SEC staff may also propose at a June 11 meeting in Washington that the companies disclose all the data that goes into a rating so competitors can grade bonds even if they weren't compensated by the underwriter, said the people, who declined to be identified because the rules aren't final. Moody's, S&P and Fitch help design securities backed by a stream of payments, making it impossible for them to be impartial raters, a May 2007 study by academics Joseph Mason and Joshua Rosner concluded.
The SEC, which has been investigating the credit-rating industry since last year, is seeking to eliminate conflicts of interest between credit raters and investment banks that pay them to grade securities. Moody's, S&P and Fitch have downgraded or put under review more than 20,000 mortgage bonds in 2008, contributing to $389 billion of writedowns and losses at the world's largest banks and securities firms.
``They basically sold ratings to the highest bidder without any regard to the performance of the rated securities,'' Mason, a former U.S. Treasury Department economist who's now chair of the banking department at Louisiana State University's E.J. Ourso College of Business, said in an interview. ``The agencies did not know how to rate these instruments.''
The SEC staff may also urge more disclosure about how well past rankings predicted the risk of default and recommend restrictions on annual gifts from underwriters to employees at credit-rating companies, all based in New York, the people said.
In addition, the companies may be required to maintain records on communications with securities firms to provide a paper trail if an investment bank requested that an analyst be removed from grading an offering, one of the people said.
SEC spokesman John Nester declined to discuss specific proposals that may be issued by the Washington-based agency, except to say that ``the comprehensive package of proposed reforms demonstrates our unstinting commitment to reliable ratings.''
S&P looks ``forward to reviewing the SEC's proposal and working with them to improve transparency,'' company spokesman Edward Sweeney said. S&P is a unit of McGraw-Hill Cos.
Fitch, a unit of France's Fimalac SA, said in an e-mailed statement that it ``continues to work constructively with the SEC and other regulators in their efforts to enhance the transparency and independence of credit ratings.''
$1.2 Trillion of Bonds
Wall Street investment banks sold $1.2 trillion of bonds backed by subprime mortgages made to the least credit-worthy borrowers during the peak of the U.S. housing boom in 2005 and 2006, according to Brian Bethune, director of financial economics for Global Insight Inc. in Waltham, Massachusetts.
The securities were blessed by credit-rating companies as safe and were attractive to investors because they offered higher returns than government bonds with the same rankings. Investors stopped buying asset-backed debt after the subprime market collapsed last year.
Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, and Alabama's Richard Shelby, the leading Republican on the banking panel, blame Moody's, S&P and Fitch for giving mortgage bonds the highest ratings and then failing to downgrade them fast enough as subprime loans began to default.
Policies and Procedures
The SEC probe is focused on whether firms broke from their policies and procedures at the urging of investment banks that sold mortgage bonds, SEC Chairman Christopher Cox told members of Congress in September. The agency plans to share findings with Congress by ``early summer,'' Cox told members of the Senate Banking Committee on April 22.
Moody's, S&P and Fitch have already agreed to change their business practices as part of a June 5 accord with New York Attorney General Andrew Cuomo, who began investigating the industry last year.
Securities firms will now pay the three major ratings companies for their preliminary work reviewing the structure of mortgage-backed securities even if they aren't selected to rate the bonds. The change is designed to eliminate shopping by investment banks for top ratings.
SEC commissioners will vote at their meeting on whether to submit the staff's proposals for public comment, usually for 30, 60 or 90 days. The staff typically incorporates changes based on the feedback and then the agency holds a second public vote to make the regulations binding.
``The ratings industry's position is that they are not in the business of giving advice on structured finance,'' said Edward Gainor, a partner at McKee Nelson LLP in Washington. ``However, it's vital to the structured-finance market that there be enough flexibility in these regulations to permit give- and-take between the issuer and the ratings agencies.''