SEC to probe role credit rating firms had in meltdown

The Securities and Exchange Commission (SEC) on Wednesday will scrutinize credit rating agencies for contributing to the financial crisis and begin considering new regulations that could take months to put in place.

Lawmakers, government oversight panels and commission officials have slammed the agencies, such as Moody’s, Standard and Poor’s and Fitch Ratings, for issuing top ratings for investments — most notably securities made up of risky home loans — that have since plummeted in value and contributed to the economic downturn.

{mosads}At the heart of their concerns is the basic industry model: These firms are paid by companies seeking their ratings. SEC Chairwoman Mary Schapiro and leading commission officials have repeatedly criticized the conflicts of interest in the rating industry, but have yet to sketch out specific changes or seek additional authority from Congress to regulate the firms. On Wednesday, the commission will hold a daylong roundtable on the industry.

 Despite the attention this week and the barrage of criticism, financial-industry sources and former government lawyers expect Congress to hold off on any major overhaul of the industry as the SEC and the Obama administration consider regulatory changes that might not require congressional attention.

“The administration is too busy with trying to sort out the banks to worry about this,” said Adam Pritchard, a professor at the University of Michigan Law School and former SEC lawyer. “They’re happy to let the SEC deal with it, and Congress — you’ve got isolated congressmen with legislative proposals, but as far as the scapegoat du jour I don’t think the rating agencies will be as sexy as executives receiving large bonuses.”

Added one financial-industry lobbyist, referring to members of Congress: “I think they want to let the new team have a crack at doing what they think that they can within their current authority before they are overly prescriptive.”

In February, the SEC adopted new rules aimed at the conflicts of interest. Among the changes, one rule would prohibit credit agency employees from directly negotiating fees for the companies they rate.

Still, agency officials and critics have called for more fundamental changes, such as promoting more competition between rating firms, trying to isolate parts of the financial industry that should not rely on ratings, and creating an alternative to the issuer-pay model. One option would be to set up a pool of money that would pay the rating firms, instead of the companies paying directly.

Deven Sharma, Standard and Poor’s president, defended the industry’s business model in written comments to the SEC.

“The issuer-pays model facilitates the highest level of coverage,” Sharma said, adding that it benefits new investments seeking a rating.

Only a handful of lawmakers so far have circulated legislation to change the industry. Sen. Jack Reed (D-R.I.) has a draft proposal that would ratchet up the SEC’s oversight of the rating agencies, aim to stop a revolving door between the agencies and companies issuing debt and, most controversially, allow lawsuits against firms for not conducting “reasonable” due diligence. The bill has not yet been introduced.

Reps. Gary Ackerman (D-N.Y.) and Mike Castle (R-Del.) introduced a bill in February that would require the SEC to establish new rules for rating agencies to evaluate structured finance investments. Those investments, particularly mortgage-backed securities and collateralized debt obligations, have been at the heart of the collapse in the housing market that has fed the wider financial crisis. Such investments were highly rated, although parts were based on many sub-prime mortgages that have since defaulted.

While government officials discuss potential regulatory changes, the rating firms will continue to play a central role in the White House’s efforts to stabilize the financial system. A program that could cost $1 trillion, called the Term Asset-Backed Securities Loan Facility, targets triple-A ratings, the highest, for any investment that would receive government support. Connecticut Attorney General Richard Blumenthal (D) is questioning why the government should pay the same agencies whose ratings contributed to the financial crisis.

Another program that intends to draw in private investors to price and purchase toxic assets could also wind up benefiting credit rating firms, industry sources say. If the private investment fund managers intend to resell the loans or securities they buy, they could seek new ratings. Many large pension and money-market funds, potential investors in those new securities, only invest in rated products.