Tuesday, April 22, 2008

SEC Examining Whether Credit-Raters Changed Policies

(Bloomberg) -- The U.S. Securities and Exchange Commission is probing whether credit-rating companies changed the way they graded debt as the market for products tied to subprime mortgages boomed earlier this decade, its chairman said.

``The volume of the structured-finance deals that were brought to the credit-rating agencies increased substantially from 2004 to 2006,'' SEC Chairman Christopher Cox told the Senate Banking Committee today. The regulator is looking at whether the companies ``adapted their rating approaches in this environment,'' Cox said.

The SEC, in response to subprime losses, may restrict companies such as Moody's Investors Service and Standard & Poor's from doing consulting work and may ban them from grading securities they helped design, Cox said. Lawmakers asked whether raters have inherent conflicts, because they're paid to evaluate debt by the same Wall Street firms who sell it.

Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, asked whether the companies ``give ratings that are overly optimistic in order to obtain more business.''

Foreclosures and Writedowns

The collapse of the U.S. market for subprime mortgages, given to borrowers with poor credit histories, has triggered a record level of foreclosures and $290 billion of losses at financial companies since the start of 2007.

Lawmakers say Moody's, S&P and smaller rival Fitch Ratings graded mortgage bonds too highly and then failed to react quickly enough when loans defaulted. Cox said the ``industry needs more competition'' to make firms more accountable.

Congress approved legislation in 2006 aimed at easing the way for companies to enter the industry. It also gave the SEC authority to inspect credit-rating companies and prohibit potential conflicts of interest.

Alabama's Richard Shelby, the top Republican on the Senate banking panel, asked whether it would be appropriate to ``jerk their license'' if rating companies are ``consistently wrong'' and ``incompetent.''

Cox, a Republican, said that would require new legislation. He told reporters after the hearing that there is an ``obvious downside'' to regulators revoking a company's right to grade bonds based on accuracy, because it would lead to less innovation.

``It's not clear that the requisite expertise exists exclusively in the federal government,'' Cox said.

The SEC has been probing the role of credit raters in contributing to the subprime crisis since last year. About 40 SEC staff members are participating in the review and the agency expects to report its findings to Congress by ``early summer,'' Cox said.

Increased Disclosure

Separately, the SEC may require more disclosure about underlying assets packaged into securities so investors can reach their own conclusions, Cox said. The agency may also mandate that all companies have access to underlying data so firms funded by investors don't face a competitive disadvantage, he said.

Cox has previously said the SEC may propose rules by June requiring credit-rating companies to tell investors how successful they've been in predicting debt won't default.

The agency may also force firms to reveal how much they rely on third parties in grading bonds rather than scrutinizing underlying assets themselves. In addition, the SEC may scrap rules that force mutual funds to take ratings into account when they purchase debt.

Lastly, the SEC may mandate that Moody's and S&P, which is owned by New York-based McGraw-Hill Cos., use different symbols for grading structured debt and corporate bonds to help investors differentiate between the two types of products.

Cox, when asked by Dodd whether they SEC needs more authority to regulate credit raters, said ``thus far, what we have in mind is amply supported'' by the 2006 legislation.

Representatives from Moody's, S&P and Fitch told the Senate panel that they're retooling their ratings procedures in response to the subprime crisis. Fitch Chief Executive Officer Stephen W. Joynt said the industry faces a ``long and difficult road'' to winning back investor confidence.

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