SEC Votes to Remove NRSRO From 38 Rules

WASHINGTON - The Securities and Exchange Commission yesterday sought to limit the influence of credit rating agencies and boost the role of analysts at investment firms, in the last of three sets of new rating agency rules the SEC has proposed in response to the subprime mortgage crisis.

The commission voted 3 to 0 in favor of stripping references to "nationally recognized statistical rating organizations" from 38 of its rules, including the portion of Rule 2a-7 on money market funds that requires such funds to hold to hold debt rated double-A or higher. Tax-exempt money market funds held $517.45 billion in the week ending June 16, according to the Money Fund Report, a service of iMoneyNet.com of Westborough, Mass.

"The official recognition of credit ratings for a variety of securities regulatory purposes may have played a role in investors over-reliance on credit rating agencies," SEC chairman Christopher Cox said at an open meeting of the commission. "The recommendations we consider today are consistent with the objective of having investors make an independent judgement of the risks associated with a particular security."

The proposal, which will be published in the Federal Register and open to 60 days of public comment, is the latest response from the SEC 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.

On June 11, the SEC approved two sets of proposed rules that are designed to limit rating agencies' conflicts of interest, increase their disclosure, and better differentiate between structured, corporate, or municipal securities by attaching symbols or a lengthy report to their structured ratings.

SEC officials have said for months that, in addition to avoiding over-reliance on credit rating agencies, stripping references to NRSRO ratings from commission rules is necessary to avoid creating a so-called moral hazard caused by the commission's seeming endorsement of the ratings.

Erik Sirri, the SEC's director of trading and markets, said at yesterday's meeting that the release provides investment firms with two paths - they can either continue to rely heavily on NRSROs or they can craft their own "mechanism" to analyze investment quality.

"As a practical matter, I think the large number of broker-dealers ... will continue to make use of NRSRO ratings," he said. "But they need not."

The proposed changes would eliminate a requirement in Rule 2a-7 that a money market fund's investments receive credit ratings in one of the two higher short-term rating categories. Instead, the rules would require a money market fund's board of directors or their designee to determine that each portfolio securities presents minimal credit risks.

In addition, the rules would require a fund to hold securities that are sufficiently "liquid," which it defines as any security that can be sold through the normal course of business within seven days. It also would require money market funds to limit their "illiquid" securities to just 10% of their assets.

Richard Larkin, senior vice president and director of research at Herbert J. Sims & Co., in Iselin, N.J., said the proposal is a "huge body blow" to the major credit rating agencies. If the 2a-7 changes had been implemented several months ago, they would have prevented a sell-off of short-term munis that were wrapped by downgraded bond insurers, Larkin contended.

"Had this been in effect, that crisis might still have happened, but it probably wouldn't have been anywhere near as severe as it was," he said. "Fund managers could have said, 'Yeah, it's been downgraded, but I've done an analysis and these are decent bonds, there's no need to liquidate them.' I think this is going to have a big impact and it's a shame it wasn't done earlier."

John Jay, a senior analyst at Aite Group in Boston, said the SEC was essentially prodding investors to conduct greater credit analysis on their own.

"This is the SEC saying, 'You investors, why don't you grow up for a change, why don't you do some of the work on your own,' " he said.

Meanwhile, the proposed rule changes also were welcomed by the Securities Industry and Financial Markets Association's credit rating agency task force.

"We agree completely with the SEC that attention should be paid to over-dependence on ratings," said Deborah Cunningham, co-chair of the task force and chief investment officer of Federated Investors. "It is important that we guard against embedded over-reliance on ratings in SEC regulations, as well as in investors guidelines, state laws, Basel II, and bilateral contact."

Basel II is a recently completed global framework for bank liquidity requirements.

Spokesmen for Standard & Poor's and Moody's Investors Service said they look forward to commenting on the rules after they are published and reviewed internally in greater detail.

David Weinfurter, a spokesman for Fitch Ratings, said the agency "concurs with the goal of having market participants enhance their own assessments of credit risk." But he added that the "ratings and research of credit rating agencies are integral and reliable components of the global risk framework and will continue to be widely used by market participants."

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