SEC: Conflicts of Interest Not Well-Managed

Rating agencies failed to adequately manage the conflicts of interest stemming from issuers paying for ratings of collateralized debt obligations and residential mortgage-backed securities, a team of attorneys from the Securities and Exchange Commission found.

A 10-month review of structured finance practices at the three major rating agencies - Moody's Investors Service, Standard & Poor's, and Fitch Ratings - also revealed, among other things, that the agencies deviated from internal models in awarding top ratings to certain structured finance products that were not as safe as their ratings suggested.

"We uncovered serious shortcomings at these firms," SEC chairman Christopher Cox said at a press conference. "When there were not enough staff to do the job right, the firms sometimes cut corners."

Though the commission's examination did not encompass the agencies' ratings of municipal securities, it nevertheless found multiple areas where conflicts of interest could be better managed, particularly when issuers are paying for the ratings it receives from the rating agencies. The findings may have some relevance to the municipal market because muni issuers pay the rating agencies for their ratings.

For instance, the commission noted that while each rating agency has policies and procedures restricting analysts from participating in fee discussions with issuers, the policies still allowed key participants in the rating process to help negotiate fees.

One rating agency allowed senior analytical managers to participate directly in fee discussions with issuers until early 2007, when it changed its policy, SEC officials said without identifying the agency.

At another rating agency, an analyst's immediate supervisor could engage in fee negotiations directly with issuers. But the firm changed its procedure in October so that analytical staff, including management, may no longer engage in fee discussions with issuers; only business development personnel may do so, the report said.

Meanwhile, the report found that structured ratings were issued even though one or more issues raised by analysts on the deals remained unresolved. The report shows one e-mail in which a CDO analyst at an unidentified rating agency said the rating companies continue to create "an even bigger monster - the CDO market."

"Let's hope we are all wealthy and retired by the time this house of cards falters," said the e-mail, which ended with an emoticon meant to designate a wink.

The report's findings were used to help the commission craft three sets of proposed rule changes within the last month that are designed to address some of the conflicts of interest that the SEC staff uncovered, among other things. In addition to the commission's proposed rules, the rating agencies are moving on their own to improve their practices, SEC officials said yesterday.

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