AFR Urges Strong Credit Rating Agency Provisions in Financial Reform Legislation

Americans for Financial Reform sent the following letter to Chairman Dodd, Ranking Member Shelby, and other members of the Senate Banking Committee.

Dear Chairman Dodd and Ranking Member Shelby:

On behalf of the Americans for Financial Reform, a coalition of nearly 200
national, state and local consumer, labor, retiree, investor, community and civil rights organizations, we write to urge you to include strong credit rating agency provisions in the legislation you adopt to reform the financial regulatory system. As one examines the causes of the financial crisis, it is impossible to overlook the central role of the credit rating agencies. These agencies failed miserably to fulfill their important function as gatekeepers in the financial system.

Overwhelming evidence suggests that our financial system places excessive
reliance on agencies that have been corrupted through the conflicts of interest inherent in the “issuer pays” business model, that are subject to weak regulatory oversight, and that provide insufficient information on the data, assumptions, and methodologies behind their ratings. In order to address these weaknesses, we respectfully request that you include the following fundamental principles and priorities regarding credit rating agency reform in proposals you are currently considering.

Reducing Conflicts of Interest

The major private credit rating agencies were significant contributors in creating the housing bubble and subsequent financial crash. They consistently delivered overly optimistic assessments of assets that either carried high, or at least highly uncertain risks.

A new approach to regulating the ratings system within U.S. financial markets is clearly needed. This new approach should include a focus on inhibiting the types of excessively risky practices that will produce another bubble and crash. Without a more fundamental change in the industry’s dynamics, the American people could still end up paying the price of another financial calamity.

Market incentives pushed credit rating agencies to provide overly favorable
appraisals. Giving favorable risk appraisals was good for the agencies’ own bottom line, since the agencies were hired by the companies whose securities they were evaluating and their profitability was increasingly dependent on their ability to gain market share in the lucrative business of rating asset-backed securities. Companies could choose to hire agencies that they thought would be more likely to provide favorable ratings, and the
rating agencies responded in the expected way to these incentives.

The most promising way to reduce these conflicts of interest is to establish an
independent office, potentially funded by a securities-transaction tax or a fee on ratings engagements, to act both as a ratings watchdog and as a clearinghouse, assigning securities offerings to ratings agencies at random.

Ideally, the clearinghouse would periodically compare the performance of the rating agencies, using simple, transparent criteria, such as the number of times that investment-grade bonds default or lose substantial value. Under such an approach, the most accurate rating agencies could be rewarded with additional assignments. Those with the poorest records could, in extreme cases, be suspended or removed from the pool.

Conflicts of interest clearly contributed to the ratings agencies’ failures. Any
regulatory solution that fails to address those conflicts cannot claim to offer
comprehensive reforms. Without such fundamental changes to their business model, the rating agencies will face constant tension between their avowed mission and their short-term business interests. Included with this letter is a paper, entitled “Reforming the Rating Agencies: A Solution That Fits the Problem,” by James Lardner which explains this proposal in greater detail.
Increased SEC Oversight Authority.

Regardless of whether this independent office is created, we support increasing regulatory oversight over the Nationally Recognized Statistical Rating Organizations (NRSROs) by the SEC, including provisions that make the SEC responsible for conducting annual inspections to ensure compliance with appropriate procedures to support reliable ratings and to address conflicts of interest, add failure to supervise and failure to conduct sufficient post-rating surveillance to the list of conducts that are subject to SEC sanction, provide the SEC with the ability to impose fines on firms and individuals associated with the firms for violations, and – very importantly – to remove ratings’ protection from SEC antifraud authority. While we do not believe that the SEC can or should be in the business of dictating methodologies to the NRSROs, we do think it is important that the agency be able to review the substance of ratings and the procedures used to arrive at them, as well as whether or not rating agencies consistently comply with procedures. Additional oversight is needed, for example, to examine what
information issuers give credit rating agencies and what procedures rating agencies follow in verifying that information. In addition, we would encourage you to provide the SEC with broad rulemaking authority.

Finally, the SEC must be able to sufficiently staff these expanded responsibilities.  We encourage you to include language that compels the office of the Commission to be “staffed sufficiently” to carry out fully the requirements of the Act, and to add a funding mechanism in the form of a modest fee on each rating issued that would be dedicated to funding the new NRSRO oversight office created under this legislation.

Reduce Reliance on Ratings / Enhance Ratings Transparency

Over the years, the financial system has become too reliant on ratings
agencies despite their repeated failure to provide reliable ratings, of which their failures with regard to mortgage-backed securities are simply the most recent and most dramatic. For this reason, we support a gradual reduction in reliance on ratings in our financial system.

In our view, the best approach is to require the various federal regulatory
agencies to conduct a case-by-case review of references to credit ratings in their regulations. The first priority should be to eliminate instances where ratings are used to reduce capital that financial institutions are required to set aside or otherwise evade regulatory restrictions. Where use of ratings is restrictive – by setting an outward limit on the investments that can be used for a particular purpose – the goal should be to either substitute more reliable measures of creditworthiness for the ratings or to supplement the use of ratings with additional measures. It should be made clear that reliance on ratings does not create a safe harbor and that financial institutions and others that use ratings are still responsible for conducting a thorough review to determine whether a particular investment is appropriate for the intended purpose and, and at least with regard to financial institutions, to document the basis for that determination.

For such a system to work, however, we must provide greater transparency both in regards to asset-backed securities and structured finance products rated by the agencies and the ratings themselves. Armed with that information, investors would be better equipped to evaluate both the underlying investments and the reliability of the ratings. Among the areas where greater disclosure would be beneficial is in the area of conflicts of interest. Better elucidating the rating agencies’ business ties to underwriters is particularly relevant, since they have the ability to bring a large volume of business and thus are better positioned than individual issuers to influence rating agencies.

Improve Governance Practices at Ratings Agencies

In addition to enhancing SEC oversight, we ask you to strengthen governance
practices at the NRSROs themselves by requiring that a majority of board members be independent and by tightening the definition of independence. We would advocate that the Board of Directors of NRSRO’s should be at least 2/3 independent rather than a 1/3 independence standard included in the House bill. We also believe that the definition of “independence” should be strengthened to ensure that independent members reflect the interests of credit ratings’ users. We believe that giving users of ratings a greater role in
overseeing the practices of rating agencies could help counteract some of the conflicts of interest and shoddy practices documented by the SEC in its report on the ratings agencies.

Ensuring Rating Agencies Accountability

We strongly support holding credit rating agencies accountable by making the Securities Act enforceable through private rights of action and by imposing legal liability when the NRSROs violate securities laws or fail to conduct an adequate review to support a reliable rating. We are concerned, however, that the Supreme Court decision regarding pleading standards in the Tellabs case has raised such a significant barrier to meritorious actions that it should be addressed in this legislation. Thus, we urge you to replace “reasonable inference” for “strong inference” in the pleading standards to reduce to a reasonable level the burden of proof that plaintiffs must meet to have their day in court. In addition, we encourage you to clarify that credit ratings are not forward-looking statements protected by a safe harbor from liability and to eliminate NRSROs’ protection from liability under Section 11 of the Securities Act.

Universal Rating for Municipal and Corporate Bonds

Highly rated asset-backed securities have had a dramatically higher default rate than similarly rated corporate bonds, and corporate bonds have had a significantly higher default rate than similarly rated government bonds. This not only adds to investor confusion and enables the sale of risky products for inappropriate purposes; it imposes unwarranted steep costs on taxpayers. Specifically, the higher standard for government bonds ends up costing taxpayers billions of dollars a year in extra interest and bond issuance costs. Addressing this inequity by requiring credit rating agencies to use a universal standard will not only reduce waste of taxpayer dollars, it will also help investors make informed investment decisions based on the risk of default and on the issuer’s ability to repay the debt and reduce the incentive to take inappropriate risks to increase returns.

We thank you again for taking up this important matter, and look forward to
working with your Committee to ensure that financial regulatory reform legislation contains the strongest possible package of credit rating agency reforms. If you have further questions, please contact Lisa Donner at Americans for Financial Reform at 202-263-4544 or Barbara Roper at 719-543-9468 or by email at

Americans for Financial Reform

Senator Tim Johnson
Senator Charles E. Schumer
Senator Evan Bayh
Senator Robert Menendez
Senator Daniel K. Akaka
Senator Sherrod Brown
Senator John Tester
Senator Herb Kohl
Senator Mark Warner
Senator Jeff Merkley
Senator Michael Bennet
Senator Robert F. Bennett
Senator Jim Bunning
Senator Mike Crapo
Senator Bob Corker
Senator Jim DeMint
Senator David Vitter
Senator Mike Johanns
Senator Kay Bailey Hutchinson