SEC finds serious shortcomings in credit raters

By Rachelle Younglai

WASHINGTON (Reuters) - Rating agencies struggled with the growth of asset-backed securities and saw breaches in their conflict-of-interest policies, according to a government report on an industry blamed for helping contribute to the subprime mortgage crisis.

A Securities and Exchange Commission examination "uncovered serious shortcomings," SEC Chairman Christopher Cox told a news conference, adding that the problems are being fixed.

The SEC spent 10 months looking at the biggest firms: Moody's (MCO.N), McGraw-Hill Cos' (MHP.N) Standard & Poor's and Fimalac SA's (LBCP.PA) Fitch Ratings.

Rating firms have policies and procedures designed to prevent them from being influenced to issue or maintain a top credit rating in order to win business, but the SEC said it found instances where key credit agency analysts took part in fee discussions.

Rating agencies have been blamed for contributing to the mortgage crisis by assigning top ratings to mortgage-backed securities that later deteriorated.

SEC staff scrutinized rating agencies' internal records and e-mails relating to ratings of residential mortgage-backed securities and collateralized debt obligations (CDOs).

Internal documents at two of the rating agencies appear to reflect struggles to adapt to the increase in the volume and complexity of deals, according to the report, which did not identify the individuals or firms.

One credit rating analyst, said she believed her firm's model did not capture "half" of a deal's risk, but that "it could be structured by cows and we would rate it."

Another e-mail from one analytical manager to a senior manager said "that the rating agencies 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."

The report found that from 2002 to 2006, the volume of the structured finance products that credit rating agencies examined increased substantially. The firms added more staff to examine the mortgage-backed securities, but two firms did not beef up staff sufficiently to match the volume of collateralized debt obligations, said the report.

Asked if any of the e-mails uncovered by the SEC would lead to enforcement actions, Cox said there is no question that there was evidence of serious problems.

"When the SEC finds evidence of wrongdoing we will pursue it aggressively," he said.

The report said the three rating firms have adopted or announced they will adopt measures "designed to improve the integrity and accuracy of the loan data they receive on underlying residential mortgage-backed securities pools."

CONFLICTS OF INTEREST

The SEC has already proposed rules to mitigate conflicts of interest, such as prohibiting rating agency employees from structuring the same products that they rate and prohibiting anyone who helps determine a rating from negotiating fees.

One rating agency, the report said, allowed senior analytical managers to participate directly in fee discussions with issuers until early 2007 when it changed its policy.

Another rating agency allowed its analytical managers to participate in internal discussions about what was appropriate for determining a fee for a certain product.

"Analysts appeared to be aware, when rating an issuer, of the rating agency's business interest in securing the rating of the deal," the report said.

The SEC has also proposed other rules including one to reduce Wall Street's reliance on credit raters, part of changes prompted by the subprime mortgage crisis.

S&P said it was fully committed to increased openness and transparency. "We will continue to take any additional steps needed to improve our processes and ensure they are of the highest quality," an S&P spokesman said.

Moody's said it has initiated a wide range of reforms that refine its analytical methodologies, improve transparency and enhance its overall independence.

"We will continue these initiatives and welcome additional recommendations from the SEC and market participants," said Moody's spokesman Anthony Mirenda.

Calls to Fitch Ratings were not immediately returned.

(Reporting by Rachelle Younglai; Editing by Tim Dobbyn)