies?
Is this interaction monitored by the agency?”
Response by Fitch (page 62):
“Analysts do not structure transactions or provide structuring advice. In the course of providing
feedback to an issuer, analysts will not propose alternative assets, legal structures or target rating
levels. More specifically, as part of feedback to an arranger’s proposed capital structure, analysts may
identify credit enhancement levels within a given pool, consistent with one or more tranche rating
levels, from which an arranger can deduce how much the size of each tranche may be varied from the
original proposal to become consistent with Fitch’s criteria for a given rating. These levels are the result
of a committee discussion, and represent the application of Fitch’s published and publicly-available
criteria. The decision to alter (or not) enhancement levels, or any other structural, legal or economic
element of the transaction, remains that of the arranger, based on the arranger’s or originator’s view of
the economic merits or advisability of the capital structure in which they wish investors to participate.
As part of its communication training for analysts, Fitch operates dedicated training sessions for
structured finance analysts, addressing the dialogue that is held with arrangers, investors and other
Response by Moody’s (page 215):
MIS (Moody’s Investor Services) does not structure, advise on, create or design securitisation products.
We are not competent to, and we do not, recommend one proposed structure over another. Structures
are designed by arrangers and investment bankers to fit the needs of particular investors. We are not
privy to many of the discussions that contemplate features of a securitisation (especially non-credit
related features) and we do not know who the ultimate investors in the transaction will be.
However, in rating any structured security (or any corporate or governmental security), we may hold
numerous, in-depth analytical discussions with issuers and/or their advisors. These discussions do not
transform credit rating agencies into investment bankers, consultants or advisors. Instead, they serve
the dual purpose of: (1) helping us better understand the particular facts of the transaction as proposed
by the issuer; and (2) clarifying to the issuer the rating implications of our methodologies for that
In circumstances where there is considerable performance history for the particular asset and where the
structure has been used previously, our published methodologies may provide sufficient transparency
about our analytical approach to significantly reduce the need for detailed “back-and-forth” discussions.
In contrast, we have more extensive conversations with issuers who are securitising new asset classes
or using novel structures. In these situations, issuers present circumstances that are different from
those we have discussed in our published methodologies (revealing limitations of a “one-size-fits-all”
approach). Therefore, we need to engage in a dialogue to assess the attributes of the proposed
transaction against existing, published methodologies.
Importantly, MIS does not receive incremental or additional payments for holding such discussions. We
believe, however, that these discussions help enhance overall market transparency and stability, in that
both issuers and investors have a better understanding of our analytical approach and the ratings that
result. The interactions of MIS (and its credit professionals) and other entities participating in structured
finance transactions are addressed in Section 2 of Part III of the MIS Code, the MCO Code of Business
Conduct and implementing internal policies of general application. Regardless of the fact that MIS does
not structure, create or design securitisation products, we are aware that a perception persists that
rating agencies are involved in these activities. We are considering various means to address more
effectively this misperception.
Response from Standard & Poor’s (page 236)
Ratings Services’ analysts do not advise issuers as to how to structure transactions. In practice,
analysts do talk to issuers as part of the ratings process, just as analysts have traditionally had
discussions with corporate issuers with respect to the rationale behind the rating their securities. This
dialogue provides benefits to the market. Critical to our ability to rate transactions is a robust
understanding of those transactions. Reading documents and reviewing the results of modeling are
important, but so is communication with those responsible for the transaction itself. Through dialogue
with issuers and their representatives our analysts gain greater insight into transactions to be rated,
including any modifications to those transactions that may occur as the process goes forward. This
dialogue promotes transparency as to our ratings process which regulators have consistently
This dialogue does not amount to “structuring” by Ratings Services, even in cases where the discussion
is about the effect different structures may have on ratings. Ratings Services does not tell issuers what
they should or should not do. Our role is reactive. Using our models and publicly available
methodologies, issuers provide us with information and we respond with our considered view of the
ratings implications. In the process, and as part of our commitment to transparency, we also may
discuss the reasoning behind our analysis. Some issuers structure transactions so as to achieve a
specific rating result as a variety of potential structures could merit a particular result. Our role is to
come to a view as to the structures presented, but not to choose among them. Again, we do not
compromise our criteria to meet a particular issuer’s goals. As Ratings Services makes methodologies
publicly available, the market can assess in a straightforward manner whether the methodology was
applied, thereby reinforcing Ratings Services’ interest in consistent application of the methodologies and
Differential default rates between asset classes
CRARA requires that NRSROs publish on an annual basis the quantitative evidence of the predictive
value of their rating symbols. This quantitative evidence is the default rates for various rating symbols.
This default data is of enormous value to users to compare and contrast ratings issued by various
NRSROs for specific securities.
Of equal value to users is the ability to compare the default rate between asset classes for example
corporate securities, municipal securities and asset backed securities. There are significant differences
in the default rates between corporate and structured finance securities even within one NRSRO.
Professor Coffee cites an example in this Senate testimony about the differential default rates on
various classes of securities. He uses these default statistics to make a point about the conflicts of
interest that may exist for NRSROs. The important point is that the default statistics of NRSROs create
a chain of evidence about their performance and allow market participants and regulators to examine
the NRSROs predicative accuracy. From Professor Coffee’s testimony:
“Looking at the default rate on Moody’s lowest investment grade rating (Baa), two financial economists
recently reported that the five year cumulative default rate on corporate bonds receiving a Baa rating
from Moody’s between 1983 and 2005 was only 2.2%, but the same five year cumulative default rate
for CDOs receiving the same Baa rating from Moody’s between 1993 and 2005 was 24%—more than
ten times higher.
Moody’s informs me that they consider the default or impairment rate for 2005 to be aberrational for
several reasons, and they have advised me that the comparable five-year cumulative default rates
ending in 2006 (as opposed to 2005) were 2.1% for corporate bonds and 17% for CDOs.
But even on their preferred comparative basis, the ratio is still over 8 to 1 (as opposed to over 10 to 1).
Even as so modified, the most plausible interpretation of this disparity is that ratings were inflated on
CDOs (at least more so than on the corporate bonds), probably because only the issuers of the former
had sufficient leverage with the rating agency. This hypothesis is not presented as established fact or as
a permanent tendency, but it is exactly the type of issue that the SEC should focus on in its
The folllowing is an important story by Bloomberg which talks about the differential default rates
between corporate and municipal securities. “Moody's Municipal Ratings Obscure Bond Safety, Citigroup
Nov. 19 (Bloomberg) -- Moody's Investors Service ranks municipal bonds with a system that may
obscure the fiscal strength of cities and states, according to Citigroup Inc.
Municipal bond prices have fallen relative to Treasuries on concern the insurers of half of all municipal
bonds, including FGIC Corp., Ambac Financial Group Inc., and MBIA Inc., may lose their AAA credit
ratings because they've backed bonds linked to subprime mortgages. The price declines may not be
justified because municipal bonds are strong credits even without insurance, according to George
Friedlander, Citigroup's municipal bond strategist. The problem is the rating system, he said.
“During periods like the present, the use of parallel scales with different default risk characteristics can
be extremely problematic, because it can obscure the actual strength of muni credits,'' Friedlander
Moody's released a report last spring that allowed investors to see how the default risk of municipal
bonds compares to the risk on corporate and other types of bonds. Using a `map' to adjust municipal
ratings, Moody's showed how school districts, water authorities, hospitals, cities and states moved up
as many as nine levels in ranking when compared with other types of debt in terms of likelihood of
Unlike the municipal scale, which ranks cities and states relative to each other, the global scale takes
into account the virtually nonexistent rate of default by municipalities which turn to higher levels of
government or taxpayers if they are unable to pay their debts.
Equivalent Disclosure and proposed legislative solutions
We propose the adoption of quot;Equivalent Disclosurequot; rules for issuer communications with NRSROs.
Equivalent disclosure would require an issuer, or person acting on its behalf, to disclose material
nonpublic information to all NRSROs if it discloses that information to one NRSRO. Equivalent disclosure
would remove the issues associated with issuer selective disclosure primarily “rating shopping”.
The institution of equivalent disclosure would strengthen financial markets by ensuring that all NRSROs
have adequate and equivalent information from issuers upon which to base their credit analysis.
We are not proposing that issuers be required to share material non-public information with all market
participants as is embodied in Regulation Fair Disclosure. We are proposing a more narrow application
to the credit markets.
Issuer disclosure would be required to all NRSROs that rate securities in the specific asset category (as
outlined in the Credit Rating Agency Reform Act of 2006 and the SEC Final Rule) for which the issuer
has securities outstanding.
This broadened disclosure will increase the volume of information available to NRSROs and help unbind
a market that has relied on the opinions of creditworthiness from a very small group of credit rating
This proposal does not alter the ability of NRSROs to have any form of business model that they
choose. Issuers can continue to pay NRSROs to rate their securities. Issuers may likely continue this
practice because of the bundle of services offered by the NRSROs to market participants.
Fitch, Moody's and Standard & Poor's have satisfactory track records in predicting defaults but current
events in the credit markets suggest that a broader array of opinions from more NRSROs would be
useful for the integrity of the markets. We are currently expecting too much from a small handful of
firms to provide timely, aggressive, and consistent credit analysis for the entire universe of fixed
The Credit Rating Agency Reform Act of 2006 creates a new framework for rating agencies to become
NRSROs but the important problem of information asymmetry from issuers to the NRSROs persists. The
adoption of equivalent disclosure will go a long way to improve the current shortcomings in the credit
It would beneficial for investors to have a wide variety of NRSROs providing credit analysis. We believe
a wealth of credit rating firms will only come about when there is a wealth of information from issuers.
SEC Chairman William Donaldson made the following remarks to the Subcommittee on Capital Markets,
Insurance, and GSEs, House Committee on Financial Services, May 21, 2001 in reference to the
adoption of Regulation Fair Disclosure for the equity markets.
quot;Selective disclosure raises several concerns. The primary issue is the basic unfairness of providing a
select few with a significant informational advantage over the rest of the market. This unfairness
damages investor confidence in the integrity of our capital markets. To the extent some investors
decide not to participate in our markets as a result, the markets lose a measure of liquidity and
efficiency, and the costs of raising equity capital are increased.
Further, if selective disclosure is permitted, corporate management can treat material information as a
commodity to be used to gain or maintain favor with particular analysts or investors. This practice could
undermine analyst objectivity, in that analysts will feel pressured to report favorably about a company
or slant their analysis to maintain access to selectively disclosed information.
Thus, selective disclosure may tend to reduce serious, independent analysis.quot;
Professor John Coffee, of Columbia Law School, made the following comments to the Senate Banking
Committee in his testimony of Sept, 26, 2007 concerning the proposal for quot;Equivalent Disclosurequot;:
“Indeed, the issuer may withhold access to non-public information for precisely the same reason that
public companies use to withhold data from securities analysts who were skeptical of them: to punish
them. Thus, some have sensibly proposed that an equivalent of Regulation Fair Disclosure (“Reg FD”)
should be adopted to require “equivalent disclosure” to all NRSROs of any information that is given by
an issuer to any NRSRO.quot;
How would Regulation Equivalent Disclosure work?
When the adoption of Regulation Fair Disclosure was being debated representatives of issuers claimed
that it would cause equity issuers to share less information with the markets. In fact, the
implementation of Regulation Fair Disclosure was a significant step forward for equity markets.
Information is more transparent and available to market participants at all levels from the largest
institutions to the smallest retail investors. Reg FD restored an enormous amount of confidence to the
It was also unclear how equity issuers would discharge their responsibility to disclose information fairly.
Although this required the adoption of new market practices solutions were developed and
For the fixed income markets the following might be adopted as a method of managing “equivalent
In the case of a new issue (especially a leveraged loan or a speculative grade bond but also to a lesser
extent for a investment grade name), the NRSRO would be given the draft offering materials for the
basic obligor and covenant structure. Questions would be directed to the issuer—not the underwriter.
The NRSROs would want to see the use of proceeds, pro forma capitalization tables, etc. An issuer could
do this on a conference call or a meeting with the NRSROs recognized in the asset class of the security.
For structured products, the issue would be more complicated and might heavily involve the
underwriter since there is no real quot;issuerquot; in terms of what you have with corporate and sovereign
One area that would require additional review and discussion is the private placement market and loan
market. There are no public documents available to NRSROs and they would need to receive disclosure
from the issuer. A possible analogy would be that the issuer might deal with NRSROs in the way that
they deal with bank lenders in terms of an organizational meeting and updates. The disclosure process
with more exotic issuers or asset classes would also require more review and discussion.
Handling material non-public information
The CRARA requires that NRSROs disclose their procedures for handling confidential and material non-
public information as part of NRSRO recognition process. NRSROs have a long history of working with
issuers and carefully protecting information that must remain confidential from information that can be
shared with the public and subscribers. We do not believe that this condition will pose a hurdle to the
adoption of “equivalent disclosure”.
Revocation of NRSRO status –
The Credit Rating Agency Reform Act of 2006 does not include a grant authority to the SEC to revoke
the NRSRO status of agencies who do not abide by the disclosure which they make to the Commission.
This leaves the Commission without a method of disciplining NRSROs who are not using accurate and
reliable methodologies when issuing ratings or who have conflicts of interest which are not managed or
properly disclosed or who no longer have the capital resources to continue as an independent entity.
This would be a significant grant of additional authority to the Commission but is necessary. If the
numbers of NRSROs increase as expected there likely will be instances where a NRSRO has stopped
providing accurate ratings to the markets and has not voluntarily withdrawn their recognition.
Confer issuer audit committees oversight of the NRSRO relationship –
Former SEC Chairman Arthur Levitt, Jr. wrote in the Wall Street Journal (September 7, 2007), “In
addition, just as Sarbanes-Oxley gave audit committees direct responsibility for the selection,
monitoring and compensation of external monitors, audit committees should be given this responsibility
over credit ratings agencies. This would bolster their independence from management and lessen any
pressure brought to bear on them.”
NRSROs are “external monitors” of the creditworthiness of an issuer. It is important that market
participants believe that the relations between issuers and NRSROs are non-conflicted. Although
operationally the communications between issuer and NRSROs must remain with management
oversight of these relationships can be done by the audit committees of board of directors.
Background - Legislative and SEC reviews
Three rounds of legislative effort concerning credit rating agencies has occurred within the past five
Sarbanes-Oxley - 2002
Credit Rating Agency Reform Act - 2006
Post CRARA examination – 2007/08
These successive examinations by the Congress and the SEC have increasingly made clear the central
role and importance of NRSROs to the efficient functioning of the credit markets.
Sarbanes-Oxley mandated the SEC to review the role and function of the credit rating agencies. This
review highlighted the need for a more transparent method for rating agencies to be recognized by
the SEC. The SEC requested additional statutory authority for oversight of NRSROs.
Congress granted additional authority to the SEC in the Credit Rating Agency Reform Act of 2006.
Statutory authority of NRSROs >> 17 CFR Parts 240 and 249b
Legislative Review One - Sarbanes-Oxley 2002
Following the collapse of Enron and WorldCom Congress mandated a review of the performance of the
NRSROs. Section 702(b) of the Sarbanes-Oxley Act of 2002 tasked the SEC to conduct an analysis of
the role of the credit rating agencies. Concern was expressed that the lack of competition
among NRSROs inhibited the aggressiveness of raters in analyzing issuers.
The SEC responded to Congress in January, 2003 with a quot;Report on the Role and Function of Credit
Rating Agencies in the Operation of the Securities Marketsquot; .
The report addressed issues including information flow, potential conflicts of interest, alleged unfair or
anti-competitive practices, reducing potential regulatory barriers to entry, and ongoing oversight,
(from page 31 of the SEC report).
...quot;In the aftermath of the Enron situation and other recent corporate failures, some have criticized the
performance of the credit rating agencies, and questioned whether they are conducting sufficiently
thorough analyses of issuers, particularly given their special position in the marketplace. Concerns also
have been raised regarding the training and qualifications of credit rating agency analysts.
In particular, the Staff Report, issued in connection with the investigation by the Senate Committee on
Governmental Affairs of the Enron situation, found that, while the credit rating agencies did not
completely ignore the problems at Enron, “their monitoring and review of [Enron’s] finances fell far
below the careful efforts one would have expected from organizations whose ratings hold so much
According to the Staff Report, in some cases the rating agencies appeared simply to take the word of
Enron officials when issues were raised, and failed to probe more deeply. In addition, the credit rating
agency analysts seemed to have been less than thorough in their review of Enron’s public filings, even
though these filings are a primary source of information for the ratings decision.
Among other things, the rating analysts appeared to pay insufficient attention to the detail in Enron’s
financial statements, failed to probe opaque disclosures, did not review Enron’s proxy statements, and
failed to take into account the overall aggressiveness of Enron’s accounting practices.
In essence, the Staff Report found that the rating agencies failed to use the necessary rigor to ensure
their analysis of a complex company, such as Enron, was sound.
Accordingly, as discussed in Section III.A.2. above, the Staff Report recommended the Commission
impose standards for credit rating agencies in deriving their ratings.
The rating agencies tend to have a more limited view of their role in verifying information reviewed in
the credit rating process. In general, the rating agencies state that they rely on issuers and other
sources to provide them with accurate and complete information. They typically do not audit the
accuracy or integrity of issuer information.
Though rating agencies may at times be able to use their influence in the marketplace to compel issuers
to provide additional information, they have no legal power to subpoena issuer information.
In cases where a rating agency concludes that important information is unavailable, or an issuer is less
than forthcoming with them, the rating agency may, depending on the significance of the information
involved, issue a lower rating, refuse to issue a rating, or even withdraw an existing rating. In general,
the rating agencies indicate that reputational concerns are sufficient to ensure that they exercise
appropriate levels of diligence in the ratings process. Nevertheless, as noted in Section V below, the
Commission intends to explore whether NRSROs should incorporate general standards of diligence in
performing their ratings analysis, and with respect to the training and qualifications of credit rating
Legislative review two: Credit Rating Agency Reform Act of 2006
Legislation adopted in the 109th Congress has already enhanced competition and transparency in the
credit ratings industry. The Credit Ratings Agency Reform Act of 2006 (CRARA) was an important
bipartisan accomplishment after many years of review and discussion.
The CRARA codified the authority of the SEC to implement rules with respect to registered credit rating
agencies for the following:
Policies preventing the misuse of confidential information
Conflicts of interest
Prohibition of unfair, abusive practices
To implement the CRARA the Commission published a Proposed Rule (Release No. 34-55231; File No.
S7-04-07 ), solicited comments on the Proposed Rule and published the Final Rule on June 5th, 2007
(Release No. 34-55857; File No. S7-04-07). The new rules went into effect on June 26, 2007.
SEC Chairman Cox described the outlines of the implementation of the CRARA as follows:
“The Rating Agency Act replaced the no-action letter process with a program of Commission oversight
of credit rating agencies that elect to register as NRSROs. Under the Rating Agency Act, a credit rating
agency seeking to be registered as an NRSRO must apply for registration with the Commission, make
public in its application certain information to help persons assess its credibility, and implement
procedures to manage the handling of material nonpublic information and conflicts of interest.
Consistent with the statutory mandate, the Commission’s implementing rules require disclosure of an
NRSRO’s conflicts of interest, and proscribe certain conflicts of interest. Key provisions of the Rating
Agency Act and the new Commission rules are summarized below.
Disclosure Requirements and Performance Measurement Statistics
The Rating Agency Act and its implementing rules require an NRSRO to disclose in its public filings with
the SEC a general description of its procedures and methodologies for determining credit ratings. In
addition, an NRSRO must make public certain performance measurement statistics including historical
downgrade and default rates within each of its credit rating categories over the short, medium, and
long terms. These statistics are intended to serve as important indicators of the performance of an
NRSRO in terms of its ability to assess the creditworthiness of issuers and obligors. Finally, as described
in the Commission’s adopting release in June 2007 regarding the NRSRO rules, the Commission is
studying whether it would be appropriate to require additional types of performance statistics to be
disclosed as an alternative, or in addition, to historical default and downgrade rates, such as a credit
rating downgrade that occurs long after a significant drop in the value of the securities being rated. We
believe that the disclosure requirements of the Rating Agency Act, as implemented now and in the
future through our rulemaking, will assist users of credit ratings in assessing the reliability of an
NRSRO’s ratings over time, and will increase transparency with respect to the accuracy of an NRSRO’s
Conflicts of Interest and Prohibited Practices
The Rating Agency Act requires an NRSRO to disclose the conflicts of interest that are inherent in its
business of determining credit ratings and to establish, maintain, and enforce written policies and
procedures reasonably designed, taking into consideration the nature of its business, to address and
manage the conflicts of interest. The Rating Agency Act also provided the Commission with authority to
prohibit or require the management and disclosure of conflicts of interest relating to the issuance of
credit ratings by an NRSRO. Pursuant to this authority, the Commission adopted rules that prohibit an
NRSRO from having certain conflicts of interest if it has not complied with the requirements in the
Rating Agency Act to disclose and manage them. One of the conflicts in this category is receiving
compensation from an issuer or underwriter to rate securities issued or underwritten by the entity. The
Commission’s rules also prohibit an NRSRO from having certain other conflicts in all circumstances. One
of the conflicts in this category is receiving compensation for determining a credit rating where the
person paying for the credit rating provided the NRSRO with net revenue in the most recently ended
fiscal year that equaled or exceeded 10% of the NRSRO’s total net revenue.
Finally, the SEC rules, among other things, also address the handling of material non-public information
by an NRSRO and prohibit certain unfair, coercive, or abusive practices by the NRSROs – including
modifying or threatening to modify a credit rating or otherwise departing from systematic procedures
and methodologies in determining credit ratings, based on whether the obligor, or an affiliate of the
obligor, purchases the credit rating or any other service or product of the NRSRO or any person
associated with the NRSRO.
Books and Records, Financial Reports, and Examination
In addition to significant disclosure requirements and conflict of interest provisions, the Rating Agency
Act and the Commission’s implementing rules also require an NRSRO to make and keep certain books
and records, including documentation of its established procedures and methodologies used by the
NRSRO to determine credit ratings. These recordkeeping rules will allow Commission examiners to
review whether an NRSRO is following its stated procedures and methodologies and otherwise
complying with the Rating Agency Act. NRSROs also are required to keep external and internal
communications received and sent by the NRSRO or its employees that relate to initiating, determining,
maintaining, changing or withdrawing a credit rating.
The Rating Agency Act and implementing rules also require NRSROs to furnish to the Commission, on a
confidential basis, certain financial reports, on an annual basis, including audited financial statements.
In addition to the audited financial statements, the rules also require NRSROs to furnish separate
unaudited financial reports that will assist the Commission in carrying out its statutory responsibilities
under the Rating Agency Act.
The Rating Agency Act provides that all records of an NRSRO are subject to such reasonable periodic,
special, or other examination by representatives of the Commission as the Commission deems
necessary or appropriate in the public interest, for the protection of investors, or otherwise in the
furtherance of the purposes of the Securities Exchange Act of 1934.
Prohibition on Regulating Rating Procedures
Finally, in implementing this statute, the Commission is ever mindful of the explicit intent of Congress
that we not substitute the Commission’s judgment for that of the rating agencies.
Legislative review three: Post CRARA examination (2007-08)
As a consequence of the credit crisis of 2007 Congress and the SEC have initiated reviews of NRSROs
and potential conflicts of interest.
The Senate Banking Committee held a hearing on September 26, 2007 on the quot;Role and Impact of
Credit Rating Agencies on the Subprime Credit Marketsquot; (see hearing web cast and testimony here).
The House Financial Services Committee also held a hearing on September 27, 2007 regarding the
quot;Role of the Credit Rating Agencies in the Structured Finance Marketquot;(see hearing web cast and
The SEC has broad new authority for oversight of NRSROs and examination of adherence to stated
methodologies and management of conflicts of interest. SEC Chairman Cox stated the following in his
testimony to the Senate Banking Committee on September 27, 2007:
“We have as yet formed no firm views on any of the reasons put forth by the credit rating agencies, but
we are carefully looking into each of them in the context of an examination the Commission has begun
with respect to NRSROs active in rating RMBS. This examination – which is being conducted on a non-
public basis – was commenced in response to the recent events in the mortgage markets. In particular,
the Commission is examining whether these NRSROs were unduly influenced by issuers and
underwriters of RMBS to diverge from their stated methodologies and procedures for determining credit
ratings in order to publish a higher rating.
The examination is also focusing on whether the NRSROs followed their stated procedures for managing
conflicts of interest inherent in the business of determining credit ratings for RMBS. In this regard, the
examination will seek to determine whether the NRSROs’ role in the process of bringing RMBS to
market impaired their ability to be impartial.
In addition to the Commission’s examination of NRSROs, the President has requested that the
President’s Working Group on Financial Markets examine the role of credit rating agencies in lending
practices, how their ratings are used, and how securitization – the repackaging and selling of assets –
has changed the mortgage industry and related business practices. As a member of the President’s
Working Group, the Commission is taking a leading role in this study.
The Commission is also a member of the credit rating agency task force created by the International
Organization of Securities Commissions (“IOSCO”) and we recently hosted an IOSCO meeting at which
the credit rating agencies most active in rating residential mortgage-backed securities made
presentations with respect to their role in developing structured finance products, and how they
manage the conflicts of interest that arise in providing rating services.”
Background - Regulation Fair Disclosure
Although there is no specific regulatory or legislative authority for an issuer to selectively disclose
material non-public information to NRSROs the general process was carved out when Regulation Fair
Disclosure was developed.
When Congress and the SEC were reviewing and developing Regulation Fair Disclosure to address
information asymmetry in the equity markets the following Comment Letter from Moody’s was
submitted in support of an exemption of selective disclosure of material non-public information to
NRSROs. The letter is dated April 27, 2000 from John J. Goggins, Vice President and Associate General
Counsel, Moody’s Investors Service.
“This letter is submitted by Moody’s Investors Service, Inc. (quot;Moody’squot;) in response to the request of
the Securities and Exchange Commission (quot;Commissionquot;) for comments on proposed Regulation FD,
which addresses concerns about selective disclosure of material nonpublic information.
Specifically, Moody’s requests that, if the Commission determines to adopt Regulation FD, it add a
specific exemption to Rule 100 or include language in the adopting release recognizing that rating
organizations regularly receive and use nonpublic information in the rating process and may continue to
In order to formulate an opinion as to the credit risks applicable to an issuer, Moody’s looks at factors
such as industry characteristics, technology, management policies and performance, profitability,
regulatory trends, capital structure, and business fundamentals. In order to obtain this information,
Moody’s reviews public financial information, including registration statements and other periodic
reports filed with the Commission. In addition, Moody’s often receives information directly from issuers,
such as earnings forecasts, financing plans, intended shifts in business or product lines, and planned
capital expenditures, and frequently meets with representatives of issuers, and their advisors, to
consider such information.
Some of the information provided to Moody’s by issuers may be material and nonpublic. For example,
management may discuss detailed plans for future business changes, including proposed divestitures
and acquisitions, product modifications, and financing needs. Issuers provide this nonpublic information
with the understanding that it will be used solely in order to evaluate and express an opinion on the
issuer's creditworthiness. Accordingly, Moody’s regularly receives and uses nonpublic information in the
rating process with the understanding that it will be used only in the process of developing its rating
Indeed, the Commission has recognized that, as part of the rating process, rating organizations have
quot;contacts with the management of issuers, including access to senior level management of the issuers.quot;
In its proposed rule to define the term nationally recognized statistical rating organization (quot;NRSROquot;),
the Commission not only recognizes that NRSROs have extensive contact with issuer management, but
also considers such contacts an essential attribute for such organizations. The same proposed rule
states that in determining whether to designate a NRSRO the Commission will evaluate the rating
agency's quot;internal procedures to prevent misuse of nonpublic information and compliance with these
procedures.quot; This factor is assessed today when the Commission designates a NRSRO through the no-
action letter process. Thus, the Commission clearly has recognized that rating organizations obtain
nonpublic information in connection with the rating opinion process.
In light of the foregoing, Moody’s requests that if the Commission decides to adopt Regulation FD, the
Commission add a specific exemption to Rule 100 providing that receipt and use of material nonpublic
information by rating organizations does not violate the rule. Moody’s and other rating organizations
provide a valuable service to the securities markets which would be severely hampered if issuers could
not share material nonpublic information in the rating process without fear that it would have to be
simultaneously disclosed to the entire market. The Commission has recognized both the value of
NRSROs ratings and the importance of access to nonpublic information in the ratings process.
If the Commission determines not to include such an exemption in Regulation FD, the adopting release
should include language making it clear that disclosure by an issuer (or a person on its behalf) to
Moody’s and other rating organizations does not give rise to the obligation to make public disclosure
under Regulation FD. At a minimum the release should make clear that issuers are not required to enter
into confidentiality agreements with a rating agency when they give it nonpublic information in
connection with the rating process.”