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SEC Votes to Propose NRSRO Rules Changes

WASHINGTON — The Securities and Exchange Commission voted yesterday to propose the first two sets of new rules for credit rating agencies that would limit their conflicts of interest, increase their disclosure, and encourage them to provide symbols for structured finance products so that investors can better differentiate between these and corporate or municipal securities.

The proposals come in response to record losses reported by Wall Street firms with investments in tainted subprime-mortgage bonds, which were rated triple-A despite their poor credit quality. They are the first the commission has considered since last year's implementation of the Credit Rating Agency Reform Act, which gave the SEC the authority to register and regulate certain rating agencies as nationally recognized statistical rating organizations.

"All of the proposed rules that we are considering are born of the subprime mortgage crisis and the resulting credit crunch," SEC chairman Christopher Cox said at a public meeting here. "In many cases, the complexity of the structured products themselves combined with the lack of quality information about the underlying assets make it exceptionally difficult for anyone to determine a credit rating at all."

Though the commission approved the rules yesterday, they will not be released publicly until they are published in the Federal Register within the next couple of weeks, SEC officials said in a background briefing with reporters yesterday.

Coxand commissioners Kathleen Casey and Paul Atkins voted unanimously to approve proposed rules that would, among other things, require NRSROs to make and retain records of all rating actions and, after a six-month delay, make such records publicly available in an interactive data format.

Other proposed rules, approved by a vote of 2 to 1 with Atkins voting no, would give the rating agencies two options for differentiating the ratings they issue on structured products from those they issue on bonds. The agencies could either use symbols, such as an identifier attached to the structured rating. Or they could issue a report disclosing the differences, for each structured product that they rate.

Cox said the proposals do not constitute a "back-door way of dictating ratings methodology" to the NRSROs. He stressed that the commission will proceed carefully to mitigate any disruptive effects that the new proposed rules would have on the market, particularly any requirements that the rating agencies use symbols to distinguish structured products.

As expected, the proposals were greeted with mixed reaction by the securities industry, which is expected to send the SEC written comments on them over the next 30 to 60 days. A task force headed by the Securities Industry and Financial Markets Association applauded the SEC for focusing on transparency and disclosure, but warned that requiring additional symbols for structured finance products could have "possible serious adverse and unintended consequences."

"Ratings modifiers ... are not the answer," said Boyce Greer, co-chair of SIFMA's credit rating agency task force and president of fixed income and asset allocation at Fidelity. "What's needed is greater transparency in the analytics and credit evaluation that underlie the rating."

In a letter to the commission, the task force warned that credit rating "modifiers" could impair the raising of capital "for student loans, auto loans, credit cards, mortgages and the like" and "lead to the sudden sale of structured finance securities, at fire-sale prices, into an already highly illiquid market at a time when our financial markets can ill afford such an unnecessary shock."

To enhance disclosure, the amendments would require the NRSROs to publish performance statistics for one, three, and 10 years within each rating category, in a way that facilitates comparison with their competitors in the industry. The rating agencies also would have to provide a number of additional disclosures for structured finance products, including the way they rely on the due diligence of others to verify the assets underlying them.

Meanwhile, to prevent conflicts of interest, the proposed rules would generally prohibit ratings analysts from accepting gifts and entertainment in excess of $25 from the borrower or issuer being rated or the underwriters or from participating in any discussion of ratings fees. They also would bar ratings analysts from structuring transactions that they rate.

In addition, if an NRSRO issues or maintains a rating for a structured finance transaction that was paid for by the issuer, sponsor or underwriter of the structured security, the NRSRO would need to disclose the fee as well as certain information about the assets underlying the instrument, on the date of the security's pricing.

The SEC plans to consider another set of recommendations at a June 25 meeting that would eliminate any explicit references to "nationally recognized statistical rating organizations" from its money market fund and other rules. The elimination of the references, which appear in more than 30 of the commission's rules, is geared toward avoiding so-called moral hazard by bestowing the government's endorsement of registered credit rating agencies, which are private firms, SEC officials have said.

The three major credit rating agencies Standard & Poor's, Moody's Investors Service and Fitch Ratings all had limited reaction to the SEC's proposals yesterday and said they look forward to commenting on them once they are publicly released.

The most expansive statement was from Fitch CEO Stephen Joynt, who said: "A number of the proposals discussed today are positive steps forward. For example, additional disclosure of the information on the underlying assets in structured finance securities should enhance transparency in the market. However, it may be most practical for issuers to provide that information to the market prior to securities' sales."

Since the commission began registering rating agencies as NRSROs last year, their number has increased from five to nine. SEC officials yesterday said they expect that number to increase to roughly 30 rating agencies in the coming years, though they stressed the number is a rough estimate.

SEC officials who spoke to reporters on background yesterday conceded that the proposals do not address a complaint of municipal issuers that they are expected, under disclosure rules, to disclose rating downgrades when they may not be aware of the downgrades if they were caused by the lowering of the rating of an insurer backing their bonds.

Under the proposals, the rating agencies would not have to publicly disclose rating changes until six months after they were made. The SEC officials said they proposed the delay so that the public disclosures would come after the rating agency sent ratings news to subscribers.

Issuers have complained that under the SEC's Rule 15c2-12 on disclosure, a dealer may not underwrite munis unless the issuer of the bonds has contractually agreed to disclose to nationally recognized repositories financial and operating information at least annually, as well as the occurrence of any of 11 specified material events, such as rating changes, bond calls, and adverse tax opinions, or events affecting the tax-exempt status of the bonds.

Specifically, the issuers say that they do not know of a single issuer that has been formally notified by either a credit rating agency or an insurer that its bonds have been downgraded because the rating on the insurer wrapping the bonds has been lowered.

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