Securities and Exchange Commission: Action Needed to Improve Rating Agency Registration Program and Performance-Related Disclosures
Published: 2010-09-22T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2006, Congress passed the Credit Rating Agency Reform Act (Act), which intended to improve credit ratings by fostering accountability, transparency, and competition. The Act established Securities and Exchange Commission (SEC) oversight over Nationally Recognized Statistical Rating Organizations (NRSRO), which are credit rating agencies that are registered with SEC. The Act requires GAO to review the implementation of the Act. This report (1) discusses the Act's implementation; (2) evaluates NRSROs' performance-related disclosures; (3) evaluates removing NRSRO references from certain SEC rules; (4) evaluates the impact of the Act on competition; and (5) provides a framework for evaluating alternative models for compensating NRSROs. To address the mandate, GAO reviewed SEC rules, examination guidance, completed examinations, and staff memoranda; analyzed required NRSRO disclosures and market share data; and interviewed SEC and NRSRO officials and market participants.
section_title: What GAO Found
paragraphs: SEC's implementation of the Act involved developing an NRSRO registration program and an examination program. As currently implemented and staffed, both programs require further attention. (1) The process for reviewing NRSRO applications limits SEC staff's ability to fully ensure that applicants meet the Act's requirements. While SEC had registered 10 of 11 credit rating agency applicants as of July 2010, some staff memoranda to the Commission summarizing their review of applications described concerns that were not addressed prior to registration. According to staff, the 90-day time frame for SEC action on an application and the lack of an express authority to examine the applicants prior to registration prevented the concerns from being addressed prior to approval. Unlike other registration application programs that have built in greater authority and flexibility for their staff to clarify outstanding questions regarding applications before approval, the NRSRO registration program requires SEC to act within 90 days of receiving the application. As a result, staff recommended granting registration with ongoing concerns about NRSROs meeting the Act's requirements. (2) With its current level of staffing for NRSRO examinations, SEC's Office of Compliance Inspections and Examinations (OCIE) would likely not have been able to meet its routine examination schedule of examining the three largest NRSROs every 2 years and others every 3 years. OCIE has requested additional resources to fully staff the NRSRO examination program. While the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) requires SEC to establish an Office of Credit Ratings to conduct annual examinations of each NRSRO and staff the office sufficiently to carry out these examinations, SEC may face challenges in meeting the required examination timetable and providing quality supervision over NRSROs unless it develops a plan that clearly identifies staffing needs, such as requisite skills and training. While SEC has increased the amount of performance-related data NRSROs are required to disclose, the usefulness of the data is limited. First, SEC requires NRSROs to disclose certain performance statistics, increasing the amount of performance information available for some NRSROs. However, because SEC does not specify how NRSROs should calculate these statistics, NRSROs use varied methodologies, limiting their comparability. Second, SEC issued two rules requiring NRSROs to make certain ratings history data publicly available. However, the data sets do not contain enough information to construct comparable performance statistics and are not representative of the population of the credit ratings at each NRSRO. Without better disclosures, the information being provided will not serve its intended purpose of increasing transparency. In July 2008, SEC proposed amendments that would have removed references to NRSRO ratings from several rules. Since the implementation of the Act, the number of NRSROs has increased from 7 to 10; however, industry concentration as measured by NRSRO revenues, the number of entities rated, and the dollar volume of new asset-backed debt rated remains high. As part of an April 2009 roundtable held to examine oversight of credit rating agencies, SEC requested perspectives from users of ratings and others on whether it should consider additional rules to better align the raters' interest with those who rely on those ratings, and specifically, whether one business model represented a better way of managing conflicts of interest than another. SEC should identify the additional time frames and authorities it needs to review NRSRO applications, develop a plan to help ensure the NRSRO examination program is sufficiently staffed, improve NRSROs' performance-related disclosure requirements, and develop a plan to approach the removal of NRSRO references from its rules. SEC generally agreed with these recommendations.

section_title: Letter
paragraphs: A credit rating is an assessment of the creditworthiness of an obligor as an  entity or with respect to specific securities or money market instruments.  In the past few decades, credit ratings have assumed increased importance  in the financial markets, in large part due to their use in law and  regulation. In 1975, the Securities and Exchange Commission (SEC) first  used the term Nationally Recognized Statistical Rating Organization  (NRSRO) to describe those rating agencies whose ratings could be relied  upon to determine capital charges for different types of debt securities  (securities) broker-dealers held. Since then, SEC has used the NRSRO  designation in a number of regulations, and the term has been widely  embedded in numerous federal and state laws and regulations as well as in  investment guidelines and private contracts.
The highly publicized, alleged failures by the three largest NRSROs to  warn investors in a timely manner about the impending bankruptcies of  Enron and other issuers raised concerns in Congress and among others  about the role and performance of NRSROs in the securities market and  SEC’s supervision of the industry. In response to a congressional  mandate, SEC prepared a report in 2003 discussing its findings from  examinations of these rating agencies, which revealed concerns related to  potential conflicts of interest caused by the business model they employ— in which the issuers of securities pay the rating agencies for their ratings  (issuer-pays model). The report also discussed the lack of a formal  regulatory program to oversee NRSROs, and SEC efforts over the years to  establish one. Participants in congressional hearings held at the time noted  the high concentration of market share among a small number of large  NRSROs and criticized SEC’s no-action letter process (used to recognize  NRSROs) as a barrier to entry to the market for new credit rating agencies,  and thus a hindrance to competition.
To address these concerns, Congress passed the Credit Rating Agency  Reform Act (Act) in 2006. The Act amended the Securities Exchange Act  of 1934 (Exchange Act) to improve ratings quality for the protection of  investors by fostering accountability, transparency, and competition in the  credit rating industry. The Act added section 15E to the Exchange Act,  which establishes SEC oversight over those credit rating agencies that  register as NRSROs. Section 15E also provides SEC with examination  authority and establishes a registration program for credit rating agencies  seeking NRSRO designation, defines eligibility requirements, prescribes  the minimum information applicants must provide in their application, and  establishes a time frame and parameters for SEC review and approval of  applications. NRSRO applicants and registered NRSROs are also required  to disclose information, including ratings performance, conflicts of  interest, and the procedures used to determine ratings.
More recently, the performance of the three largest NRSROs in rating  subprime residential mortgage-backed securities (RMBS) and related  securities renewed questions about the accuracy of their credit ratings  generally, the integrity of the ratings process, and investor reliance on  NRSRO ratings for investment decisions. In July 2008, SEC made public  its report on its examinations of these three NRSROs, which identified  significant issues with their documentation and disclosure of critical  ratings processes and the management of conflicts of interest related to  these products. Partially in response to these findings, SEC issued  additional rules in 2008 and 2009 intended to enhance NRSRO disclosure  to investors, strengthen the integrity of the ratings process, and more  effectively address the potential for conflicts of interest. SEC also held a  roundtable relating to its oversight of credit rating agencies in April 2009,  where roundtable participants offered proposals to, among other things,  reduce conflicts of interest and increase NRSRO incentives to produce  accurate ratings by establishing alternative means for compensating  NRSROs.
Section 7 of the Act requires us to review, by September 2010, the  implementation and impact of the Act and the rules issued under it on the  quality of credit ratings, financial markets, competition in the credit rating  industry, the process for NRSRO registration, and other matters. This  report responds to that mandate. It also responds to your interest in  identifying and assessing alternative models for compensating NRSROs  and assessing the potential impact of removing NRSRO references from  SEC rules.
Specifically, this report (1) discusses the implementation of the Act,  focusing on SEC rulemaking and SEC’s implementation of the NRSRO  registration and examination programs; (2) evaluates the performance- related NRSRO disclosures that the Act and SEC rules require; (3)  evaluates the potential regulatory impact of removing NRSRO references  from certain SEC rules; (4) evaluates the impact of the Act on competition  among NRSROs; and (5) provides an overview of proposed alternative  models for compensating NRSROs and an evaluative framework for  assessing the models.
To address the first objective, we reviewed the rules SEC adopted to  implement the Act, SEC’s July 2008 public report discussing examination  findings on selected NRSROs, SEC’s Division of Trading and Markets  (Trading and Markets) internal memoranda to the commissioners  documenting its review of NRSRO applications, and an internal  memorandum on NRSRO monitoring. We also reviewed the Office of  Compliance Examinations and Inspections’ (OCIE) guidance for  conducting an NRSRO examination and reviewed completed  examinations. We discussed the application review process with Trading  and Markets staff, and conducted interviews with staff from SEC’s  Division of Investment Management (Investment Management) and the  Financial Industry Regulatory Authority (FINRA) about their respective  registration programs and with OCIE staff regarding NRSRO  examinations. For the second objective, we analyzed SEC rules requiring  NRSRO disclosure of performance statistics and ratings history samples.  We analyzed and compared the NRSROs’ 2009 disclosures of performance  statistics, focusing on the corporate and structured finance asset classes,  and we reviewed voluntary disclosures of additional performance  statistics by several NRSROs. We also assessed NRSRO ratings history  data disclosed by the seven issuer-pays NRSROs pursuant to SEC’s rule to  determine their reliability and usability for generating comparative  performance statistics. We identified a number of issues that led us to  determine that the data were not in a format that allowed us to generate  comparative performance statistics. For the third objective, we obtained  and reviewed SEC’s proposed rules to remove references to NRSRO  ratings, focusing on proposed amendments to rule 2a-7 under the  Investment Company Act of 1940 (Investment Company Act) and  Exchange Act rule 15c3-1, as well as the comment letters submitted to  SEC on the proposals. We also reviewed OCIE examinations of money  market funds from FY 2003–2009 that reviewed rule 2a-7 compliance. We  conducted interviews with OCIE staff, Trading and Markets staff,  Investment Management staff, and market participants and observers.
For the fourth objective, we reviewed proposed and final SEC rules   intended to promote competition among NRSROs, as well as the comment  letters SEC received in response to those rules. We reviewed SEC’s 2008  and 2009 mandated annual reports on NRSROs, including SEC’s studies on  competition in the credit rating industry. We used the Herfindahl- Hirschman Index (HHI)—a measure of industry concentration that reflects  both the number of firms in the industry and each firm’s market share—to  track industry concentration over time. We calculated the HHI using  three alternative variables: (1) NRSRO revenues, (2) the number of  organizations or entities rated by the NRSROs that issue debt securities,  and (3) for asset-backed securities (ABS), the dollar amount of new U.S.- issued debt rated. We obtained the revenue data from the NRSROs’ Form  NRSRO filings, the registration form SEC requires credit rating agencies to  submit when applying for NRSRO registration and then annually after  registration. We interviewed staff from Trading and Markets to determine  the steps they took to ensure the data represented the firms’ total  revenues. We obtained data on the number of rated organizations or  entities that issue debt securities from the NRSROs. To ensure consistency  among the data, we specified how the NRSROs were to count rated  organizations and entities and classify them. We also examined trends  within the data. We obtained data on the dollar value of rated new U.S.-  asset-backed securitization from an industry newsletter that tracks these  issuances. We obtained information from this firm on the processes and  procedures it used to collect and manage the data. We also used these data  to generate a series of descriptive graphs showing the NRSROs’ market  coverage, that is, the percentage of new U.S. asset-backed issuance that  each rated. For all of our data sources, we determined that the data were  reliable enough for our purposes, which were to show the relative  concentration of NRSROs in the industry. We also reviewed academic  studies on competition in the industry and obtained the views of SEC’s  Office of Risk Analysis (ORA), the NRSROs, credit rating agencies that are  not registered NRSROs, institutional investors, issuers, and industry  experts on the impact of the Act on competition.
For the fifth objective, we identified proposals on alternative models for  compensating NRSROs by reviewing white papers submitted to the SEC  roundtable on credit rating agency oversight, academic and white papers,  and interviewed the authors of the proposed models. We obtained the  views of Trading and Markets, ORA, NRSROs, and credit rating agencies  that are not registered as NRSROs, institutional investors, issuers, and  academic and industry experts. To develop the framework for evaluating  the models, we reviewed prior GAO reports and academic and market  research to identify appropriate factors for inclusion. We then convened a  panel of GAO experts (financial markets specialists, economists, an  attorney and a social scientist) to review the framework and incorporated  their comments. Finally, we solicited comments from NRSROs, proposal  authors, industry experts, and trade associations and incorporated them as  appropriate. For all relevant objectives, we also reviewed the recently  passed Dodd-Frank Wall Street Reform and Consumer Protection Act  (Dodd-Frank Act) to understand additional changes to SEC’s oversight of  NRSROs.
We conducted this performance audit from May 2009 to September 2010 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives. Appendix I provides a more detailed  description of our scope and methodology.
subsections: section_title: Background
paragraphs: The ratings produced by the NRSROs generally are letter-based symbols  intended to reflect assessments of credit risk for entities issuing securities  in public markets. Typically, credit rating agencies designate issuers or  securities considered investment-grade, or lower risk, with higher letter  ratings, and issuers or securities considered speculative-grade, or higher  risk, with lower letter ratings. For example, Standard & Poor’s and Fitch  Ratings (Fitch) designate investment-grade, long-term debt with ratings of  AAA, AA, A, and BBB, and speculative-grade, long-term debt with ratings  of BB, B, CCC, CC, and C. The rating scale employed by Moody’s Investors  Service (Moody’s) uses Aaa, Aa, A and Baa for investment-grade, long-term  debt, and Ba, B, Caa, Ca, and C for speculative-grade, long-term debt.  Rating agencies may employ different rating scales for different regions,  sectors, jurisdictions, or types of securities. For example, the rating scale  that a ratings agency uses to assign short-term obligations may differ from  the scale it uses for long-term obligations.
NRSRO credit ratings are designed to measure the likelihood of default for  an issue or issuer, although some also measure other variables, such as the  expected value of dollar losses given a default. These assessments reflect a  variety of quantitative and qualitative factors that vary based on sector.  The NRSROs describe ratings as intended only to reflect credit risk, not  other valuation factors such as liquidity or price risk. To determine an  appropriate rating, credit analysts use publicly available information, and  market and economic data, and may obtain nonpublic information from  the issuer and engage in discussions with its senior management.  However, not all NRSROs rely on nonpublic information in producing  credit ratings.
Issuers seek credit ratings for a number of reasons, such as to improve the  marketability or pricing of their financial obligations, or to satisfy  investors, lenders, or counterparties. In certain markets, such as the U.S.  long-term corporate debt market, a single-rated debt issue may be priced  below an issue with similar ratings from two agencies, because the  absence of a second rating is interpreted as an issuer’s inability to obtain  another equivalent rating. However, in other markets such as the ABS  market, a single rating may be adequate confirmation of asset quality.
Institutional investors, such as mutual funds, pension funds, and insurance  companies, are among the largest owners of debt securities in the United  States and are substantial users of credit ratings. Retail participation in the  debt markets generally takes place indirectly through these fiduciaries.  Institutional investors may use credit ratings as one of several important  inputs to their own internal credit assessments and investment analysis, or  to identify pricing discrepancies for their trading operations. Broker- dealers that make recommendations and sell securities to their clients also  use ratings. These firms often act as dealers in markets that place  significant importance on credit ratings. For example, in the over-the- counter derivatives markets, broker-dealers tend to use credit ratings  (when available) to determine acceptable counterparties, as well as  collateral levels for outstanding credit exposures. Large broker-dealers  also frequently obtain credit ratings as issuers of long- and short-term  debts.
Academic literature suggests that credit ratings affect financial markets  both by providing information to investors and other market participants  and by their use in regulations. Several studies suggest that bond prices,  stock returns, and credit-default swap spreads vary with credit ratings  downgrades. Other studies find that obtaining a credit rating generally  increases a firm’s access to capital markets and that firms with credit  ratings have different capital structures than firms without them as a  result. Furthermore, some studies suggest that firms adjust their capital  structure to achieve a particular credit rating. One explanation for these  relationships is that rating agencies have access to private information  about the issuers and issues they rate, and the ratings they assign  incorporate this information. Thus, ratings are a mechanism for  communicating this otherwise unavailable information to market  participants. Alternatively, at least in market segments with rating-based  regulations, investors’ willingness and ability to purchase bonds with  credit ratings above a regulatory threshold could be greater than their  willingness and ability to purchase bonds with ratings below the threshold.  Thus, firms with credit ratings above the regulatory threshold have lower  costs of capital than those with credit ratings below the threshold.
NRSROs today operate primarily under one of two compensation models:  issuer-pays or subscriber-pays. Under the issuer-pays model, issuers pay  the NRSRO for a rating. These ratings are generally free to the public,  although users may have to purchase access to in-depth reports explaining  the basis for the rating. Under the subscriber-pays model, users pay a  subscription to the NRSRO for access to its ratings.
Trading and Markets administers and executes the agency’s programs  relating to NRSRO oversight, which includes administration of the NRSRO  registration program and rulemaking. OCIE administers SEC’s nationwide  examination and inspection program. Within OCIE, the NRSRO  examination team within the Office of Market Oversight conducts NRSRO  examinations. The purpose of an NRSRO examination is to promote  compliance with applicable laws and rules, identify any violations of such  laws and rules, and ensure remedial action. Examinations also serve to  inform SEC and SEC staff of NRSROs’ compliance with their regulatory  obligations and noteworthy industry developments. If OCIE discovers  potential violations of federal securities laws or rules during an NRSRO  examination, it may refer the case to Enforcement, which is responsible  for further investigating these potential violations; recommending SEC  action when appropriate, either in a federal court or before an  administrative law judge.
section_title: NRSRO Application Review Process Limits SEC Staff’s Ability to Ensure That Applicants Meet the Act’s Requirements and NRSRO Examination Program Faces Staffing Challenges
paragraphs: SEC’s implementation of the Act involved developing an NRSRO  application review process and an examination program. As currently  implemented and staffed, both programs require further attention. First, in  June 2007, SEC adopted final rules that established a voluntary  registration program for recognizing credit rating agencies as NRSROs.  Over the past 3 years, SEC has registered 10 credit rating agencies as  NRSROs, instituted proceedings to determine whether to deny registration  to one applicant, and has begun examinations. However, as implemented,  the registration process potentially limits the staff’s ability to ensure that  applicants meet the Act’s requirements and may create a situation in  which ratings from an NRSRO that may not meet the Act’s requirements  are used by investors and for regulatory purposes. Second, although SEC  has established an OCIE branch dedicated to the examination of NRSROs  and hired individuals with experience in credit rating analysis and  structured finance to fill these positions, OCIE has not completed timely  examinations of the NRSROs and has expressed concerns about its ability  to meet its planned NRSRO routine examination schedule of examining  the three largest NRSROs every 2 years and the other NRSROs every 3  years. While SEC requested additional resources that it anticipated using  to fully staff this oversight function, it will likely need to revisit those  requests due to the passage of the Dodd-Frank Act, which among other  things, requires that each NRSRO be examined every year and that SEC  establish an Office of Credit Ratings to carry out these examinations.  Formalizing a plan to assess not only the number of staff it needs for this  office but also the skills required of this staff would help SEC be  strategically positioned to implement the Dodd-Frank Act requirements.  SEC may face challenges in meeting the required examination timetable  and providing quality oversight over NRSROs unless it develops a plan that  ensures SEC has sufficient staff that have the appropriate qualifications  and are appropriately trained.
subsections: section_title: SEC Established a Formal Registration and Oversight Program for NRSROs and Continues Rulemaking under the Act
paragraphs: SEC adopted final rules for a formal regulatory and oversight program for  NRSROs in June 2007. The rules establish a voluntary registration  program for those credit rating agencies that seek to be recognized as  NRSROs and require that NRSROs make and retain certain records,  furnish financial reports to SEC, and establish procedures to address uses  of material nonpublic information. The rules also require the disclosure of  certain performance measures and ratings methodologies, prohibit certain  conflicts of interest and require the management of other conflicts of  interest, and prohibit specified coercive and unfair practices by NRSROs.  SEC amended several of these rules in February and December 2009 with  the goal of further increasing transparency of NRSRO rating  methodologies, strengthening the disclosures of ratings performance,  prohibiting NRSROs from engaging in certain practices, and enhancing  NRSRO record keeping. These amendments were designed in part to  address concerns that SEC staff identified in its July 2008 report about the  integrity of the process by which the three largest NRSROs rated  structured finance products. Table 1 summarizes the rules and  amendments to those rules adopted by SEC under the Act.
The Act replaced the SEC staff no-action letter process for recognizing  credit rating agencies as NRSROs with a speedier and more transparent  registration system. It created a registration process with required  information for applicants to submit, a specific time frame for SEC’s  review of the application, and specific reasons for which SEC could deny  an application. According to the Senate report accompanying the Act’s  passage, the new registration program does not favor any particular  business model, thus encouraging purely statistical models to compete  with the qualitative models of the dominant rating agencies and  subscriber-pays models to compete with issuer-pays models. The Senate  Report stated that the new registration program would enhance  competition and provide investors with more choices, higher-quality  ratings, and lower costs.
The Act added new section 15E to the Exchange Act, which provides, in  pertinent part, that a credit rating agency electing to register as an NRSRO  must submit the following information to SEC:    statistics that measure the performance of credit ratings over short-, mid-,  the procedures and methodologies the applicant uses in determining credit  ratings;    policies or procedures the applicant adopted and implemented to prevent  the misuse of material, nonpublic information;  the organizational structure of the applicant;  its code of ethics and, if one does not exist, why not;    any conflicts of interest relating to the issuance of credit ratings;  the categories for which the applicant intends to apply for registration;    on a confidential basis, a list of the 20 largest issuers and subscribers that  use its credit rating services;    on a confidential basis, written certification from 10 or more qualified  institutional buyers (QIB) that have used the credit ratings of the applicant  for at least 3 years immediately preceding the data of the certification;  and    any other information and documents concerning the applicant and any  person associated with such applicant as SEC, by rule, may prescribe as  necessary or appropriate in the public interest or for the protection of  investors.
In implementing Section 15E of the Exchange Act, SEC created and  adopted Form NRSRO to collect the required information as well as  audited financial statements and revenue and compensation information.  Form NRSRO requires certification by the applicant that the information  contained is accurate in all significant respects.
Section 15E(a)(2)  sets forth the application  review requirements. SEC must either grant registration or institute  proceedings to determine if registration should be denied within 90  calendar days of a credit rating agency furnishing its application to SEC.  The deadline can be extended if the applicant consents. If SEC institutes  proceedings, it has to provide the applicant a notice of the grounds for  denial under consideration and an opportunity for a hearing and conclude  the proceedings not later than 120 days after the date on which the  application for registration was furnished. SEC can extend the  conclusion of the proceedings for up to 90 days, if it finds good cause for  such extension and publishes its reasons for so finding, or for longer  periods if the applicant consents. The Act requires that SEC shall grant  registration if it finds the requirements of section 15E are satisfied, unless  it makes either of two findings (in which case registration must be  denied): first, that the applicant does not have adequate financial and  managerial resources to consistently produce credit ratings with integrity  and to materially comply with the procedures and methodologies  disclosed in Form NRSRO as well as with the requirements of the Act  regarding the prevention of misuse of nonpublic information, management  of conflicts of interest, prohibited conduct, and the designation of a  compliance officer. Second, that the applicant or a person associated  with it committed or omitted any act such that if the applicant were  registered, its registration would be subject to suspension or revocation  under subsection (d) of Section 15E of the Exchange Act.
section_title: SEC Staff View Their Ability to Ensure That an NRSRO Applicant Meets the Act’s Requirements as Limited
paragraphs: The NRSRO registration program has provided greater transparency and  shortened the time between application and SEC recognition. However, as  currently implemented, the registration process potentially limits staff’s  ability to ensure information provided on applications is accurate and  lacks criteria needed to recommend that SEC deny an application. Since  the implementation of Section 15E, 11 credit rating agencies have applied  for NRSRO registration. To apply, a credit rating agency must fill out  Form NRSRO and submit it and the required accompanying information to  SEC.  Trading and Markets staff review these documents and draft a  memorandum to the Commission with the results of their review and  recommendation for registration or denial of the application. We reviewed  10 memoranda that Trading and Markets provided the Commission and  found that staff recommended that all be registered. The Commission has  instituted proceedings to deny the application of the eleventh applicant.
A few of the 10 memoranda we reviewed described concerns that Trading  and Markets had with the applications.
Staff told us these concerns generally were not resolved before  registration for several reasons: (1) staff lacked criteria against which to  measure certain concerns, (2) staff lacked the ability to examine the credit  rating agencies before registration, and (3) staff came up against the 90- day time frame for the review of applications. According to Trading and  Markets staff, some of these concerns were not addressed because they  were qualitative in nature and would have required subjective judgments  by the staff for which section 15E, implementing rules, or Form NRSRO do  not provide criteria. For example, staff noted a concern about one  applicant’s managerial resources because the designated compliance  officer lacked experience as a credit analyst. However, because section  15E, the rules implementing section 15E, and Form NRSRO do not  prescribe minimum qualifications for the compliance officer position, staff  were unable to support a finding that the applicant lacked the necessary  managerial resources. As previously noted, a finding that the applicant did  not have adequate financial and managerial resources would have been  grounds for denying registration.
Staff noted that because of the newness of the registration and oversight  programs and the rules, no history of regulatory compliance could be used  as a benchmark or criteria by which SEC could evaluate whether the  applicant had adequate financial or managerial resources. Staff reviewed  financial statements, other required financial information, and required  managerial information, and provided summaries of the information in  their memoranda.
Trading and Markets staff also stated that for some of the concerns raised,  they likely would need to conduct examinations to obtain the information  necessary to assess if the concerns were legitimate. However, staff stated  they cannot examine the applicants’ books and records to investigate  qualitative concerns because an applicant does not become subject to  SEC’s oversight authority until it becomes a registered NRSRO. For  example, staff noted that one NRSRO appeared to produce ratings that are  significantly more volatile than those of other applicants. Staff noted that  appropriate explanations for the ratings volatility could exist but without  the ability to examine the applicant, determining the causes of this  volatility would be difficult, as would determining whether or not it  demonstrated inadequate managerial resources. Similarly, staff said that  any assessment of financial sufficiency would have to be determined  through an examination because of the uniqueness of the applicants’  business models. For example, they said a firm that uses only publicly  available information and a quantitative model to produce its ratings likely  needs far fewer financial resources than a firm that uses qualitative  information and must employ analysts to assess this information.
In addition to qualitative concerns, staff also noted factual concerns about  the veracity of some information provided on Form NRSRO. However,  staff said that the 90-day deadline for action and the lack of express  authority to conduct an examination of the applicant did not allow for the  resolution of these types of concerns during the application process. The  deadline can be extended with the applicant’s consent but to date only two  applicants have done so.
Staff said that even if SEC had authority to examine an NRSRO applicant  prior to acting on its application, the Act’s 90-day deadline for acting on an  application would not provide enough time for a more thorough review.  An application is deemed “furnished” to SEC, and thus begins the 90-day  time frame, when SEC receives a complete and properly executed Form  NRSRO. Staff said the Act does not provide SEC with any way to extend  the review period without the applicant’s consent or an SEC decision to  institute proceedings (which would extend the deadline by 30 days, or an  additional 90 days based upon a finding of good cause or upon the  applicant’s consent). Staff said that generally speaking, they would not  recommend that SEC institute proceedings absent sufficient evidence to  support the findings necessary to deny an application. While possible, they  said that providing sufficient material on Form NRSRO to support the  institution of proceedings would be unlikely.
Trading and Markets staff said their principal purpose in raising qualitative  and factual concerns in memoranda was to inform the Commission and  notify OCIE so these issues could be monitored through future  examinations. Trading and Markets staff said that conducting the lengthy  examinations that likely would be needed to resolve many of these  qualitative issues in effect could be viewed as a return to the prior staff no- action letter process in which examinations were used to make qualitative  and subjective assessments of a credit rating agency seeking NRSRO  designation. Staff pointed to the legislative history of the Act as illustrating  that Congress clearly found that the prior staff no-action letter process  created artificial barriers to entry to NRSRO registration, and that the Act  specifically was designed to replace that process with a more efficient and  transparent registration program. For this reason, staff told us they have  interpreted the Act to mean it is not appropriate for SEC to institute  proceedings to deny an application merely to resolve staff questions about  an application, and absent sufficient evidence at the application stage to  support one of the statutory grounds for denial of registration. As Trading  and Markets staff interpret the NRSRO registration program, they believe  that the Commission must find an applicant has satisfied the requirements  of Section 15E if the applicant meets the definition of a credit rating  agency, submits the required material, and is capable of complying with  the applicable U.S. securities laws.
Because the Act allows SEC to deny an application if the applicants are  found to have inadequate managerial or financial resources, the investing  public may have some expectation that SEC determined that applicants  had the financial and managerial resources to produce ratings with  integrity before registering them. Furthermore, because each applicant  must certify the accuracy of its information and statements, an  expectation could exist that the information provided to SEC and on  which the Commission bases its approval decision was accurate and  complete. This not only includes the qualified institutional buyer  certifications, which are used to determine whether or not the market  recognizes and uses the ratings provided by the NRSRO, but also the  public disclosures, such as the descriptions of the ratings methodologies.  We identified other registration processes that have built in greater  authority and flexibility for the staff to clarify issues before registering  applicants. For example, both FINRA’s registrant application process for  broker-dealers and SEC’s registration process for investment advisors  require applicants to provide specific information and utilize deadlines to  ensure an efficient process. According to staff from these programs, they  are able to clarify any outstanding questions they have regarding  information required on the application and to delay registering the  applicant until they are satisfied the applicant has met all of the necessary  requirements. However, because the NRSRO registration program  requires SEC to act within 90 days of receiving the application and SEC  has limited ability to extend that deadline, staff have recommended  granting registration to credit rating agencies as NRSROs with some  concerns outstanding about their meeting the Act’s requirements.  Furthermore, the uncertainty as to the extent of SEC’s authority to compel  the production of certain additional information that could be used to  verify the information provided on Form NRSRO and the lack of specific  criteria against which to assess the application may lead to SEC granting  registration to an applicant that does not fully meet Section 15E’s  requirements as an NRSRO.
section_title: New Dedicated Teams in SEC Provide Input on Regulatory Initiatives and Examine NRSROs
paragraphs: In December 2008, Trading and Markets created an NRSRO monitoring  unit to provide input on regulatory initiatives related to NRSROs. The  members of this unit are responsible for meeting periodically with  NRSROs to establish an ongoing dialogue and discuss topics such as  updates to rating methodologies and practices, financial results, and  compliance and internal audit activity. The unit is also responsible for  preparing internal periodic profile reports of each NRSRO and the annual  report to Congress on NRSROs, and analyzing and preparing reports on  topics of interest or potential concern. According to documents we  reviewed, the unit also is supposed to meet periodically with NRSROs to  discuss issues specifically related to model development, validation, and  governance to gain a better understanding of the models and the controls  around each. As of August 2, 2010, this unit has three members with  qualifications and experience, ranging from a former rating agency  managing director with more than 20 years experience to an analyst with 6  years of experience as a corporate credit analyst.
Following its registration as an NRSRO, a credit rating agency immediately  becomes subject to SEC oversight, including compliance examinations  and enforcement. OCIE, which conducts NRSRO examinations, in May  2009 reorganized the Office of Market Oversight to create a new NRSRO  examination team (a branch chief, a senior specialized examiner, and  three staff examiners) to perform NRSRO examinations. The senior  specialized examiner and three staff examiners were new SEC employees  and include two former NRSRO analysts (both former managing directors  of a major rating agency with over 20 and over 10 years experience  respectively) and attorneys with experience in structured finance products  and corporate law. According to OCIE staff, the new examiners have  received standard OCIE training and on-the-job training from the branch  chief and other examiners who completed previous NRSRO examinations.  In addition, OCIE is considering incorporating NRSRO-specific training  into its standard examiner training and has developed written guidance to  assist examiners and foster consistency in examinations.
Based on our review of OCIE’s NRSRO examination guidelines and  interviews with OCIE staff, OCIE plans to conduct routine and special  NRSRO examinations. Routine examinations assess an NRSRO for  compliance with the Act and applicable rules and regulations at regular  intervals. Special, or cause, examinations typically originate from a tip or  need to gather specific information (limited scope) or follow up on past  examination findings and recommendations. OCIE expects to conduct  special or cause examinations as necessary. According to the guidelines,  each routine examination will generally begin with an initial risk  assessment and scope analysis of the NRSRO to be reviewed. Specific  review areas for each examination (such as conflicts of interest or  document retention) are determined during the risk assessment process  and throughout the examination. OCIE explained that all examinations are  based on risk assessment to maximize the examination team’s time and  resources.
NRSRO examination staff typically review, among other things, whether  the NRSRO adequately has (1) disclosed a description of its ratings  procedures and methodologies; (2) documented internally its ratings  procedures and methodologies; (3) documented its ratings process in  ratings files, including making and retaining required documentation; and  (4) adhered to its ratings policies and procedures in the creation of ratings.  OCIE examinations do not assess whether the NRSRO produces accurate  ratings, as SEC is prohibited from evaluating the substance of credit  ratings or the procedures and methodologies by which an NRSRO  determines credit ratings. Areas of review may include credit rating and  surveillance process, record retention, prevention of the misuse of  material nonpublic information, conflicts of interest, prohibited acts and  practices, financial operations, marketing, compliance, internal audit, and  unsolicited ratings. For example, under the conflicts of interest area, the  guidance provides a description of the applicable rule (17g-5) and a  description of the disclosure requirements. It suggests OCIE request all  current written policies and procedures related to conflicts of interest, and  then assess if these policies and procedures were designed reasonably,  captured all the relevant conflicts, and were followed. OCIE has been  working with the NRSROs to standardize the level of detail that the  examiners would expect to see. This process is ongoing and examiners  likely will have to complete a few examinations before determining  exactly what they would need to see to make compliance determinations.  If deficiencies were found, OCIE would send a deficiency letter to the  NRSRO requesting that it make the appropriate corrections and notify  OCIE of how it plans to make those corrections. In cases of potential  violations, OCIE may refer the NRSRO to the Enforcement Division for  further review.
OCIE completed its first series of examinations of the largest NRSROs in  July 2008. The examinations focused on the rating of subprime RMBS by  Standard & Poor’s, Moody’s, and Fitch and were initiated in response to  the recent mortgage crisis. OCIE conducted these examinations jointly  with Trading and Markets and made its examination results public.
Although these examinations occurred after the enactment of the Act, the  period subject to examination predated the Act.
Among other things, the examinations found that    RMBS and collateralized debt obligations (CDO) deals substantially  increased in number and complexity since 2002, and some of the rating  agencies appear to have struggled with that growth;    significant aspects of the rating process were not always disclosed;  the management of conflicts of interest raised some concerns; and  the surveillance processes the ratings agencies used appeared to have  been less robust than the processes used for initial ratings.
The examinations also resulted in remedial actions that the examined  NRSROs stated they would take to address the findings of these  examinations and additional rulemaking by SEC. Examples of remedial  actions included that the examined NRSROs evaluate, both at that time  and on a periodic basis, whether they have sufficient staff and resources to  manage their volume of business and meet their obligations under Section  15E of the Exchange Act and the rules applicable to NRSRO, and that each  NRSRO conduct a review of its current disclosures relating to process and  methodologies for rating RMBS and CDOs to assess whether it is fully  disclosing its ratings methodologies in compliance with Section 15E of the  Exchange Act and the rules applicable to NRSROs. The additional  rulemaking included amendments to SEC’s rules identifying a series of  conflicts of interest that NRSROs must disclose and manage and others  that were outright prohibited.
In October 2008, OCIE began routine examinations of four of the  remaining seven NRSROs. As of August 30, 2010, OCIE had completed  three examinations and closed the remaining examination. OCIE staff  explained these routine examinations took longer to complete than  anticipated because of the transition from the old to the new staff, the  resignation or departure from the area of some examination staff, and the  need to conduct other examinations and initiatives. For example, OCIE  also has completed three special (limited scope) examinations and begun  another special (cause) examination since the NRSRO examination  program started. Given the small number of NRSRO examiners, the need  to conduct these additional examinations slowed progress on the routine  examination schedule. NRSRO examiners also have been conducting  outreach initiatives for designated compliance officers of the NRSROs,  which are intended to educate them on SEC’s expectations with regard to  compliance officers’ skills and backgrounds. As a result, with the current  level of staffing it is unlikely that OCIE would have been able to meet its  planned routine examination schedule of examining the three largest  NRSROs every 2 years and the remaining NRSROs every 3 years depending  on staffing resources, and two examinations have taken over 18 months to  complete. SEC requested additional resources which it anticipated using  to fully staff this oversight function.
Under the recently passed Dodd-Frank Act, SEC must establish an Office  of Credit Ratings and conduct annual examinations of each NRSRO. The  Dodd-Frank Act also outlines eight specific areas these examinations must  review and requires that the Commission produce an annual public report  summarizing the findings of these examinations. According to OCIE staff,  in August 2010, the NRSRO examination team will begin new examinations  of all NRSROs as mandated by the Dodd-Frank Act. OCIE staff said they  are relying on currently designated NRSRO examiners and examiners from  other OCIE examinations programs to staff the teams.
The Dodd-Frank Act requires SEC to staff the office sufficiently to carry  out these requirements. Although SEC may be able to staff the teams  needed to conduct the first round of annual examinations by using staff  from other examination programs, such an approach is not sustainable in  the long term. In creating this new office, developing a plan to assess not  only the number of staff it needs but also the skills required of this staff  would help SEC be strategically positioned to meet the Act’s requirements.  Without a plan that helps ensure SEC has sufficient staff that have the  appropriate qualifications and are appropriately trained, SEC may face  challenges in meeting the required examination timetable and providing  quality oversight over NRSROs.
section_title: SEC Has Increased the Amount of Performance-related Data NRSROs Are Required to Disclose, but These Data Have Limited Usefulness
paragraphs: Since the implementation of the Act, SEC has made several revisions to  the Form NRSRO that are intended to make more information publicly  available for evaluating and comparing NRSRO performance. The revised  Form NRSRO requires NRSROs to disclose credit rating performance  statistics over 1-, 3-, and 10-year periods. SEC has also required NRSROs to  make ratings history data publicly available. SEC intended these  disclosures to allow users to better evaluate and compare NRSRO  performance. However, because SEC did not specify how NRSROs should  calculate these statistics, the NRSROs used varied methodologies, limiting  their comparability. Further, we found that the ratings history data sets do  not contain enough information to construct comparable performance  statistics and are not representative of the population of credit ratings at  each NRSRO. Without better disclosures, the information being provided  will not serve its intended purpose of increasing transparency.
subsections: section_title: SEC-required Performance Statistics Have Increased the Data Available from NRSROs, but Their Comparability Is Limited
paragraphs: Pursuant to the requirements of section 15E of the Exchange Act, NRSROs  are required to disclose credit rating performance statistics over short-,  mid-, and long-term periods, as applicable. Form NRSRO specifies that  these statistics must at a minimum show the performance of credit ratings  in each class of class for which an NRSRO is registered over 1-, 3-, and 10- year periods, including, as applicable, historical transition and default  rates for each rating category and notch. The statistics must include  defaults relative to initial ratings. Transition rates compare ratings at the  beginning of a time period with ratings at the end of the time period, while  default rates show the percentage of ratings with each rating that  defaulted over a given time period. SEC requires NRSRO applicants to  furnish the required transition and default rates as part of their NRSRO  application on Form NRSRO, and once registered, to update the statistics  annually. As part of these disclosures, NRSROs must define the credit  rating categories they use and explain these performance measures,  including the inputs, time horizons, and metrics used to determine them.
subsections: section_title: SEC Intended Statistics to Facilitate Comparison of Credit Rating Performance among NRSROs
paragraphs: In adopting these requirements, SEC stated that these types of statistics  are important indicators of the performance of a rating agency in terms of  its ability to assess the creditworthiness of issuers and, consequently,  would be useful to users of ratings in evaluating a rating agency’s  performance. SEC specified the 1-, 3-, and 10-year periods so that the  performance statistics the NRSROs generated would be more easily  comparable. SEC also stated that requiring NRSROs to define the ratings  categories used and explain their performance statistics would assist users  of ratings in understanding how the measurements were derived and in  comparing the measurement statistics of different NRSROs.
In deciding which statistics to require, SEC identified default and  transition rates as common benchmarks. To compute 1-year transition  rates by rating category, an NRSRO will form cohorts by grouping all of  the entities (issues or issuers) with ratings outstanding at the beginning of  the year by their rating at the beginning of the year. The NRSRO then  calculates the number or percentage of entities in each cohort that have  each possible rating at the end of the year. Table 2 provides a hypothetical  example of a 1-year transition matrix for cohorts of rated entities for 2009.
The rows of the matrix show all possible credit ratings an entity could  have at the beginning of the year, by rating category. The columns of the  matrix show all possible credit ratings an entity could have at the end of  the year, also by rating category. The matrix also includes columns for  defaults (D) and withdrawals (W), since an entity could default or have its  rating withdrawn during the course of the year. The table cells show the  rates at which ratings migrate upward, downward, or stay the same. For  example, 1.3 percent of the entities rated A at the beginning of the year  were rated AA at the end of the year, 6.9 percent of the entities rated A at  the beginning of the year were rated BBB at the end of the year, and 91.3  percent of the entities rated A at the beginning of the year were rated A at  the end of the year.
By showing the number or fraction of entities in each cohort with stable  ratings—that is, with the same beginning-of-year and end-of-year ratings—  transition matrixes allow users to compare the stability of different rating  categories (for the same NRSRO). Table 1 shows that 93.3 percent of entities  rated AAA at the beginning of the year were still rated AAA at the end of the  year, but 90.4 percent of entities rated BBB at the beginning of the year were  still rated BBB at the end of the year. Thus, AAA ratings demonstrated more  stability than BBB ratings. In general, an NRSRO’s credit ratings are intended  to order rated entities by their creditworthiness, with high ratings indicating  relatively more creditworthiness than low ratings. One aspect of  creditworthiness is the extent to which it changes over time, with more  creditworthy entities demonstrating greater stability. Thus, an NRSRO’s  higher ratings should exhibit more stability than its lower ratings. Transition  rates illustrate how well a particular rating scale rank orders credit risk on  this margin.
As previously stated, default rates show the percentage of entities with  each rating that defaulted over a given time period. For example, to  calculate simple 1-year default rates relative to beginning-of-year ratings,  an NRSRO will form cohorts by grouping all of the entities with ratings  outstanding at the beginning of the year by their rating at the beginning of  the year. The NRSRO then calculates the fraction of entities in each cohort  that default during the year. Table 2 shows hypothetical 1-year default  rates for the 2009 cohorts of rated entities. For example, no bonds rated  AAA defaulted during 2009, while 20 percent of bonds rated CC defaulted  during this period.
SEC rules require that NRSROs disclose on their Form NRSRO 1-, 3-, and  10-year default rates relative to initial ratings. For example, to calculate  simple 1-year default rates relative to initial ratings, an NRSRO could form  cohorts by grouping all of the entities assigned initial ratings during a  given time period by their initial rating. The NRSRO could then calculate  the fraction of entities in each cohort that default within 1 year after they  receive their initial rating. As previously discussed, an NRSRO’s credit  ratings are intended to put rated entities in order of their creditworthiness.  It follows that entities with higher credit ratings should default less often  than entities with lower credit ratings. Default rates also illustrate how  accurately a particular rating scale rank orders credit risk on this margin.
section_title: NRSROs’ Differing Methodologies for Calculating Performance Statistics Limit Their Comparability
paragraphs: We reviewed the 2009 performance statistics published by the 10 NRSROs  as part of their annual update to Form NRSRO, focusing on the corporate  and structured finance asset classes. The required disclosures increased  the amount of information publicly available about the performance of  some NRSROs, particularly those that were newly registered. However,  SEC did not specify how the NRSROs were to calculate the required  performance statistics, and, as a result, the NRSROs used different  methodologies for calculating the transition and default rates. For the  transition rates, they differed by whether they (1) were for a single cohort  or averaged over many cohorts, (2) constructed cohorts on an annual  basis or monthly basis, (3) were adjusted for entities that have had their  ratings withdrawn or unadjusted, and (4) allowed entities to transition to  default or not. Because of these differences, users cannot use the  performance statistics to compare transition rates across NRSROs, as the  rule intended.
First, some NRSROs provided transition rates for individual cohorts for the  most recent 1-, 3-, and 10-year period. These NRSROs provided statistics  summarizing the transition rates for individual cohorts—for example, 1-year  transition rates for the 2009 cohort, 3-year transition rates for the 2007  cohort, and 10-year transition rates for the 2000 cohort. Other NRSROs  provided average transition rates for multiple 1-, 3-, and 10-year time periods  over a range of years. For example, one NRSRO calculated 1-year transition  rates for every annual cohort from 1981 to 2009 (obtaining 28 separate 1- year transition rates) and then averaged the rates in those matrixes to  obtain average 1-year transition rates for each rating category and notch.  The NRSRO used the same methodology to calculate average 3-year and  average 10-year transition rates over the same period.
Single and average cohort approaches provide different information about  an NRSRO’s performance. The single cohort approach uses information  from only the most recent 1-, 3-, and 10-year periods and thus describes  the NRSRO’s performance at specific points in time. As such, it is useful  for describing the historical experience of a particular group of ratings  under a particular set of circumstances. Single cohort transition matrixes  are thus useful as predictors of the performance of ratings in future time  periods under similar circumstances, but they are less useful as predictors  of the performance of ratings in future time periods under different  economic and other conditions. On the other hand, the average cohort  approach uses information from multiple time periods and thus describes  the NRSRO’s performance during an average 1-, 3-, or 10-year time period.  As such, average cohort transition rates are useful indicators of expected  transition rates in the future, given that future economic and other  conditions are unknown. Both approaches are valid, depending on the  needs of the user, but they do not yield comparable information.
Second, the NRSROs differ in whether they construct cohorts on an  annual or monthly cohort basis. The frequency with which the cohorts are  formed affects the accuracy of average transition rates. The higher the  sampling frequency—the shorter the time period between cohort  formation dates—the more observations are available for calculating the  averages and the more accurate the transition rates are for predictive  purposes. Most of the NRSROs used annual cohorts (that is, they formed a  new cohort on December 30 or 31 or January 1 of each year), but one  NRSRO used monthly cohorts (that is, it formed a new cohort on the first  day of each month). Using monthly cohorts means that 12 times as many  observations contribute to average transition rates.
Third, we found some NRSROs adjusted their transition rates to reflect  those entities with ratings that were withdrawn during the time period,  while others did not. NRSROs withdraw ratings for a number of reasons.  In many cases, the issue matures and the rating is no longer needed. In  other cases, the NRSRO discontinues a rating for lack of information.  Transition rates that include entities with withdrawn ratings in the cohorts  are called “unadjusted” rates, while those that exclude entities with  withdrawn ratings are called “withdrawal-adjusted” rates. The treatment of  withdrawn ratings in calculating transition rates can have a significant  impact on the magnitude of the rates. For example, suppose a cohort with  an initial BBB rating has 100 rated entities at the beginning of the time  period, and suppose that 25 are withdrawn during the period and the  remainder are still rated BBB at the end of the period. The unadjusted  transition rate from BBB to BBB would be 75 percent (75/100) and the  withdrawal-adjusted transition rate would be 100 percent (75/75). For one  NRSRO, we could not determine from the disclosures how it treated  withdrawals in its transition rates.
Fourth, one NRSRO did not include transitions to default in its transition  rates. As a result, its performance statistics do not include information on  the number of ratings that moved from a particular rating category to  default during the 1-, 3-, or 10-year periods. This information is important  to the investor, because ratings that move from a higher rating category  (such as AAA, AA, or A) directly to default within the time period may  signal poor ratings performance by the NRSROs. Table 3 summarizes the  variation in the calculation of transition rates that we found in reviewing  the NRSROs’ 2009 performance statistics.
NRSROs also used different methodologies for calculating default rates. In  general, default rates differed by whether they were (1) relative to ratings  at the beginning of a given time period or relative to initial ratings, (2)  adjusted for entities that had their ratings withdrawn or unadjusted, (3)  adjusted for how long entities survived without defaulting or unadjusted,  (4) calculated using annual or monthly cohorts, and (5) calculated for a  single cohort or averaged over many cohorts. Because of these  differences, users cannot compare default rates across NRSROs, as the  rule intended.
First, most NRSROs reported default rates relative to ratings at the  beginning of a specific time period, while two reported default rates  relative to initial rating. Calculating default rates relative to ratings at the  beginning of a given time period is similar to calculating transition rates  relative to ratings at the beginning of a given time period. NRSROs form  cohorts by grouping entities that had the same outstanding rating on a  specific date, and then calculating the number or fraction of entities in  each group that defaulted over a given time period. To calculate default  rates relative to initial rating, NRSROs form cohorts by grouping entities  that were assigned the same initial rating, regardless of when the initial  ratings were assigned. One NRSRO calculated the default rates relative to  initial ratings over the entire period for which it had historical ratings data,  from 1983–2009. Issuers that were assigned initial ratings of AAA at any  point during that 26-year period were grouped, as were issuers that were  assigned initial ratings of AA, and so forth. The NRSRO then determined  whether there had been any defaults at any time for any of those issuers  over the 26 years and calculated the default rate. Another NRSRO used a  different methodology and provided default rates relative to the initial  ratings only for those ratings that were outstanding at the beginning of the  most recent 1-, 3-, and 10-year periods. For example, for the 1-year period,  this NRSRO determined the ratings that had been outstanding as of  December 31, 2008, grouped them according to their initial ratings,  determined whether any defaulted in 2009, and calculated the default  rates.
Default rates for entities based on their initial rating omit important  information about the performance of NRSRO ratings over time. In some  asset classes (specifically corporate, financial institution, and insurance  company), performance statistics are based on issuer ratings, not the  ratings on specific securities of those issuers. For some issuers, their  ratings history spans decades or longer. The initial rating given to those  firms is not relevant information at the time the issuer defaulted, because  the performance of the issuer likely changed throughout the years. For  example, an issuer initially could have been rated AAA 30 years ago but  deteriorated in the last few years. An investor likely would be more  interested in the last ratings the NRSRO provided for the issuer to  determine whether it accurately predicted the default. In contrast,  structured finance products typically do not have maturities that last for  decades, so calculating defaults relative to initial ratings may provide more  useful information in that sector.
Second, as with transition rates, some NRSROs calculated their default  rates adjusting for withdrawn ratings, while others did not. In addition to  affecting the relative magnitude of default rates, the treatment of  withdrawn ratings also provides different information about default risk.  Unadjusted default rates describe the historical frequency of defaults for a  cohort during a given time period and treat entities with withdrawn ratings  as if they had remained in the data sample for the entire period. They can  be used to predict the expected probability of default for entities over a  time period that is at most as long as the period used to calculate the  default rate. However, unadjusted default rates likely underestimate actual  default rates for a cohort because NRSROs are less likely to observe  defaults among entities with withdrawn ratings, either because they  choose not to track those entities or because they have less access to  information about them. Furthermore, unadjusted default rates are only  useful for predicting default rates for entities that have withdrawal  patterns similar to those of the cohort used to calculate the unadjusted  default rates. The greater the differences in the withdrawal experience of  two groups of rated entities, the less useful the unadjusted default rates  for one group are for predicting defaults in the other group. For one  NRSRO, we could not determine from the disclosures how it treated  withdrawals in its default rates.
On the other hand, withdrawal-adjusted default rates describe the  historical frequency of defaults for entities during a given time period  conditional on those entities having a rating outstanding for the entire  period. These statistics treat entities with withdrawn ratings as if they  faced the same likelihood of default as entities with ratings that were not  withdrawn. Withdrawal-adjusted default rates can be used to predict the  expected probability of default for entities over the same length of time as  the period used to calculate the default rate. The usefulness of the  prediction does not depend on similarities in withdrawal patterns for the  entities. However, withdrawal-adjusted default rates assume that  withdrawals are random and not correlated with the likelihood that an  entity defaults. Withdrawal-adjusted default rates can be biased downward  or upward if entities with withdrawn ratings are more or less likely to  default, respectively, than entities with ratings that were not withdrawn.
Third, some NRSROs reported simple default rates while others reported  default rates conditioned on how long the entities went without defaulting  or withdrawing. NRSROs calculate simple default rates by dividing the  number of defaults that occurred over a specific time period by the  number of rated entities in the cohort at the beginning of the time period.  For example, some NRSROs reported the simple 3-year default rate for the  2007 cohort. To calculate this, they formed cohorts for 2007, took the  number of defaults that occurred over the 3-year period in each cohort,  and divided them by the number of rated entities included in each cohort.  NRSROs calculate conditional default rates by adjusting for the fact that  entities can default at different points during the chosen time period. This  method is called conditional because default rates are conditioned upon  those issuers that “survived” for a particular amount of time. Simple  defaults rates are equal to conditional defaults rates if neither are adjusted  for withdrawals. However, simple withdrawal-adjusted default rates are  larger than conditional withdrawal-adjusted default rates. The former  assume that all withdrawals occurred at the beginning of the period and  thus never had an opportunity to default. The latter reflect the fact that  withdrawals occur at different times during the period, so the number of  ratings that could default are larger at the beginning of the period than at  the end.
Fourth, as with transition rates, the frequency with which the cohorts are  formed affects the accuracy of average transition rates. Again, most of the  NRSROs used annual cohorts, but two NRSROs used monthly cohorts.
Fifth, some NRSROs reported default rates for the most recent 1-, 3-, and  10-year periods for individual cohorts, while others reported average 1-, 3-,  and 10-year default rates for multiple cohorts. For example, some NRSROs  reported simple 3-year default rates for the 2007 cohort. However, one  NRSRO reported average simple 3-year default rates for 1990–2009. It did  so by first calculating simple 3-year default rates for every cohort from  1990 through 2009 and then averaging those default rates.
Table 4 summarizes the variation in the calculation of the default rates that  we found in our review of the 2009 performance statistics.
Besides not specifying how the NRSROs should calculate their transition  and default rates, SEC did not specify how the NRSROs should present  their performance statistics. For example, four NRSROs reported their  transition and default rates as percentages, but did not report the absolute  number of ratings in each cohort. As a result, these disclosures have  limited utility for comparison purposes. All else being equal, transition and  default rates will be more precise, and thus more meaningful, the greater  the number of observations used to calculate them. Furthermore, defaults  are relatively rare events that may not be observed at all in samples that  are too small. Knowing the absolute numbers of ratings in each cohort is  thus important for comparative purposes to give users an idea of precisely  how transition and default rates are calculated and the total numbers of  entities involved in each rate. That is, if an NRSRO’s default rate is 20  percent, it is useful for users to know if one out of five rated entities  defaulted, or if 10,000 out of 50,000 rated entities defaulted. As another  example, if an NRSRO’s default rate increases from 10 to 12 percent in  different years, it is useful for users to know whether that 2 percentage  point difference resulted from the default of 20 or 2,000 additional rated  entities.
At least one SEC-designated asset classes may be too broadly defined to  be meaningful. Two NRSROs may rate the same asset class, but  differences in ratings performance may reflect the differences between the  sets of rated issues and issuers, and not necessarily provide insights into  the relative merits of the ratings methodology used. For example, several  NRSROs specialize in rating certain asset classes. Realpoint only rates  commercial mortgage-backed securities (CMBS) while Japan Credit Rating  Agency and Ratings and Investment, the two Japanese NRSROs, focus on  Japanese issues. Thus, comparing the transition and default rates of these  NRSROs with those of other NRSROs that may rate more types of  structured finance products or focus on other geographic regions, may not  be meaningful. In structured finance, the NRSROs that rate ABS generally  present performance statistics for this asset class by sectors in their  voluntary disclosures; that is, CMBS, RMBS, and ABS backed by auto,  student, or credit card loans. These ABS sectors have risk characteristics  that vary significantly. Thus, presenting performance statistics for the ABS  asset class as whole, instead of by sectors, may not be useful. SEC has not  yet re-evaluated the appropriateness of the currently designated asset  classes to determine if they are appropriate for presenting performance  statistics.
Trading and Markets staff said SEC issued rules requiring the NRSRO to  publish performance statistics under tight time frames. Because this is a  new area for SEC, staff said they wanted to focus on drafting a rule that  would be appropriate. They said that once SEC, NRSROs, and the market  obtain some experience with these disclosures, SEC could respond to any  issues or comments with further rulemakings. Because the NRSROs do not  have specific guidance for calculating and presenting their currently  required performance statistics, they used different methodologies. As a  result, users of these statistics cannot compare ratings performance across  NRSROs. Further, asset classes that are defined too broadly limit the  usefulness of the disclosures.
Under the Dodd-Frank Act, SEC must adopt rules requiring the NRSROs to  publicly disclose information on the initial credit ratings determined by  each NRSRO for each type of obligor, security, and money market  instruments, and any subsequent changes to such credit ratings. The  purpose of these rules is to allow users of credit ratings to evaluate the  accuracy of ratings and compare the performance of ratings by different  NRSROs. At a minimum, these disclosures must be comparable among  NRSROs, clear and informative for investors having a wide range of  sophistication who use or might use credit ratings, and include  information over a range of years and for a variety of credit ratings,  including those credit ratings that the NRSROs withdraw. In developing  these new disclosure requirements, it will be important for SEC to provide  clear and specific guidance to the NRSROs. Otherwise, the resulting  disclosures may lack comparability.
section_title: Although Using Consistent Methodologies to Generate Performance Statistics Is Helpful, Other Differences Can Make Comparisons among NRSROs Difficult
paragraphs: Even if NRSROs use the same methodologies to generate and present  performance statistics, there are differences in NRSROs’ measures of  creditworthiness, ratings scales, ratings methodologies, and other  processes. It is important that users of NRSRO performance statistics be  aware of this contextual information when comparing NRSRO  performance.
NRSROs vary in how they measure creditworthiness. For example, some  NRSROs’ credit ratings measure the likelihood of default, while others also  measure other characteristics, such as the anticipated severity of dollar  losses given a default.
NRSROs also vary in how they define the elements of their ratings scales.
As previously discussed, NRSRO rating scales rank rated entities  according to their relative creditworthiness, with higher ratings indicating  higher creditworthiness. However, the creditworthiness associated with  each rating category can vary across NRSROs. Even within a rating scale,  the assignment of ratings in the same rating category to issuers and issues  may not fully reflect small differences in the degrees of risk. Moreover, the  degree of risk within a particular rating scale can change over time.
NRSROs can differ in how they determine when to withdraw a rating. As  previously discussed, withdrawals typically occur when an issue matures,  but NRSROs also exercise judgment on whether or not to withdraw ratings  in other cases, such as when they believe they do not have sufficient  information to provide a rating. They also can vary in the extent to which  they track withdrawn ratings. We obtained information from four NRSROs  on their treatment of withdrawn ratings. Three NRSROs continue to track  the issue or issuer after a rating is withdrawn to determine whether it  eventually defaulted. These NRSROs then update their performance  statistics to account for these defaults. One NRSRO did not. NRSROs that  track post-withdrawal defaults will show a higher default rate than those  that do not, all other things being equal.
NRSROs can differ in how they define default. Therefore, some agencies  may have higher default rates than others as a result of a broader set of  criteria for determining that a default has occurred.
Differences in NRSROs’ rating methodologies can affect the relative  stability of ratings. For example, in their public disclosures, two NRSROs  stated that they rate through the business cycle, meaning that their ratings  are intended to measure how an issuer will weather a variety of  macroeconomic conditions, relative to other issuers. These rating  agencies, upon receiving new information about the issuer, may not  immediately revise the rating. As a result, ratings that reflect a through- the-cycle approach are less likely to fluctuate over time. However, another  NRSRO told us that it updates ratings more frequently to reflect current  market information and conditions. NRSROs that use this approach likely  will have transition rates that show more volatility than the transition rates  of NRSROs that rate through the business cycle.
Users of NRSRO performance statistics can obtain some of this contextual  information from other disclosures NRSROs are required to make under  Form NRSRO. As previously discussed, NRSRO applicants and registered  NRSROs are required to disclose general descriptions of their policies and  procedures for determining ratings. For example, these disclosures  discuss each NRSRO’s approach to measuring creditworthiness,  identifying defaults, and determining when to withdraw a rating. As part of  their required disclosures of performance statistics, NRSROs also must  describe the rating categories for their ratings scales. However, these  descriptions define only the rank ordering of the elements of the rating  scale, and do not give any indication of the actual degree of risk associated  with a rating category.
When it proposed rules to require performance disclosures from the  NRSROs, SEC requested comments on whether the performance statistics  should use standardized inputs, time horizons, and metrics to allow for  greater comparability. Some commenters opposed the use of  standardized measures, stating that such measures would be impractical  because credit rating agencies use different methodologies to determine  credit ratings and different definitions of default and that the use of such  measures could interfere with the methodologies for determining credit  ratings. However, a few commenters supported the use of standardized  measures because it would make it easier to compare NRSROs. In light of  the different views expressed, SEC stated it would continue considering  this issue to determine the feasibility and potential benefits and limitations  of devising measurements that would allow reliable comparisons of  performance between NRSROs. SEC’s ability to achieve comparability on  some of these margins may be limited, however, given Section 15E  prohibits SEC from regulating credit ratings and the procedures and  methodologies used to determine them.
section_title: Required Disclosures of Ratings History Data Have Limited Usefulness for Generating Comparative Performance Statistics
paragraphs: In February 2009, SEC adopted a rule requiring issuer-pays rating agencies  to disclose a random 10 percent sample of outstanding ratings in each  class of ratings in which they have more than 500 issuer-paid ratings. In  December 2009, SEC issued a second rule requiring all NRSROs to  disclose 100 percent of the histories of their ratings actions for credit  ratings initiated on or after June 26, 2007. SEC intended the two rules to  be complementary and allow users to generate a variety of performance  measures and comparative studies. However, we found that the data  disclosed under the 10 percent sample disclosure requirement do not  contain enough information to construct comparable performance  statistics and are not representative of the population of credit ratings at  each NRSRO and that the data disclosed under the 100 percent disclosure  requirement likely present similar issues.
subsections: section_title: Factors Limiting Utility of 10 percent Samples Include Lack of Information on Ratings Types and Variables, and Sampling Methodologies
paragraphs: According to SEC, the 10 percent sample requirement is intended to foster  accountability and comparability—and hence, competition—among  NRSROs. SEC stated in the final rule that market observers should be able  to develop performance statistics based on the data to compare the rating  performance of different NRSROs, which will foster NRSRO competition.  The rule specified that the ratings histories NRSROs must provide for each  security that is part of their sample should include (1) all ratings actions  (initial rating, upgrades, downgrades, placements on watch for upgrade or  downgrade, and withdrawals); (2) the date of such actions; (3) the name of  the security or issuer rated; and (4) if applicable, the CUSIP number of a  rated security or CIK number of a rated issuer. New ratings actions must  be disclosed no later than 6 months after they are taken.
We reviewed the 10 percent samples from the seven issuer-paid NRSROs.  We could not use these samples to generate reliable performance statistics  for the NRSROs, as the rule intended, for the following reasons: (1) the  data fields the NRSROs included in their disclosures were not always  sufficient to identify complete ratings histories for the rated entities  comprising each sample, (2) the data fields did not always give us enough  information to identify specific types of ratings for making comparisons,  (3) the data fields did not always give us enough information to identify  the beginning of the ratings histories in all of the samples, (4) SEC rules do  not require the NRSROs to publish a codebook or any explanation of the  variables used in the samples, (5) not all NRSROs are disclosing defaults in  the ratings histories provided as part of their 10 percent samples, and (6)  SEC guidance to the NRSROs for generating the random samples does not  ensure that the methods used will create a sample that is representative of  the population of credit ratings produced by each NRSRO. As a result,  users cannot generate valid comparative performance statistics that can  be compared across NRSROs.
First, SEC did not specify the data fields the NRSROs were to disclose in  the rule, and the data fields provided by the NRSROs were not always  sufficient to identify a complete rating history for ratings in each of the  seven samples. If users cannot identify the rating history for each rating in  the sample, they cannot develop performance measures that track how an  issue or issuer’s credit rating evolves.
Second, the data fields did not always give users enough information to  identify specific types of ratings for making comparisons. In one sample,  we could not distinguish between issue ratings and issuer ratings.  Distinguishing issuer rating histories from issue rating histories is  important because, as we previously discussed, performance statistics for  some asset classes, such as corporate issuers, financial institutions, and  insurance companies, typically are calculated using issuer ratings, while  performance statistics for issuers of ABS typically are calculated using  issue ratings. Distinguishing between issuer and issue ratings is important  for evaluating comparable entities across agencies. Comparing the  performance of one agency’s issuer ratings with another agency’s issue  ratings would not be meaningful. For ABS, one NRSRO told us that its  sample did not have enough information to identify the individual tranches  that constitute a deal. Without this ability, users cannot construct  meaningful performance measures for ABS.
Third, the data fields did not always give us enough information to  consistently identify the beginning of the ratings histories in all of the  samples. One NRSRO did not include a variable describing rating actions,  so we could not identify the initial rating in the rating histories. As a result,  we could not calculate transitions or defaults relative to initial rating for  this sample. We also could not calculate measurements, such as path-to- default or time-to-default, which depend upon comparing a starting point  to the state of a rating at the time of default. The rating histories in three  NRSROs’ samples did not always begin with an initial rating action. Those  histories could not be used to calculate the performance statistics  discussed above for the three NRSROs.
Fourth, SEC rules do not require NRSROs to publish a codebook or any  explanation of the variables used in the samples, and none voluntarily  publish one to accompany its sample data. For several NRSROs, we had to  contact them to obtain an explanation of variables used in the samples.  Without the ability to easily determine what data the variables represent,  users could not begin to construct performance statistics.
Fifth, not all NRSROs have been disclosing defaults in the ratings histories  provided as part of their 10 percent samples. As previously discussed, SEC  requires that the ratings histories disclosed as part of the sample include  all ratings actions taken. However, not all NRSROs consider the  designation of “default” as a rating action. For example, one NRSRO does  not consider default as part of its rating scale, so it does not disclose any  defaults for any of the ratings that are part of its sample. Without this  information, users cannot calculate any default statistics or other statistics  that incorporate default rates for this sample.
Sixth, SEC guidance to the NRSROs for generating the random samples  does not help ensure that the methods used will create a sample that is  representative of the population of credit ratings at each NRSRO. The rule  requires NRSROs to generate a random 10 percent sample of the  outstanding ratings in each asset class for which the NRSRO is registered,  but does not specify what kind of ratings to draw the sample from.  Depending on how NRSROs construct their universe of outstanding credit  ratings from which they draw the 10 percent samples, the samples may not  represent similar ratings. For example, two NRSROs said they draw the 10  percent sample from the total number of entities that are rated, while two  other NRSROs said they draw the sample from the total number of ratings.  A corporate issuer may have a long-term debt rating and a short-term debt  rating. An NRSRO drawing the sample from the total number of entities  rated would count the corporate issuer as one rated entity. However, an  NRSRO drawing the sample from the total number of ratings would count  the ratings on both the issuer and the issue. Further, where samples  include both issuer and issue ratings for asset classes such as corporate,  financial institutions, or insurance companies, the user may have to first  separate out the issuer ratings in order to calculate performance statistics.  However, the fraction of issuers represented in the samples varies across  asset classes and NRSROs and users do not know what these fractions are.  Where NRSROs construct their universe of ratings based on the total  number of ratings issued, and provide multiple kinds of ratings, the  fraction of the sample that represents rated issuers is likely to be relatively  small. Because NRSROs are not required to draw the sample from the  rating types that are typically analyzed in each asset class, users may not  have enough observations to generate statistically valid performance  measures or develop comparable measures.
Furthermore, NRSROs are not required to redraw the 10 percent samples  periodically. The rule requires that NRSROs re-examine their samples  periodically to make sure that they remain 10 percent of outstanding  ratings. We obtained information from five NRSROs on their methods for  maintaining compliance with the rule. Two NRSROs told us they create a  larger-than-required sample so that over time it is unlikely to dip below 10  percent of outstanding ratings. The other three NRSROs said they review  the samples periodically to identify those securities that have matured or  been withdrawn and replace them with randomly selected outstanding  issues. These NRSROs do not redraw the samples. However, in both  methodologies, the distribution of some ratings types will become less  representative over time. For example, some ratings mature and are  withdrawn at a faster rate than others, but these may be replaced with  ratings that mature more slowly. If the NRSROs do not periodically redraw  their samples, over time, statistics generated from the samples will  become less representative of the population of credit ratings.
Most importantly, an NRSRO’s 10 percent sample is representative only of  the NRSRO’s currently outstanding ratings, a subset of all the ratings the  NRSRO has produced. That is, they do not represent ratings that have  been withdrawn in prior time periods. As previously discussed, the  methodologies used by some NRSROs for constructing default and  transitions rates over time factor in ratings that have been withdrawn so  that the statistics represent the population of ratings that were in effect  during the period studied. Moreover, because withdrawn ratings may be  systematically different from outstanding ratings, the 10 percent samples  may not be representative of the underlying populations of all ratings the  NRSROs have issued. Thus, historical performance statistics calculated  using an NRSRO’s sample may contain biases that are not present in the  universe of ratings that the NRSROs use to compose cohorts in their own  studies. Furthermore, the extent of these biases may differ across  NRSROs. Because the samples do not contain information on withdrawn  ratings, they also do not contain information on the post-withdrawal  performance of such ratings. As previously discussed, some NRSROs track  issuers for evidence of default after their ratings are withdrawn. They then  count these defaults as part of their own studies. One NRSRO said that  defaults on withdrawn ratings account for about 20 percent of all the  defaults it reports in its performance statistics for corporate issuers,  financial institutions, and insurance companies. Unless NRSROs include  withdrawn ratings as part of their samples, users cannot calculate  performance statistics that are representative of the underlying  population.
section_title: Exclusion of Many Issuers Limits Utility of 100 Percent Requirement for Comparative Purposes
paragraphs: As previously mentioned, SEC adopted a second rule in December 2009  requiring all NRSROs to disclose 100 percent of their ratings actions  histories for credit ratings initiated on or after June 26, 2007. In the case of  issuer-paid credit ratings, each new ratings action must be disclosed no later  than 12 months after it is taken. For ratings actions that are not issuer-paid,  each new ratings action must be disclosed no later than 24 months after it is  taken. SEC stated in the final rule that the 100 percent requirement will help  individual users of credit ratings design their own performance metrics.  SEC also noted in the final rule that the 10 percent requirement and 100  percent requirement will provide different types of data sets with which to  analyze and compare the performance of NRSROs’ credit ratings.
For example, SEC stated in the final rule that because the 10 percent  sample requirement applies to all outstanding and future credit ratings in  the rule’s scope, initially it will provide information that is much more  retrospective and include histories for ratings that have been outstanding  for much longer periods. However, SEC stated that because the 100  percent requirement is broader in scope, the disclosure eventually will  provide for a more granular comparison of ratings performance. SEC  stated that, unlike the 10 percent requirement, it will permit users of credit  ratings and others to take a specific debt instrument and compare the  ratings history of each NRSRO that rated it. SEC also noted that while the  10 percent sample requirement is limited to issuer-paid credit ratings, the  100 percent requirement covers all credit ratings, thereby allowing  comparisons of a broader set of NRSROs.
The 100 percent requirement will make a larger amount of data available  to users over time than the 10 percent requirement; however, several  factors may limit the usefulness of the data for generating meaningful and  comparable performance statistics. First, according to Trading and  Markets staff, the rule does not require that these data include the ratings  of any issuer that was rated before June 26, 2007. Officials from two  NRSROs told us their samples thus exclude issuer ratings on many major  American corporations. We searched the data disclosed by a third NRSRO  pursuant to this rule, and could not find issuer ratings for several issuers  that this NRSRO currently rates, such as the Allstate Corporation, Ford  Motor Company, and General Electric Company. As performance statistics  for several asset classes, including corporate issuers, are based on issuer,  not issue ratings, performance statistics calculated using data that do not  include the ratings of issuers rated prior to June 26, 2007, would not reflect  the overall rating performance of NRSROs and may not be representative  of the universe of issuer ratings. For example, one NRSRO told us that  new issuers, especially new nonfinanical companies, generally are rated  speculative. It said that its ratings history data would include ratings on  only these issuers, and not the older, more established issuers. Where the  data do not contain the types of ratings typically analyzed for a particular  asset class, they will have limited usefulness for generating performance  statistics.
Second, as with the 10 percent samples, data on withdrawn ratings and  any subsequent defaults on withdrawn ratings are not required to be  disclosed. To the extent that withdrawn ratings are not included in the  data, users will not be able to generate withdrawal-adjusted statistics and  the data will underrepresent defaulted issuers and issues. Finally, SEC  required that NRSROs disclose the same ratings history information for  the 100 percent disclosure requirement as for the 10 percent sample  disclosure requirement (ratings action, date of such actions, the name of  the issuer or issue, and the CUSIP or CIK number), but again, did not  specify the data fields NRSROs were to include in their disclosures. As we  discussed, the data fields provided by the NRSROs in their 10 percent  samples were not always sufficient to ensure that the rating histories had  enough information to allow the user to construct complete ratings  histories or identify specific types of ratings for making comparisons.  Without additional SEC guidance to NRSROs on how to format and  describe the data, the 100 percent data sets likely will present challenges  similar to those for 10 percent sample for users seeking to construct  ratings histories and develop comparable performance statistics.
section_title: NRSROs’ Different Methodologies for Counting Total Outstanding Ratings Limit the Usefulness of These Disclosures
paragraphs: SEC requires that each NRSRO publicly disclose on its initial application  and annual certification of Form NRSRO the approximate number of total  outstanding ratings by each of the five major asset classes. In requiring  public disclosure of this information, SEC said that users of credit ratings  will find this information useful in understanding an NRSRO. For example,  SEC said it would provide information to users of credit ratings as to how  broad an NRSRO’s coverage is within a particular class of credit ratings.
However, SEC did not specify how the NRSROs were to count their  outstanding ratings. As a result, the NRSROs used diverse methodologies  to count up their outstanding ratings. For example, in the corporate  issuers, financial institutions, insurance company, and government  securities asset classes, some NRSROs counted the number of issuers  rated, others counted the number of ratings on issues (which could be  multiple) and others counted the number of rated issuers and issues. As  another example, in the structured finance asset class some NRSROs  counted the number of issuers whose deals they rated, some counted the  number of deals, others counted the number of tranches underlying each  deal, and others counted the number of ratings on each tranche (which  could also be multiple). The NRSROs did not disclose how they  determined their total outstanding ratings, so users have no way of  knowing that these differences exist. Because of the inconsistencies in  how the NRSROs count their total outstanding ratings, users cannot rely  on the disclosures to assess how broad an NRSRO’s coverage is within a  particular class of credit ratings.
section_title: As SEC Works to Remove NRSRO References from SEC Rules, It Will Need To Ensure It Has the Staff with the Requisite Skills to Evaluate Compliance with Any Alternative Creditworthiness Standard
paragraphs: In July 2008, SEC proposed amendments to multiple rules and forms that  would have removed the references to NRSRO ratings from those rules.  While SEC removed references from six rules and two forms, it retained  the use of the ratings or delayed further action on two rules. These rules  govern money market fund investments and the amount of capital broker- dealers must hold and use NRSRO references as risk-limiting measures.  We found that OCIE examiners had concerns with these proposals. For  example, in the securities rule regulating money-market fund investments,  SEC proposed to remove NRSRO references, which the rule used to define  the minimum credit quality of the securities a money market fund could  hold, and relying instead solely on the existing requirement that fund  boards independently assess the credit quality of portfolio securities and  determine that each presents minimal credit risks to the fund. OCIE  examiners expressed concerns that the proposed rule might allow money  market funds to invest in riskier securities than the current rule allows.  SEC opted not to remove references at that time. The recently adopted  Dodd-Frank Act requires SEC and other federal agencies to remove  references to NRSRO ratings from their regulations and substitute an  alternative standard of creditworthiness. Given the Dodd-Frank Act  requirements, SEC’s previous experience with proposals to remove credit  rating references highlights the importance of developing a plan to help  ensure that (1) any adopted alternative standards of creditworthiness for a  particular rule facilitate its purpose (e.g., that money market funds invest  only in high-quality securities or that broker-dealers hold sufficient capital  against their investments), and (2) examiners have the requisite skills to  apply the adopted standards. Without such a plan, SEC may develop  alternative standards of creditworthiness that are not effective in  supporting the purpose of a particular rule.
subsections: section_title: SEC Has Removed References from Multiple SEC Rules and Forms but Retained Their Use or Delayed Action on Two Rules
paragraphs: In the past 2 years, SEC has proposed or made changes to regulations that  rely on the use of NRSRO ratings. Federal securities and banking  regulations rely on NRSRO ratings for a variety of purposes. For example,  NRSRO ratings are components of the definition of a mortgage-related  security and establish criteria for eligibility for certain types of securities  registration. According to a recent Joint Forum survey, U.S. federal  banking and securities statutes, legislation, regulations, and guidance  contain 81 references to NRSRO ratings, 45 of which are in SEC  regulations or guidance and 36 in the statutes, regulations or guidance of  various banking regulators.
In particular, SEC has proposed removing references to NRSRO ratings  from Investment Company Act rule 2a-7, which contains provisions that  limit the types of securities a money market fund can hold, and from  Exchange Act rule 15c3-1 (the “net capital rule”), which includes provisions  to designate the capital that broker-dealers must hold against their assets.  Rule 2a-7 governs the operations of money market funds. Unlike most other  investment companies, money market funds seek to maintain a stable share  price, typically $1.00 per share. The Investment Company Act and  applicable rules generally require investment companies to calculate current  net asset value per share by valuing portfolio instruments at market value  or, if market quotations are not readily available, at fair value as determined  in good faith by, or under the direction of, the board of directors. Rule 2a-7  exempts money market funds from these provisions, but contains  conditions on the investments of the fund such as maturity, quality, liquidity,  and diversification, which are designed to minimize the deviation between a  fund’s stabilized share price and the market value of its portfolio. If the  deviation becomes significant, the fund may be required to take certain  steps to address the deviation, including selling and redeeming its shares at  less than $1.00 (breaking the buck). Among these risk-limiting conditions,  rule 2a-7 limits a money market fund’s portfolio investments to eligible  securities. Under rule 2a-7, eligible securities are those securities that have  received a credit rating from the “requisite NRSROs” in one of the two  highest, short-term rating categories or are comparable unrated securities.  Rule 2a-7 further restricts money market funds to holding securities that the  fund’s board of directors (or those on whom they rely) determines present  minimal credit risks. This second requirement specifically requires that the  determination “be based on factors pertaining to credit quality in addition  to any rating assigned to such securities by an NRSRO.”
The net capital rule requires broker-dealers to maintain, at all times, a  minimum amount of net capital and uses NRSRO ratings as a third-party  assessment of credit risk in prescribing the level of capital required to be  held. The rule was adopted to create uniform capital requirements for and  help ensure the liquidity of all registered broker-dealers. In computing net  capital, broker-dealers must deduct from their net worth certain  percentages of the market value of their proprietary securities positions.  The deductions are known as haircuts and serve to provide a margin of  safety against losses broker-dealers might incur as a result of market  fluctuations in the prices of, or lack of liquidity in, their proprietary  positions. SEC allows broker-dealers to apply reduced haircuts for certain  types of securities they hold that at least two NRSROs rate as investment- grade because these securities typically are more liquid and less volatile in  price than securities not so highly rated. That is, the more highly rated the  security, the more it counts toward the total amount of capital the broker- dealers are required to hold. In addition to NRSRO ratings, the net capital  rule uses measures such as position concentration, maturity, and type of  security to determine appropriate haircuts.
SEC proposed removing references to ratings in rule 2a-7 and the net  capital rule in July 2008. Among other reasons, SEC proposed these  amendments to address the risk that the references to and use of NRSRO  ratings in SEC rules could be interpreted by investors as an endorsement  of the quality of the rating and might encourage investors to place undue  reliance on them. For rule 2a-7, SEC proposed eliminating the requirement  that portfolio securities have a certain NRSRO rating (or be a comparable  unrated security), while retaining the requirement that portfolio securities  be limited to those that the fund’s board of directors determines present  minimal credit risks. The proposal also would have specifically required  the board’s determination to be based on factors pertaining to credit  quality and the issuer’s ability to meet its short-term financial obligations.
The proposal would have eliminated the requirement that money market  funds restrict themselves to investing in securities highly rated by NRSROs  (or comparable unrated securities), and instead relied on the existing  requirement that the fund’s board of directors determine that the  securities present minimal credit risks. Under the proposal, fund boards  could have continued to use quality determinations prepared by outside  sources, including NRSRO ratings, if they concluded these ratings were  credible for making credit risk determinations. In the rule proposal, SEC  stated it expected that boards of directors (or their designees) would  understand the basis for the rating and make an independent judgment of  credit risk. In February 2010, SEC adopted amendments to rule 2a-7,  which continues to use NRSRO ratings in defining eligible securities. The  amendments require money market fund boards to designate, at least once  each calendar year, at least four NRSROs, the credit ratings of which the  boards deem to be sufficiently reliable for use by their funds to comply  with rule 2a-7’s eligible security requirements.
As proposed in July 2008, the revisions to the net capital rule would  substitute two new standards for the current NRSRO ratings-based  categories. For determining haircuts on commercial paper, SEC proposed to  replace the top tiers of ratings-based categories with a requirement that the  instrument be subject to a minimal amount of credit risk and have sufficient  liquidity so that it could be sold at or near its carrying value almost  immediately. For determining haircuts on nonconvertible debt securities,  SEC proposed a requirement that the instrument be subject to “no greater  than moderate” credit risk and have sufficient liquidity so that it could be  sold at or near its carrying value in a reasonably short time. According to  SEC, the proposed standards are meant to serve the same purpose as the  prior standards. Thus, securities with “no greater than moderate” credit risk  would encompass all so-called investment-grade securities. SEC believes  broker-dealers have the financial sophistication and the resources necessary  to make the basic determination of whether or not a security meets the  requirements in the proposed amendments and distinguish between  securities subject to minimal credit risk and those subject to moderate  credit risk. Under the proposal, broker-dealers would have to be able to  explain how the securities they used for net capital purposes met the  standards in the proposed amendments. However, SEC stated it would be  appropriate, as one means of complying with the proposed amendments, for  broker-dealers to refer to NRSRO ratings for the purposes of determining  haircuts under the rule. SEC decided to delay any action on this proposal  and as of June 2010, continued to solicit comments.
In October 2009, SEC adopted amendments to six rules and two forms that  removed the references to NRSRO ratings made in these rules. Four of  these rules and the two forms originally were adopted in 1998 as part of  SEC’s new framework for regulation of exchanges and alternative trading  systems and utilized “investment-grade” and “non-investment-grade” to  distinguish between classes of securities. The adopted amendments and  changes to forms eliminated the distinction between classes of securities  and the use of “investment grade” and “non-investment-grade.” The  remaining two rules utilize the terms “highest rating category from an  NRSRO” and “investment-grade rating from at least one NRSRO” to define  securities exempted from specific requirements or define a class of  securities eligible for purchase by funds when the security’s principal  underwriter had certain relationships with the fund or its investment  adviser. In both cases, the adopted amendments remove the references to  ratings and either remove the exemption or redefine the class of eligible  securities.
section_title: Developing a Plan to Address the Implications of the Adopted Alternative Standards May Help SEC Ensure It Has the Skills and Resources Necessary to Evaluate Compliance with the Standards
paragraphs: The proposed changes to rules 2a-7 and 15c3-1 would have eliminated the  bright-line creditworthiness standard OCIE examiners used to determine  that money market funds invested in high quality securities or the  appropriateness of the haircut a broker-dealer took for net capital  purposes on a security. We reviewed OCIE’s 2a-7 examination module and  65 OCIE money market fund examinations (for FY 2003–2009) identified as  having 2a-7 deficiencies to understand how OCIE examiners assess  compliance with the rule’s requirements for determining an “eligible  security” and minimal credit risks and how the removal of NRSRO  references would affect SEC’s ability to oversee a fund’s exposure to  credit risks.
As stated above, rule 2a-7 limits money market funds investments to those  securities that are rated in one of the two highest short-term categories by  an NRSRO or comparable unrated securities and that the fund’s board  determines present minimal credit risks for the fund. OCIE examiners  examine money market funds for compliance with this provision by  reviewing the NRSRO ratings at the time of purchase for securities held.  Examiners typically identify if securities held by a money market fund are  eligible securities by requesting a list of all portfolio holdings, including  the current NRSRO rating for each holding, and verify the NRSRO ratings  by reviewing the published ratings on Bloomberg or on the NRSRO Web  site.
OCIE examiners then typically review a fund’s compliance and procedures  manuals to help ensure that the board has established minimal credit risk  guidelines and receives periodic credit risk updates and reports from the  adviser verifying that all the securities comply. Examiners further request  and review a small sample of credit analysis packages that demonstrate that  the securities are eligible and a sample of the materials presented to the  fund’s security evaluation committee as evidence of ongoing reviews that a  security continues to present minimal credit risks. According to OCIE  examiners, policies, procedures, and practices for conducting minimal  credit risk analysis vary widely.
Of the 65 examinations of money market funds OCIE completed in FY  2003-2009 that we reviewed, 36 examinations identified 42 deficiencies in  the funds’ compliance with the requirement for a minimal credit risk  determination. They generally could be categorized as deficiencies in  fund board oversight, policies and procedures, or credit file  documentation. According to OCIE examiners, citing funds for a  deficiency in documenting its analysis of minimal credit risk in an  examination is not unusual. For example, in one examination deficiency  letter OCIE found no current written documentation in the credit files  substantiating that the fund adequately determined that each security  purchased presented minimal credit risks and requested that the fund  bring its files up-to-date. According to Enforcement staff, SEC has not  brought any enforcement actions against a money market fund for  violations of this requirement.
OCIE examiners expressed concerns with the proposed rule because they  believed it might allow money market funds to invest in riskier securities  than the current rule allows. Under the proposed rule, a money market  fund could invest in any security it finds to present a minimal credit risk.  OCIE examiners stated they would have likely continued to evaluate for  compliance with the minimal credit risk determination requirement as  they do under the current rule. As such, OCIE only examines a fund’s  policies and procedures to assess if they effectively address credit risk and  to assess whether a fund follows its policies and procedures in making  credit risk determinations. It does not evaluate the standards used to  determine whether a security is deemed to represent a minimal credit risk,  dictate the types of analyses that must be included in a minimal credit risk  determination, or make any of its own determinations as to whether the  security represents a minimum credit risk to that fund. According to  Investment Management staff, the minimum credit risk requirement was  not designed for these purposes as the rule recognizes that funds can have  different investment objectives and positions, and as such, the same  security could present different risks to different funds. One fund might  consider a particular security an appropriate investment, while another  would not. OCIE examiners stated that the proposed rule eliminated the  floor, in terms of creditworthiness, that NRSRO references provided and it  was unclear how, if at all, the standard for eligible securities under the  proposed rule would ensure that money market funds continued to invest  only in securities of the highest credit quality.
Further, if OCIE examiners were given the authority to evaluate funds’  credit risk determinations, OCIE staff told us that additional resources and  skill sets would be needed to conduct such examinations and they  questioned OCIE’s ability to evaluate the credit risk determinations. To  date, examiners have not needed to have these skills because examiners, as  dictated by the rules and interpretations, relied on NRSRO ratings. OCIE  examiners told us that as proposed, they likely would approach compliance  examinations by continuing to focus on ensuring that funds had reasonable  policies and procedures in place for determining what constituted an  eligible security and documentation demonstrating that those policies and  procedures were followed and an analysis of credit risk completed.
The proposal to remove NRSRO references from the net capital rule also  would eliminate the credit-risk criteria OCIE examiners currently use,  among other factors, to determine whether a broker-dealer was taking  appropriate haircuts. Under the current rule, broker-dealers use a variety  of factors, including whether the security is rated investment grade, to  determine the haircut they must take on debt securities when determining  their net worth for regulatory capital purposes. OCIE examiners  generally confirm the net capital calculation by reviewing and confirming  a firm’s inventory, selecting a sample of securities with which to verify the  existence of a ready market, and verifying that the haircuts were accurate  and considered in the net capital computation. Under the proposed rule,  broker-dealers would be responsible for determining the level of risk a  security presented and the amount of the subsequent haircut, which could  be different for each broker-dealer, depending on the methods used.
Going forward, the Dodd-Frank Act requires SEC to remove NRSRO  ratings from its rules. SEC’s previous experience with proposals to remove  credit rating references highlights the importance of developing a plan to  help ensure that (1) any adopted alternative standards of creditworthiness  for a particular rule facilitate its purpose (e.g., that money market funds  invest only in high-quality securities or that broker-dealers hold sufficient  capital against their investments), and (2) examiners have the requisite  skills to determine that the adopted standards have been applied. Without  such a plan, SEC may develop alternative standards of creditworthiness  that are not effective in supporting the purpose of a particular rule.
section_title: The Number of NRSROs Has Increased since the Act Was Implemented but Industry Concentration Remains High
paragraphs: Since the implementation of the Act, the number of NRSROs has increased  from 7 to 10. However, the market remains highly concentrated. Continued  concentration is likely a result of multiple factors. First, relatively little  time has passed since SEC implemented the NRSRO registration program  and NRSRO rulemaking. Second, credit rating agencies face barriers in  entering the credit rating industry and registering as an NRSRO. Academic  research suggests that increasing competition among NRSROs improves  information availability but the impact on ratings quality is unclear.
subsections: section_title: The Number of NRSROs Has Increased from 7 to 10, but the Industry Remains Concentrated
paragraphs: Since the implementation of the Act, the number of NRSROs has increased  from 7 to 10; however, the market remains highly concentrated. As  previously discussed, 7 credit rating agencies had received SEC staff no- action letters recognizing them as NRSROs prior to the Act. When the  NRSRO registration program became effective, these firms applied to  register as NRSROs and received SEC approval. All of these operate  primarily under an issuer-pays business model. SEC also granted NRSRO  registration to 3 additional credit rating agencies that operate primarily  under a subscriber-pays business model.
Figure 1 indicates when the 10 NRSROs began producing credit ratings  and the year that SEC first recognized them as NRSROs, either through the  he  no-action letter process or the NRSRO registration program.  no-action letter process or the NRSRO registration program.
None of the 10 NRSROs, including the 3 newly registered subscriber-pays  NRSROs, is a new entrant into the credit rating industry. Further, all 10  NRSROs have been producing ratings for a number of years. A.M. Best,  Fitch, Moody’s, and Standard & Poor’s have been producing ratings the  longest—for more than 80 years. Several of these NRSROs have undergone  mergers with or acquisitions of other rating agencies or NRSROs over the  years. For example, Poor’s Publishing and Standard Statistics merged in  1941 to form Standard & Poor’s, and Moody’s was acquired by Dun and  Bradstreet in 1962. Fitch merged with IBCA Ltd in 1997, and in April 2000,  acquired Duff & Phelps Credit Rating Company and Thomson  BankWatch. More recently, in May 2010 Realpoint was acquired by  Morningstar, Inc.
Credit rating agencies can apply to register as NRSROs in five distinct  asset classes: financial institutions, insurance companies, corporate, ABS,  and government securities. Table 5 describes the asset classes in which  each NRSRO is registered.
Some NRSROs, such as Moody’s, Standard & Poor’s, and Fitch, cover a  wide range of securities that span all five asset classes. Others have  specialized in a particular asset class, sector, or geographic region. For  example, although Realpoint is designated in ABS, it specializes in one  type of ABS, specifically CMBS. LACE is designated in four asset classes,  but specializes in rating financial institutions. Similarly, A.M. Best is  designated in four asset classes, but specializes in rating insurance  companies and related securities. Japan Credit Rating Agency and  Ratings and Investment, Inc., are Japanese rating agencies that mainly rate  Japanese issuers.
Although the number of NRSROs has increased, the credit rating industry  remains highly concentrated. To assess the impact of the Act on  competition among NRSROs, we calculated the HHI, a key statistical  measure used to assess market concentration and the potential for firms  to exercise their ability to influence market prices. The HHI reflects the  number of firms in the industry and each firm’s market share. It is  calculated by summing the squares of the market shares of each firm  competing in the market. The HHI also reflects the distribution of market  shares of the top firms and the composition of the market outside the top  firms. The HHI is measured on a scale of 0 to 10,000, with larger values  indicating more concentration. According to DOJ, markets in which the  value of the HHI is between 1,500 and 2,500 points are considered to be  moderately concentrated, and those in which the value of the HHI is in  excess of 2,500 points are considered to be highly concentrated, although  other factors also play a role.
We calculated the HHI by summing the squares of the market shares of all  the firms competing in the industry. Doing so requires defining what  constitutes the industry and specifying our measure of market share. We  defined the relevant industry as the set of credit rating agencies that have  NRSRO status, and we used a variety of market share definitions to ensure  that any trends in industry concentration we observed were robust to  alternative specifications of NRSROs’ market shares. A firm’s market share  typically is measured in terms of dollars, as either its sales or revenue as a  fraction of total sales or revenue for all firms in the industry, or in terms of  quantities, such as its output as a fraction of total output produced by all  firms in the industry.
We first calculated the HHI using market shares based on total revenues  earned by the NRSROs. NRSROs generally earn revenues from a number  of activities related to the production of credit ratings. Issuer-pays  NRSROs earn the bulk of their revenues from the fees paid by issuers to  have their issues rated. However, issuer-pays NRSROs offer other services  as well, including subscription services to users of credit ratings.  Subscriber-pays NRSROs earn their revenues from subscription fees and  other services. Some of the types of services offered by the subscriber- pays NRSROs are data and valuation and proxy services for financial  institutions.
NRSRO applicants and registered NRSROs must provide data on the total  revenues earned in the prior calendar year to SEC on Form NRSRO. We  used these data to calculate the HHI from 2006 to 2009. Table 6 provides  the results of these calculations.
The table shows that while the HHI declined between 2006 and 2009, the  industry remains highly concentrated according to DOJ standards. This  decline is likely influenced by the entrance of the three new NRSROs in  late 2007.
An NRSRO’s total revenue does not necessarily reflect its total output; that  is, the number of ratings it produces. For example, both issuer-pays and  subscriber-pays NRSROs could provide ratings on the same group of  entities, but receive vastly different revenues. Because market shares  based on numbers of ratings can differ from those based on total revenue,  so can the HHI, possibly revealing a different trend in industry  concentration. To assess industry concentration using an output-based  measure of market share, we attempted to calculate the HHI using market  shares based on the number of each NRSRO’s outstanding ratings.  However, as previously discussed, we found inconsistencies in the  methods that the NRSROs use to count their outstanding ratings. As such,  the data were not valid for purposes of calculating the HHI.
As an alternative assessment of industry concentration using an output- based measure of market share, we calculated the HHI using market  shares based on the number of issuers each NRSRO rates (see table 7).  We obtained data from nine of the NRSROs on the number of issuers they  rated in each asset class in 2006–2009 and used it to calculate the HHI for  these 4 years. We were unable to obtain data on the number of rated  issuers from one NRSRO because it said it did not track rated  organizations by whether or not they issue debt securities. However, this  NRSRO did provide us with the total number of organizations it rated.
The table shows that the industry is concentrated in every asset class in  every year according to DOJ standards, although the industry has become  less concentrated in corporate issuers, financial institutions, insurance  companies, and issuers of ABS asset classes with the HHIs decreasing by 5  percent, 4 percent, 10 percent, and 2 percent, respectively, between 2007  and 2009. The industry has become more concentrated in the issuers of  government securities asset class, with the HHI increasing by about 2  percent between 2007 and 2009. These results, however, assume that none  of the organizations rated by the 10th NRSRO issues debt securities.
To assess the sensitivity of these results to the missing data from the  NRSRO that did not track which of its rated organizations issue debt  securities, we recalculated the HHIs assuming that all of the organizations  this NRSRO reported rating issue debt securities. We did so because it is  likely that some of the organizations this NRSRO rates do issue debt  securities, but we cannot determine how many. Calculating the HHIs  based on the alternative assumption that all of the organizations this  NRSRO rates issue debt securities gives us a range within which the true  value of the HHI is likely to fall.
The main difference between our alternative and baseline estimates is in  the HHI for the financial institutions asset class. The alternative  assumption produces estimates of the HHI for the financial institutions  asset class for 2008 and 2009 that are 133 percent and 136 percent,  respectively, larger than our baseline estimates. The two estimates differ  because the NRSRO that did not provide us with data rates at least 10  times as many organizations in the financial institutions asset class as any  other NRSRO. Assuming that all of these organizations issue debt  securities produces high HHI estimates because it implies that the  excluded NRSRO has a relatively high market share and thus that the  industry is relatively highly concentrated.
Finally, to assess trends in concentration in the market for rating  structured finance securities, we calculated the HHI for January 2004–June  2010 using market shares based on the dollar value of issuance of U.S.- issued ABS rated by an NRSRO. Issuance-based HHI declined by about 18  percent over this time period (1 percent during 2004-2007 and 17 percent  since 2007), indicating that this market has become less concentrated (see  table 8). We note that the market for ABS declined considerably since  2007. According to data from Asset-Backed Alert, the number of ABS deals  declined from over 3,000 in 2006 to about 370 in 2009. For 2010, 223 deals  were reported as of the end of June.
Since the U.S. ABS asset class includes distinct products, we also  examined five sectors in the ABS asset class to determine if trends in  market concentration varied across these sectors (table 8). The five  sectors are traditional ABS (that is, securities backed by student loans,  auto loans and credit card loans, but not by mortgages), prime RMBS,  nonprime RMBS, CMBS, and CDO. We calculated the HHI for the market  for rating securities in each of these sectors using market shares based on  the dollar value of issuance rated by an NRSRO. The 17 percent reduction  in the HHI for the market for rating securities in the ABS asset class as a  whole since 2007 was driven primarily by the reduction in concentration in  the market for rating traditional ABS and CMBS. For these markets, the  issuance-based HHI declined by about 7 percent and 13 percent,  respectively, since 2007. On the other hand, the markets for rating prime  RMBS, and CDOs have become more concentrated since 2007. While the  market for rating nonprime RMBS also has become more concentrated  since 2007, the number of issuances offered since then has declined so  rapidly that trends in the HHI are difficult to interpret.
The HHI indicates that the market for rating ABS remains highly  concentrated by DOJ standards, even in those sectors in which  concentration has declined since 2007. To assess which NRSROs are  dominating this market, we examined the NRSROs’ annual market  coverage. Annual market coverage is an indication of the quantity of  ratings an NRSRO produces relative to the quantity of issues or issuers  that are available to be rated. Because more than one NRSRO can rate an  issue or issuer, the sum of each NRSRO’s annual market coverage can add  to more or less than 100 percent. We measure an NRSRO’s annual market  coverage as the dollar volume an NRSRO rates as a fraction of the total  volume issued. We did not assess the causal factors behind any trends we  observed.
Trends in annual market coverage from January 2004 through June 2010  among the six NRSROs that rated U.S. ABS issuance generally shifted  beginning in 2007 (see fig. 2). These six were the only NRSROs to rate  new U.S. ABS issuance during this period. From 2004-2007, Standard &  Poor’s, Moody’s, and Fitch provided the most annual market coverage in  this asset class, rating an average of about 94 percent, 89 percent, and 49  percent, respectively, of issuance. Starting in 2008, Standard & Poor’s and  Moody’s annual market coverage began to decline. For the first half of  2010, Standard & Poor’s and Moody’s were rating only about 73 percent  and 62 percent, respectively, of issuance. Fitch’s annual market coverage  peaked in 2009 at about 59 percent of issuance, and then declined to about  31 percent for the first half of 2010. On the other hand, DBRS increased its  coverage from about 4 percent in 2007 and 2008 to about 33 percent in  June 2010.
We also examined NRSROs’ coverage of the five sub-sectors in the ABS  asset class and found that trends in annual market coverage varied across  sectors. Trends in coverage of traditional ABS are similar to those for the  ABS asset class as a whole, the main difference being that Fitch’s coverage  did not peak in 2009 before declining (see fig. 3).
In prime RMBS, Moody’s market coverage began to decline in 2007 from  about 88 percent to about 6 percent in June 2010. Standard & Poor’s  annual market coverage of prime RMBS began to decline in 2008, falling  from about 94 percent in 2007 to about 42 percent in 2009, but it has since  increased to about 63 percent (see fig. 4). Fitch’s market share peaked in  2009 at about 62 percent, but has since declined to about 9 percent.
Trends in coverage of the nonprime RMBS market are the most dramatic,  with both Standard & Poor’s and Moody’s coverage plummeting from  more than 90 percent to zero for 2009 and 2010, and Fitch’s coverage  falling from about 57 percent for 2005 to about 1 percent for 2008 (see fig.  5). On the other hand, DBRS coverage of nonprime RMBS increased from  about 14 percent for 2005, and 12 percent in 2006–2007 to about 73 percent  for 2008. Furthermore, DBRS was the lead NRSRO to rate the most  nonprime RMBS deals issued in 2009 and the first half of 2010, rating three  more than Moody’s.
Declines in Standard & Poor’s, Moody’s, and Fitch’s coverage of the CMBS  market through 2009 were almost as dramatic as those in the nonprime  RMBS market, but they have not been matched by correspondingly  dramatic increases in DBRS’s coverage of the nonprime RMBS market (see  fig. 6). Rather, Realpoint’s CMBS coverage has increased from virtually  zero through 2008 to 19 percent in 2010. In addition, Standard & Poor’s,  Moody’s, and Fitch’s coverage of the CMBS market have all rebounded  somewhat in 2010, with Fitch’s annual market coverage in 2010 about  equal to its annual market coverage in 2005 (about 56 percent).
Finally, in the CDO market, Moody’s coverage fell from about 97 percent in  2007 to about 39 percent in 2009 (see fig. 7).
Moody’s CDO coverage was about the same as Standard & Poor’s in 2007,  but has declined steadily since then to about 40 percent in 2009. It has  since increased to 100 percent. Fitch’s CDO coverage declined from about  35 percent in 2004 to zero in 2010 (with a brief increase in 2009 covering  about 22 percent of the market). DBRS’s CDO coverage has remained  negligible throughout the period.
In December 2009, SEC adopted rule amendments that are intended, in  part, to increase competition in the rating of ABS. Beginning in June  2010, the amended rule requires an NRSRO hired by arrangers to rate a  structured finance product to disclose on its password-protected Website  each structured finance product it has been hired to rate, along with the  type of  structured finance product, the name of the issuer, the date the  rating process began, and the Web site at which the issuer will disclose the  information it has provided to the NRSRO for the rating. The amended rule  requires the arranger to provide representations to the hired NRSRO that it  will make available the information it has provided to the hired NRSRO   for determining an initial rating or for monitoring a rating on the issuer’s  password-protected Web site. The issuer must also provide  representations to the hired NRSRO that it will allow other NRSROs  access to the information so that the other NRSROs can produce  unsolicited ratings on the same structured finance product.  SEC proposed  these rule amendments after its examinations of the three largest NRSROs  identified issues in the management of conflicts of interest particular to  structured finance ABS. In particular, SEC found that analysts appeared to  be aware of NRSROs’ business interest in securing the rating of the deal  and that rating agencies did not appear to take steps to prevent  considerations of market share and other business interests from  influencing ratings or rating criteria. In the proposed rule amendments,  SEC stated it believed that the issuer-pays conflict is particularly acute in  the case of structured finance products because certain arrangers of  structured finance products bring repeat business to NRSROs. As such,  SEC believes that some arrangers have the potential to influence NRSROs  on structured finance products more than on corporate securities.
In the amended rule, SEC stated that one of its goals is to facilitate the  issuance of credit ratings for structured finance products by nonhired  NRSROs at the same time as the hired NRSRO and provide investors with  more views on the creditworthiness of the structured finance product.  SEC stated this practice may serve to increase unsolicited ratings for  structured finance products, mitigate ratings shopping, and affect  competition among NRSROs by having more ratings in the market.  Furthermore, SEC stated that market participants could use unsolicited  ratings to evaluate the ratings issued by the hired rating agency.  Specifically, SEC intends that by opening up the ratings process to more  NRSROs, hired NRSROs will find it easier to resist any pressure by the  arranger to obtain better-than-warranted ratings, because of the likelihood  that any steps taken to inappropriately favor the arranger could be  exposed to the market through credit ratings issued by other NRSROs.
Although not enough time has passed to assess the impact of the amended  rule on competition, we found that one NRSRO has withdrawn its NRSRO  registration in this asset class and the other NRSROs had varying views on  its potential effectiveness. One NRSRO said that the high cost of  establishing and maintaining the data systems could negatively impact  both NRSROs and issuers. Further, this NRSRO said the amended rule  could deter issuers from taking innovative structured finance products to  the market because they would have to disclose proprietary information.  Another NRSRO said the cost of implementing the rule could burden  nonhired NRSROs, who may need to post only very limited information  under the rule, and thus compromise the effectiveness of the rule. In May  2010, one NRSRO announced it was withdrawing its NRSRO registration in  this asset class. This NRSRO said it made this decision in part because it  believed that the funds raising activities through structured finance  products in the geographic region it serves might be negatively affected. A  fourth NRSRO agreed that publishing unsolicited ratings could enhance  the transparency of the ratings process, but said that rating new structured  finance issuances was too costly without fees from an issuer. For example,  this NRSRO said that its costs were approximately $2,500 to verify the data  underlying the security in an ABS that it rates. Additionally, this NRSRO  said that legal costs for analyzing the securities in a deal ranged from  $25,000 to $50,000. However, another NRSRO was not concerned with the  costs associated with implementing the rule and believed the new rule  could be effective.
section_title: Multiple Factors Likely Account for Continued Concentration among NRSROs
paragraphs: The continued concentration among NRSROs since the implementation of  the Act likely resulted from several factors. First, little time has passed  since the Act took effect. Second, the three new NRSROs registered under  the new program have not had much time to build market share.  Furthermore, SEC rules implementing the new NRSRO registration  program and requiring disclosures of ratings performance, ratings  methodologies, and conflicts of interest have been in place since June  2007, and have been amended twice. Finally, the credit crunch and the  ensuing financial crisis occurred soon after the implementation of the Act,  substantially slowing certain sectors of the credit market.
Generally speaking, barriers to becoming an NRSRO create challenges for  newer and smaller credit rating agencies. Two types of barriers to entry  likely contributed to the continued concentration of the industry: entering  the credit rating industry and registering as an NRSRO.
We have identified three barriers to entering the credit rating industry.  First, credit rating agencies may have relatively high fixed costs. Credit  rating agencies that are established can produce ratings in volume leading  to economies of scale. The combination of high fixed costs and economies  of scale favor larger established rating agencies and pose barriers to  smaller firms entering the market. And, the markets for some asset classes  may be more difficult for rating agencies to enter than others. For  example, a credit rating agency told us it is difficult for a credit rating  agency to get into the credit rating market for the structured finance class  because of costs associated with acquiring the expertise to rate this type  of product. Further, rating methodologies for structured finance products  are complex, requiring expertise to develop and apply the models needed  to rate this type of product.
Second, establishing a reputation takes time. The better a rating agency’s  reputation for producing ratings, the more business it will be able to  attract as compared with a credit rating agency without a reputation.  However, given the nature of the ratings, reputation can take years to  establish. In most cases, ratings are intended to predict the likelihood of  default over the life of the bond, but some securities take from 10 to 30  years to mature. When a new rating agency begins to rate securities,  evaluating the quality of those ratings at the time of purchase is difficult.  Instead, users need to see how the ratings perform over the life of the  bond to determine how accurate and timely they are. Several NRSROs  have commented that their reputation is critical to their success. One  NRSRO said that a reputation is difficult to earn and easy to lose.
Third, network effects pose a challenge to entry in the ratings industry and  favor the larger, more established credit rating agencies. The more  securities a specific NRSRO rates, the more value to assigning ratings to  that same NRSRO, because comparing securities rated by that NRSRO  would be easier for investors and other market participants. Network  effects can make gaining market share difficult for new entrants if  investors and other market participants already are using an existing  NRSRO’s ratings. NRSRO references have been widely embedded in  numerous federal and state laws and regulations. Further, many  investment guidelines and private contracts reference specific NRSROs,  which makes marketing to investors, other users, or issuers more difficult  for newer NRSROs. Several institutional investors and investment advisors  with whom we spoke told us they use the big three NRSROs’ ratings either  because of investor guidelines, regulatory guidelines, or depth of ratings  coverage. Although there is no limit on the number of NRSROs that can  rate a particular issue, asset managers may face budgetary constraints that  limit their ability to subscribe to NRSROs beyond those their investment  agreements require them to consider. For example, one asset manager  told us that they have a limited budget for subscriptions to ratings and that  purchasing subscriptions for each analyst in the credit research  department is costly. They told us they have subscription services with  four NRSROs but have a limited working relationship with the others.  Three issuers with whom we spoke told us that their choice of NRSRO is  driven by investor expectations, which directs them to the big three firms.
A credit rating agency also encounters barriers to entry when registering  as an NRSRO. Despite the efficiency and transparency of the new NRSRO  registration program, compliance with the Act and SEC rules may result in  higher costs for smaller NRSROs and may inhibit credit rating agencies  from registering as NRSROs. For example, one small NRSRO estimated it  spent $500,000 annually to maintain the NRSRO designation. Two rating  agencies with which we spoke said they would not register because of the  regulatory burden associated with being in compliance with the Act.  Furthermore, one NRSRO told us it might de-register as an NRSRO should  regulation became too costly.
Besides barriers to entry, differences between NRSROs’ compensation  models and a degree of specialization may also contribute to market  concentration. For example, subscriber-pays NRSROs may be limited in  their ability to rate newly issued securities. One NRSRO explained that it  uses the subscriber-pays model to provide ongoing surveillance of rated  securities in the secondary market, which it produces using publicly  available information. However, it said it could not use the subscriber-pays  model to rate the initial offering of securities because, under this model, it  would not have access to the data provided by the issuer to complete the  analysis and produce an initial ratings. To the extent the subscriber-pays  NRSROs are not rating new issues, market coverage of these securities  will be concentrated among issuer-pays NRSROs. As another example, the  difference between the issuer-pays and the subscriber-pays compensation  models could also impact market concentration when it is measured in  terms of total revenues. As previously discussed, both issuers-pays and  subscriber-pays NRSROs could provide ratings on the same group of  entities, but receive vastly different revenues. Issuer-pays NRSROs charge  the issuers fees for every rating produced, while subscriber-pays NRSROs  are charging users a subscription fee for access to their ratings. Thus, if  issuer-pays and subscriber-pays rate the same entities, total revenue will  likely be concentrated among NRSROs using the compensation model that  generates the greatest revenues per rated entity. Finally, to the extent  certain NRSROs specialize in a particular asset class, sector, or  geographic, the overall credit rating industry will likely be highly  concentrated among those NRSROs, which rate across asset classes,  sectors, and geographic regions. However, a specialized NRSRO could  have a significant presence in its market.
section_title: Academic Research Suggests Increasing Competition in the Credit Rating Industry Improves Information Availability, but the Impact on Rating Quality Is Unclear
paragraphs: The impact of increasing competition on the quality of credit ratings is not  yet well understood. Academic researchers generally measure the quality  of credit ratings according to how much information they convey about  the risk of default or of loss in the event of default. Their findings suggest  that the entry of new credit rating agencies can improve overall  information available to investors and other market participants. However,  the effect of entry on the quality of ratings produced by any one rating  agency is not clear. Moreover, there have been few studies investigating  the effect of new entrants and competition in the credit rating industry.  These studies are unpublished and, thus, their findings should be viewed  as preliminary in nature.
We reviewed three studies that examined the impact of competition on  ratings quality. Based on an analysis of insurance company ratings, one  study suggests that entry of a new credit rating agency improves the  amount of information available to investors and other market  participants. This study suggests that new entrants have stricter criteria  than incumbents for assigning the same rating, assuming they both use the  same rating scale. It is more difficult for an issuer to get the highest rating  from the new rating agency than from the incumbent rating agency. An  issuer can choose to be rated by the incumbent rating agency, by the new  rating agency, or both. Furthermore, the two ratings agencies’ criteria are  different. As a result, an issuer can communicate more information about  its riskiness to the market by its choice of ratings agency and the  combination of ratings it gets than it could communicate when there was  only one rating agency.
A different study of CDO ratings also suggests that the number of rating  agencies from which an issuer requests ratings is informative. Specifically,  tranches rated by more than one rating agency were less likely to be  downgraded than those rated by a single rating agency. This result is  consistent with the hypothesis that issuers of less-risky CDOs were more  likely to request two or more ratings.
Based on ratings of corporate issuers, insurance companies, and financial  institutions, a third study analyzes the impact of competitive pressure  from a new credit rating agency on the quality of an incumbent rating  agency’s ratings. The study uses three alternative indicators of quality. The  first indicator is the correlation between a bond’s rating and its yield, with  lower correlations indicating that ratings are less informative about bond  repayment and thus are of lower quality. The second indicator is the  magnitude of the effect of a downgrade on an issuer’s stock price, with  larger magnitudes indicating that the downgrade is worse news. The last  indicator is the rating it assigns to an issuer or a bond, with higher ratings  presumed to be more favorable to the issuer and thus of lower quality.  This study suggests that the incumbent credit rating agencies produce  lower-quality ratings in market segments in which smaller, newer credit  rating agencies have higher market share.
Together, the three studies’ findings have implications for the amount of  information available to credit market participants and for the quality of  credit ratings and may offer some preliminary observations about the  impact of new entrants on rating quality and competition. The first and  second studies both suggest that entry of new credit rating agencies will  allow issuers and other rated entities to communicate more information to  the market, both by the numbers of ratings they request and by the  combination of ratings they receive from different rating agencies. The  findings of the second and third studies together seem to suggest that  entry of new credit rating agencies will lead incumbent rating agencies to  produce lower-quality ratings, either relative to the new entrant’s ratings  or relative to their own ratings in markets in which they face less  competitive pressure. However, it is difficult to predict what the effect will  be on the incumbent rating agencies’ ratings when a new entrant enters  the market.
section_title: Models Proposing Alternative Means of Compensating NRSROs Intend to Address Conflicts of Interests in the Issuer- Pays Model
paragraphs: As part of an April 2009 roundtable held to examine oversight of credit  rating agencies, SEC requested perspectives from users of ratings and  others on whether it should consider additional rules to better align the  raters’ interest with those who rely on those ratings, and specifically,  whether one business model represented a better way of managing  conflicts of interest than another. In response, some roundtable  participants proposed alternative models for compensating NRSROs, and  market observers have proposed others in congressional hearings and  academic literature. We identified five unique models that have been  proposed, although they are in various stages of development. To assist  Congress and others in assessing these proposals, we created an  evaluative framework of seven factors that any compensation model  should address to be effective. By applying these factors, users of the  framework can identify the potential benefits of the model consistent with  policymakers’ goals as well as any tradeoffs.
subsections: section_title: Proposed Alternative Compensation Models
paragraphs: In recent years, academic researchers and industry experts have begun to  develop a number of alternative compensation models for credit rating  agencies in response to concerns about conflict of interest, ratings  integrity, and competition. In a July 2008 report discussing the  examinations of the three most active NRSROs and their performance of  in rating subprime RMBS and related CDOs, SEC staff identified issues in  the management of conflicts of interest resulting from the issuer-pays  model the firms used. NRSROs using this model have an interest in  generating business from the firms that seek the rating, which could  conflict with providing quality ratings. In response to the examination  findings, SEC introduced new and amended rules intended to improve the  management of conflicts of interest in the issuer-pays model. In April  2009, as part of the roundtable held to examine oversight of credit rating  agencies, SEC requested perspectives from users of ratings and others on  whether SEC should consider additional rules to better align the NRSROs’  interest with those who rely on those ratings, and specifically, whether  one form of model represented a better way of managing conflicts of  interest than another.
In response, some roundtable participants proposed alternative models for  compensating NRSROs. These models generally intend to address the  conflict of interest in the issuer-pays model, better align the NRSROs’  interest with users of ratings, or improve the incentives NRSROs have to  produce reliable and high-quality ratings. Other models with similar goals  have been presented in Congressional hearings and in academic literature.  Below, we provide a summary of the key provisions of five distinct  alternative models for compensating NRSROs (alternative compensation  models). Given their theoretical nature, they vary greatly in the amount of  detail currently available. None of these models has been implemented to  date.
Five alternative compensation models have been proposed: random  selection model, investor-owned credit rating agency model, stand-alone  model, designation model, and user-pay model.
subsections: section_title: Random Selection Model
paragraphs: Under the random selection model, a ratings clearinghouse randomly  would select a credit rating agency to rate a new issuance. All issuers or  sponsors that wanted to obtain ratings for their issuances would be  required to request ratings from the clearinghouse, which would use a  random number generator, such as a computerized algorithm, to assign a  credit rating agency. The clearinghouse would notify the credit rating  agency of the opportunity to rate the issuance and provide basic  information pertaining to the type of issuance, but not the issuer’s name.  Not until the credit rating agency agreed to complete the rating would the  clearinghouse disclose to the credit rating agency the identity of the issuer  and the details of the issuance. If the selected credit rating agency agreed  to rate the issuance, the issuer would pay a fee to the ratings  clearinghouse. The clearinghouse then would distribute the fees to the  credit rating agency upon the completion of the initial and maintenance  ratings. The letter rating would be free of charge to the public. In addition  to this function another primary role of the clearinghouse would be to  design the criteria by which new entrants could qualify as a credit rating  agency.
According to the proposed model, the ratings clearinghouse could be a  nonprofit organization, a governmental agency such as SEC, or a private- public partnership. Funding for this ratings clearinghouse would be paid  for by the issuer, on top of that required to rate the security, to cover  clearinghouse costs. The ratings clearinghouse also would be responsible  for setting the ratings fees for the credit rating agency depending on the  type of security issued.
The proposal incorporates a peer comparison review to create an  incentive for credit rating agencies to produce quality ratings. As part of  this review, the ratings clearinghouse would evaluate the performance of  all credit rating agencies on the basis of two empirical tests. As one  potential test, the proposal suggests an analysis of the magnitude of debt  instruments that default or lose substantial value for investment-grade  debt instruments. If the default percentage for a given credit rating  agencies differed from its peers by a set parameter, then it would be  subject to sanctions, which would range from losing a percentage of  business to losing a percentage of rating fees. The second potential test  would evaluate annual yields, as set by the market, to be compared to  identically rated debt securities from different asset classes for each credit  rating agency. Securities in different asset classes that are rated similarly  should have the same yield. If a threshold differential exists between the  yields of identically-rated securities for a credit rating agency, then it  would be subject to sanctions.
According to the architect of the model, this model would eliminate the  conflict of interest when an issuer pays a credit rating agency for a rating  by making the compensation neutral, eliminating the linkage between the  credit rating agency and the issuer (the conflict of interest). The  elimination of the conflict of interest would remove a barrier to entry and  would allow for new competition. Furthermore, he believes that the peer  comparison review coupled with economic sanctions for poor  performance would motivate the credit rating agencies to continually  adjust their rating models and produce quality ratings.
section_title: Investor-Owned Credit Rating Agency Model
paragraphs: Under the investor-owned credit rating agency (IOCRA) model,  sophisticated investors—termed highly sophisticated institutional  purchasers (HSIP)—would create and operate an NRSRO that would  produce ratings. Issuers would be required to obtain two ratings; one from  the IOCRA and the second from their choice of NRSRO. More specifically,  an NRSRO would be prohibited from publicly releasing a rating that was  paid for by the issuer or sponsor, unless the NRSRO received written  notification that the issuer had made arrangements and paid an IOCRA to  publicly release its rating. The IOCRA would publish its rating  simultaneously when the NRSRO published its rating.
Institutional investors would have to qualify as an HSIP before forming an  IOCRA or joining an existing one. To qualify as an HSIP, an institutional  investor would have to demonstrate that it was large and sophisticated,  managed billions of dollars in assets, and could be relied upon to represent  the buy-side interest in accurately rating debt market instruments. The  HSIPs would hold a majority voting and operational control over the  IOCRA. The proposal contemplates that the IOCRA could be a for-profit or  a not-for-profit entity. There would not be a regulatory limit on the number  of IOCRAs that could be formed.
Under the proposal, market forces would set IOCRA fees, which likely  would be comparable to fees currently charged by the dominant NRSROs.  The letter rating and the underlying research would be free to the public.
Proponents of this model believe it would improve the rating process by  changing the incentive structure of the NRSROs’ business. They said the  IOCRA would affect competition and ratings quality by introducing new  competition to the industry, and the investors’ interest would be counter- balanced against the interest of the issuers.
section_title: Stand-Alone Model
paragraphs: Under the stand-alone model, NRSROs only would be permitted to  produce credit ratings. The NRSROs would be able to interact with and  advise organizations being rated, but could not charge fees for providing  advice. Instead of receiving issuer fees, the NRSROs would be  compensated through transaction fees imposed on original issuance and  on secondary market transactions. Part of the fee would be paid by the  issuer or secondary-market seller, and the other portion of the fee by the  investor purchasing the security in either the primary or secondary  market. The NRSRO would be compensated over the life of the security  based on these transaction fees. The letter rating would be free to the  public.
Proponents of this model believe that by creating a funding source that is  beyond the influence of both issuers and investors, the focus of the  NRSRO will be on producing the most accurate and timely credit analysis  rather than on satisfying the desires of any other vested interest.
section_title: Designation Model
paragraphs: Under the designation model, all NRSROs would have the option of rating  a new issuance, and security holders would direct, or designate, fees to the  NRSROs of their choice, based on the proportion of securities that they  owned. When an issuer decided to bring a security to market, it would be  required to provide all interested NRSROs with the information to rate the  issuance. The issuer would pay the rating fees to a third-party  administrator, which would manage the designation process. When the  security was issued, the security holders would designate which of the  NRSROs that rated the security should receive fees, based on their  perception of research underlying the ratings. The security holders could  designate one or several NRSROs. The third-party administrator would be  responsible for disbursing the fees to the NRSROs in accordance with the  security holders’ designations. After the initial rating, the issuer would  continue to pay maintenance rating fees to the third-party administrator,  which bond holders also would allocate through the designation process  every quarter over the life of the security. When the debt was repaid (or  repurchased by the issuer), a final rating fee would be paid in conjunction  with the retirement of the security. The letter rating would be free to the  public, while the research underlying it would be distributed to  securityholders and (at the discretion of the relevant NRSROs) to potential  securityholders.
The proposed model suggests that the issuer’s transfer agent could  perform the responsibilities of the third-party administrator. The transfer  agent currently is responsible for maintaining ownership records of the  security holders.
The authors of this model believe this model would eliminate the conflict  of interest between the issuers paying for the rating and the NRSRO and  would increase competition by encouraging NRSROs to prepare  unsolicited ratings, because each NRSRO would be assured of receiving  compensation for its rating, provided some group of investors or other  users of ratings found them useful enough to allocate to the provider a  portion of the fees they designated or paid.
section_title: User-Pay Model
paragraphs: Under the user-pay model, issuers would not pay for ratings. Rather, to  address the free-rider problem, the model specifies that all users of ratings  would be required to enter into a contract with the NRSRO and pay for the  rating services of an NRSRO. The proposal defines “user” as any entity that  included a rated security, loan, or contract as an element of its assets or  liabilities as recorded in an audited financial statement. Users of ratings  would include holders of long or short positions in a fixed-income  instrument, as well as parties that refer to a credit rating in contractual  commitments (that is, as parties to a lease) or that are parties to derivative  products that rely on rated securities or entities. A user would be required  to pay for ratings services supplied during each period in which it booked  the related asset or liability.
The model relies on third-party auditors to ensure that NRSROs receive  payment from users of ratings for their services. Any entity that required  audited financial statements in which the rated instrument or covenant  was included among the assets or liabilities would be required to  demonstrate to the auditors that the holder had paid for the rating  services. No audit opinion would be issued until the auditor was satisfied  that the rating agencies had been properly compensated. The model would  require the close cooperation of the auditing community and the Public  Company Auditing Oversight Board.
The architects of this model believe that, while more cumbersome, the  model attempts to capture “free riders”—those users of ratings that do not  compensate NRSROs for the use of their intellectual property and require  them to pay for the ratings.
section_title: Framework to Evaluate Alternative Compensation Models
paragraphs: In this report, we are not evaluating the proposed alternative  compensation models. Instead, we are providing a framework that  Congress and others can use to evaluate or craft alternative compensation  models for NRSROs. The framework contains seven factors, all of which  are essential for a compensation model to be fully effective. Furthermore,  we have provided key questions under each factor that can be applied to  an alternative compensation model to identify its relative strengths and  weaknesses, potential trade offs (in terms of policy goals), or areas in  which further elaboration or clarification would be warranted. Similarly,  the framework could be used to further develop proposals or identify  aspects of current regulations to make them more effective and  appropriate for addressing the limitations of the current credit rating  system.  1.  Independence. The ability for the compensation model to mitigate  conflicts of interest inherent between the entity paying for the rating and  the NRSRO.
What potential conflicts of interest exist in the alternative  compensation model?
What controls, if any, would need to be implemented to mitigate these  conflicts? How does the compensation model seek to limit conflicts of  interest between the entity paying for the ratings and the NRSRO?  Between users of ratings and the NRSRO? Between issuers and the  NRSRO?
As previously discussed, conflicts of interest arise between the entity  paying for the rating and the NRSRO. The alternative compensation  models we have identified continue to rely on issuer fees to fund ratings  and to help ensure that ratings remain free to the public. However, several  intend to mitigate the potential for the issuer to influence NRSROs in  different ways—either by increasing the investor’s role in the rating  process or assigning NRSROs using a rotational process or randomly. In  assessing these as well as other potential compensation models, it is  important to consider whether the models introduce any new conflicts of  interest and evaluate the steps the models propose to mitigate them.  2.  Accountability. The ability of the compensation model to promote  NRSRO responsibility for the accuracy and timeliness of their ratings.
How does the compensation model create economic incentives for  NRSROs to produce quality ratings over the life of a bond?
How is NRSRO performance evaluated and by whom? For example,  does the compensation model rely on market forces or third parties to  evaluate performance? For models that rely on third parties, how are  “quality” credit ratings defined and what criteria would be used to  assess ratings performance?
When an NRSRO demonstrates poor performance, what are the  economic consequences under the compensation model and who  determines these consequences? For example, how is an NRSRO’s  compensation or opportunity for future ratings business linked to  ratings performance?
The quality of an NRSRO’s ratings largely is determined by the ratings  methodologies it employs, but the compensation model also can affect the  ratings process. An effective compensation model will provide economic  incentives for the rating agency to produce not only a quality rating at  issuance, but also appropriate surveillance of the security over its life. It  also should link NRSRO compensation to the performance of the rated  entity. As such, when evaluating various compensation models it is  important to consider how NRSRO performance is evaluated and by  whom. NRSRO performance could be evaluated by market participants or  an independent arbiter, with the consequences of performance dictated by  the compensation model. For example, models can rely on market  discipline to evaluate NRSRO ratings and determine which ones merit  future business. Models also could rely on third parties to evaluate NRSRO  performance which might require that the third party develop performance  measures. However, as we previously discussed, there are differences in  the NRSROs’ measures of creditworthiness, ratings scales, ratings  methodologies, and other processes that can make comparison of NRSRO  performance difficult when using these measures.   3.  Competition. The extent to which the compensation model creates an  environment in which NRSROs compete for customers by producing  higher-quality ratings at competitive prices.
On which dimensions does the compensation model encourage  NRSROs to compete? To what extent does the compensation model  encourage competition around the quality of ratings? Ratings fees?  Product innovation?
To what extent would the compensation model encourage new  entrants and reduce barriers to entry in the industry?
To what extent does the model allow for flexibility in the differing  sizes, resources, and specialties of NRSROs?
To what extent do market forces determine ratings fees?
When evaluating an alternative compensation model, considering its  potential impact on the competition in the ratings industry is important.  Most importantly, the model should not in itself present a barrier to entry  or increase existing barriers. It should not promote convergence of one  class of products or methodologies by NRSROs, but should foster diversity  in ratings methodologies and products. For example, the compensation  model should be flexible to allow for relatively smaller NRSROs or  NRSROs with specialties to adapt to any new requirements and not  inadvertently hinder them from competing with the larger NRSROs or  expanding their product lines to meet market demand.
An effective compensation model also will promote competition around  the quality of ratings. In that sense, this factor is closely related to the  accountability factor, in that the compensation model should not  economically reward NRSROs that consistently produce poor-quality  ratings. Some compensation models could increase competition by  reducing barriers to entry for smaller or newer NRSROs; for example, by  offering or guaranteeing them more opportunity to produce ratings and  increase their coverage of the market. However, it is unclear whether a  model that increases the number of NRSROs would result in more  competition among them to produce quality ratings over time. In assessing  these models, considering their potential impact on NRSROs’ incentives to  compete around ratings quality, product innovation, and overall efficiency  is important.
Similarly, an effective compensation model will promote competition  around ratings fees. Some NRSROs are highly specialized, serving  particular markets or asset classes. As such, the ratings fees charged by  each NRSRO reflects its own cost structure. Compensation models should  not incorporate a uniform approach to setting ratings fees. Such an  approach would promote inefficiencies in the market and dissuade some  NRSROs from continuing to offer services if they believed they were  economically disadvantaged. Those NRSROs with comparatively lower- cost structures for producing ratings might benefit from such an approach,  but overall it would not encourage NRSROs to produce ratings cost  effectively.  4.  Transparency. The accessibility, usability, and clarity of the  compensation model and the dissemination of information on the model to  market participants.    How clear are the mechanics of the compensation model to market  participants? How transparent are the following procedures and  processes:    how the NRSROs obtain ratings business;    how ratings fees are determined;    how NRSROs are compensated; and    how the compensation model links ratings performance to NRSRO  compensation.
An effective compensation model should be transparent to market  participants to help them understand it and to increase market  acceptance. For example, the model should be transparent about how  NRSROs obtain ratings business, such as (1) whether issuers will select  the NRSROs; (2) whether ratings business will be assigned, randomly  awarded, or mandated; or (3) whether NRSROs will have the option to  provide ratings on any new business. If the model relies on third parties or  systems for this function, it should be explicit about the criteria or  procedures employed. Similarly, if ratings fees are not determined by  market forces, the model should clearly explain the process and criteria  for determining fees. Issuers, NRSROs, oversight bodies, and users of  ratings also should understand the proposed compensation mechanism,  and it should clearly link ratings performance to NRSRO compensation.  Any criteria for evaluating ratings performance and the process for  determining these criteria should be disclosed. Lack of transparency in  any of these areas could hinder support and trust in the model.  5.  Feasibility. The simplicity and ease with which the compensation model  can be implemented in the securities market.
Is the model easily implemented? If not, how difficult will  implementing the model be?
Could the compensation model be instituted through existing  regulatory or statutory authority or are additional authorities needed?
What are the costs to implement the compensation model and who  would fund them?
Which body would administer the compensation model, and is this an  established body? If not, how would it be created?
What, if any, infrastructure would be needed to implement the  compensation model? What information technology would be required?  Which body would be responsible for developing and maintaining it?
What impact would the alternative compensation model have on  bringing new issuances to market and trading on the secondary  market?
How many NRSROs would be required for the compensation model to  function as intended? How would the exit of an NRSRO from the  ratings industry affect the model’s feasibility? What impact would the  alternative compensation model have on the financial viability of an  NRSRO?
When assessing a compensation model, considering the model’s feasibility  for successful implementation is essential. We note that the market itself  has not undertaken the implementation of any compensation model other  than the current issuer- and subscriber-pays models. As such, SEC or  Congress likely would have to direct market participants to implement any  alternative model. Models that are technically simplistic in nature will be  more feasible to implement than complex ones. Further, some alternative  models we identified involve potentially significant costs. For example,  some models would require the development of information technology  systems that would be used across the market by potentially thousands of  participants. Assessing not only the costs of implementing these models,  but also determining who would be responsible for overseeing and paying  for their development upfront is a key question. Costly models could deter  market participants from implementing and participating in them.
Assessing the impact of any potential model on the efficiency of the  securitization market is an important part of the evaluation process. An  alternative compensation model should be flexible and adaptable to real- time demands of the securities markets, and not hinder the timing of initial  issuance and trading on the secondary market. The model also should be  viable regardless of the number of NRSROs that enter or exit the market.
For compensation models that require a third-party administrator, the  process for selecting or creating this administrator could have a significant  impact on the success of its implementation. If market participants  question the independence or capability of the administrator to run the  model effectively and efficiently, they may be less likely to accept the  model.
For a compensation model to work as intended, it should not have to rely  on a certain number of NRSROs to attain its goal. Such models could be  undermined if only one or two NRSROs participated in the rating of  specific types of securities or if an NRSRO exited the industry. While some  proposed alternative compensation models intend to encourage  competition among the NRSROs, the models themselves should not hinder  the financial viability of an NRSRO. For example, the potential impact on  the smaller NRSROs of any participation costs should be considered. The  model also should not introduce undue uncertainty into the industry, so  that NRSROs could not conduct appropriate business planning (that is,  attract and retain qualified staff).  6.  Market Acceptance and Choice. The willingness of the securities  market to accept the compensation model, the ratings produced under  that model, and any new market players established by the compensation  model.
What role do market participants have in selecting NRSROs to produce  ratings, assessing the quality of ratings, and determining NRSRO  compensation? More specifically, what are the roles of issuers and  investors in these processes? Where do these roles differ between  models and what are the trade offs?
Are all market participants likely to accept the ratings produced under  the compensation model? If not, what are the potential consequences  for the securitization market?
What impact, if any, would the model have on each market participant  using the ratings?
Would market participation need to be mandated, and if so, for which  participants?
The likelihood that market participants will accept an alternative  compensation model is another important consideration in its evaluation.  In achieving its goals, such as increasing independence in the ratings  process or competition among NRSROs, a particular model may limit or  promote the participation and choices of some market participants over  others and could affect the market’s acceptance of and participation in the  model. For example, as we have pointed out, the proposed models we  have identified require that the issuer pays for the rating; however, in most  of the models the issuer is no longer able to select which NRSRO rates the  security. Limiting the issuer’s choice may address conflicts of interest and  increase the independence of the ratings process, but also could deter  issuers from soliciting NRSROs to rate their debt. Market acceptance by  institutional investors is also instrumental to the success of the model. For  example, many private investment guidelines require the use of specific  NRSROs. If these specified NRSROs are not producing ratings under an  adopted model, then these investors may be limited in the securities that  they can consider purchasing. Such tradeoffs would need to be carefully  evaluated to ensure the model’s viability and minimize its impact on the  securities market.
Market participants should accept the ratings produced by the  compensation model. If market participants, particularly issuers and end  users of ratings, do not have confidence in the ratings produced under the  model, its viability could be significantly undermined. This is a particular  concern with models that would mandate the use of a particular NRSRO  or otherwise limit the market’s influence in the supply and demand for  ratings. Market participants, including regulators outside of the United  States, also could affect the acceptance of the model. A rating that is not  accepted could create inconsistencies between domestic and foreign  securities markets for investors that rely on ratings.  7.  Oversight. The evaluation of the model to help ensure it works as  intended.
Does the model provide for an independent internal control function?
What external oversight (from a regulator or third-party auditor) does  the compensation model provide to ensure it is working as intended?
If third-party auditors provide external oversight, how are they  selected, what are their reporting responsibilities, and to whom do they  report?
Who will compensate the regulator or third-party auditor for auditing  the compensation model? How will the compensation for  regulator/auditor be determined?
To what extent will a third-party auditor allow flexibility in oversight to  accommodate NRSROs of different sizes?
An effective alternative compensation model also will provide for  independent internal controls and robust, external oversight to ensure  its integrity. This is especially important when a model calls for third- party administration or the use of information technology systems in its  implementation. For example, any centralized system that collects fees  from issuers and compensates the NRSRO(s) should be audited, as  should any procedures used to award ratings business to an NRSRO,  evaluate NRSRO performance, or apply economic penalties. Such  oversight will help ensure the model functions as intended, thus  increasing transparency and market acceptance. Funding for this  oversight should be specified.
The Dodd-Frank Act contains a mandate for SEC to conduct a study of the  feasibility of establishing a system in which a public or private utility or a  self-regulatory organization assigns NRSROs to determine the credit  ratings of structured finance products. The study must include an  assessment of the potential mechanisms for determining fees for NRSROs,  appropriate methods for paying fees to the NRSROs, and the range of  metrics that could be used to determine the accuracy of credit ratings.  SEC also must evaluate alternative means for compensating NRSROs that  would create incentives for accurate credit ratings. Our framework  could be used to evaluate current proposals for compensating NRSROs,  develop new proposals, and identify tradeoffs among them.
section_title: Conclusions
paragraphs: The Credit Rating Agency Reform Act sought to improve ratings quality for  the protection of investors, including establishing SEC oversight over  credit rating agencies that register as NRSROs. However, SEC faced a  number of challenges in implementing the law, and the recent financial  crisis resulted in additional changes to SEC’s oversight of NRSROs under  the Dodd-Frank Act. As SEC starts to implement its new requirements,  there are a number of challenges from its existing responsibilities that  must also be addressed.
SEC’s implementation of the Act involved developing an NRSRO  registration program and an examination program. As currently  implemented and staffed, both programs require further attention.
As intended by the Act, the new registration program for NRSROs reduced  the time SEC staff took to act on an application and improved the  transparency of SEC’s process for awarding NRSRO designations to  interested credit rating agencies. However, due to the time constraints, a  lack of criteria, and lack of express preregistration examination authority,  Trading and Markets staff said the registration process generally does not  allow staff to conduct reviews that would allow staff  to confirm that the  information provided on Form NRSRO was accurate and the applicant met  all of the Act’s requirements. However, SEC has yet to explicitly identify  the legislative changes needed to address this limitation and work with  Congress to ensure it has the authority needed to effectively carry out its  oversight responsibilities. This raises a concern because SEC may approve  applicants that do not meet the Act’s requirements.
Although SEC has established an OCIE branch dedicated to the  examination of NRSROs and hired individuals with experience in credit  rating analysis and structured finance to fill these positions, OCIE has not  completed timely examinations of the NRSROs and expressed concerns  about its ability to meet its planned NRSRO routine examination schedule  of examining the three largest NRSROs every 2 years and the other  NRSROs every 3 years. While SEC requested additional resources that it  anticipated using to fully staff this oversight function, it will likely need to  revisit those requests due to the passage of the Dodd-Frank Act, which  requires SEC to establish an Office of Credit Ratings and examine each  NRSRO every year. As SEC begins its planning of this new office, it is  essential that SEC assess not only the number of staff it needs but also the  skills required of this staff. Approaching this effort strategically may  facilitate the recruitment and training of new hires. Without a plan that  details the amount of staff needed with the requisite qualifications and  training, SEC may face challenges in meeting the required examination  timetable and providing quality oversight of the NRSROs.
SEC rules requiring NRSROs to publish short-, medium-, and long-term  performance statistics have increased the amount of information publicly  available about the performance of some NRSROs, particularly those  newly registered. Overall, the disclosure of these statistics has not had the  intended effect of increasing transparency for users. Specifically,    SEC has not provided specific guidance for the NRSROs for calculating  and presenting the required performance statistics. Therefore, NRSROs  have used different methodologies for calculating the required  performance statistics, which renders them ineffective for comparative  purposes.
SEC has yet to evaluate the appropriateness of the required performance  statistics for SEC’s currently designated asset classes to determine if the  requirements need to be modified. Asset classes that are defined too  broadly limit the usefulness of the disclosures.
The Dodd-Frank Act directs SEC to adopt additional rules requiring   NRSROs to publicly disclose information on the initial credit ratings  determined by each NRSRO for each type of obligor, security, and money  market instruments, and any subsequent changes to such credit ratings. In  developing these new disclosure requirements, it will also be important for  SEC to provide clear and specific guidance to NRSROs. Otherwise, the  resulting disclosures may lack comparability. Recent SEC rules to make  ratings history data publicly available are intended to generate  performance measures and studies to evaluate and compare NRSRO  performance. However, it is unlikely that the ratings histories NRSROs  publish pursuant to the 10 percent and 100 percent requirements can be  used for these purposes. Specifically,    SEC did not specify the data fields the NRSROs were to disclose as part of  their 10 percent sample disclosures, and the data fields provided by the  NRSROs did not always provide sufficient information to allow users to  identify a complete rating history for each rating in the sample, including  the beginning of rating histories, or specific types of ratings for making  comparisons. As a result, users cannot develop performance measures  that track how an issue or issuer’s credit rating evolves, evaluate  comparable entities across NRSROs, or calculate measures that compare a  starting point to the state of a rating at the time of default.
Users cannot easily determine what data the variables represent because  NRSROs were not required to provide an explanation of the variables used  in the samples as part of their disclosures. Without such explanations,  users may find it difficult to begin to construct performance statistics.
Because SEC did not require it, not all NRSROs disclosed defaults as part  of their ratings histories in the samples. As such, users cannot calculate  default statistics for those NRSROs.
Because SEC guidance to NRSROs for generating the 10 percent random  samples does not specify that the NRSROs draw the sample from those  ratings that are typically analyzed in each asset class and does not require  the NRSROs to periodically redraw the samples or include ratings that  have been withdrawn in prior time periods, the samples are not  representative of the population of credit ratings at each NRSRO. As a  result, users cannot generate performance measures that represent the  population of credit rating over time and that can be compared across  NRSROs.
Because the 100 percent disclosure requirement does not require that the  NRSROs disclose the ratings of any issuer rated before June 26, 2007, or  include data on withdrawn ratings, performance statistics calculated using  the 100 percent data set would not reflect the overall rating performance  of NRSROs and may not be representative of the universe of issuer ratings.
As SEC also did not provide guidance to NRSROs on how to format and  describe the data disclosed under the 100 percent requirement, users will  likely experience challenges when seeking to construct ratings histories  and develop comparable performance statistics.
Finally, SEC’s rule requiring NRSROs to disclose total outstanding ratings  is intended for users to assess how broad an NRSRO’s coverage is within a  particular class of credit ratings. However, because SEC did not specify  how NRSROs were to count their outstanding ratings, NRSROs used  diverse methodologies to count up their outstanding ratings. As a result,  users of data cannot use them for their intended purpose.
The Dodd-Frank Act requires SEC and other federal agencies to remove  references to NRSRO ratings from their regulations, and substitute an  alternative standard of creditworthiness. SEC has recently removed or  proposed to remove references to NRSRO ratings from several rules. In  comparison, the Dodd-Frank Act requirement is a broader undertaking  that requires a strategic approach. SEC’s previous experience highlights  the importance of developing a plan to ensure that (1) any adopted  alternative standards of creditworthiness for a particular rule facilitate its  purpose and (2) examiners have the requisite skills to determine that the  adopted standards have been applied. Without such a plan, SEC may  develop alternative standards of creditworthiness that are not effective in  supporting the purpose of a particular rule.
Among its stated goals, the Act intended to improve competition among  NRSROs by creating a more efficient and transparent NRSRO designation  process for SEC to administer. The Act made receiving an NRSRO  designation easier and resulted in three new, subscriber-pays NRSROs.  However, industry concentration remains high. Given the limited time that  has passed since SEC implemented the registration program, the impact of  the credit crisis on the securities market, and uncertainty about changes in  the regulatory environment, significant changes in industry concentration  in the short term are not likely. However, whether any changes in industry  concentration will materialize in the long term is still unclear. The credit  rating industry continues to manifest its traditional barriers to entry, such  as high fixed costs, that make gaining customers and achieving significant  coverage of the securities market a challenge for new entrants. In some  asset classes, such as structured finance, these barriers are especially  high. Recognizing this, SEC amended the Exchange Act rule 17g-5 to  increase the number of structured finance ratings by requiring issuers that  contract with an NRSRO for a rating to agree to make the underlying data  free to other interested NRSROs in order to encourage nonhired NRSROs  to produce unsolicited ratings. As this rule became effective in June 2010,  not enough time has passed to assess its impact. However, we note that  the impact of competition on the quality of credit ratings is not well  understood. The limited academic research conducted in this area  suggests that the entry of new credit rating agencies will improve overall  information available to investors and other market participants, but that  the effect of entry on the quality of ratings produced by any one rating  agency is not well-established.
To assist Congress and others in evaluating proposed models for  compensating NRSROs, we created an evaluative framework of seven  factors that any compensation model should address to be effective. The  Dodd-Frank Act contains a mandate for SEC to conduct a study of the  feasibility of establishing a system in which a public or private utility or a  self-regulatory organization assigns NRSROs to determine the credit  ratings of structured finance products. SEC also must evaluate alternative  means for compensating NRSROs that would create incentives for  accurate credit ratings. Our framework could be used to evaluate current  proposals for compensating NRSROs, develop new proposals, and identify  trade offs among them.
section_title: Recommendations for Executive Action
paragraphs: To address the concern that the current process for registering credit  rating agencies may result in SEC approving applicants that do not meet  the Act’s requirements, the Chairman of the Securities and Exchange  Commission should:  Identify the additional authorities and time frames necessary to ensure  that staff can verify the accuracy of the information provided on Form  NRSRO and that the applicant meets all of the Act’s requirements; the  Chairman should also work with Congress to ensure that SEC has the  authority needed to effectively carry out its oversight responsibilities.
To ensure that SEC has sufficient staff with the skills necessary to address  the requirement in the Dodd-Frank Act that SEC establish an Office of  Credit Ratings and examine each NRSRO every year, the Chairman of the  Securities and Exchange Commission should:    Develop and implement a plan for the establishment of this office that  includes the identification of the number of staff and the skills required of  these staff to meet the required examination timetable and provide quality  oversight of the NRSROs, including plans for the recruitment of any new  hires and appropriate training.
To address the inconsistencies in the NRSROs’ methodologies for  calculating required performance statistics and total outstanding ratings  for initial and updated Form NRSRO filings, address limitations in the  required 10 percent and 100 percent rating history disclosures, and  increase the comparability and usefulness of these disclosures, the  Chairman of the Securities and Exchange Commission should take the  following eight actions:  for the disclosures of required performance statistics,    provide specific guidance for NRSROs for calculating and presenting  these performance statistics, considering the impact of different  methodologies on the information content of the performance statistics  and the purpose for which SEC intends the statistics to be used; and    evaluate the appropriateness of  SEC’s currently designated  asset  classes for presenting performance statistics, and where SEC determines  that the asset classes are not appropriate, modify the requirements  accordingly;  for the disclosures of required 10 percent and 100 percent ratings histories,    ensure that the data elements required as part of the datasets allow  users to construct complete ratings histories, identifying the beginning  of ratings histories, and distinguish between different types of ratings;    consider requiring NRSROs to publish a codebook to explain the  variables included in the datasets;    clarify that NRSROs should include defaults in the ratings histories  review its guidance to NRSROs for generating the 10 percent samples  and modify it as needed to ensure that the samples are 10 percent of  the type of ratings typically analyzed in each asset class, that  withdrawn ratings are not removed from these samples, and that the  samples are periodically redrawn; and  review its guidance to NRSROs for generating the 100 percent rating  history disclosures and modify it as needed to ensure that these  histories include those ratings that are typically analyzed in each asset  class; and that withdrawn ratings are not removed from these  disclosures;  for the disclosures of total outstanding ratings required on Form NRSRO,    provide specific guidance to NRSROs to calculate their total  outstanding ratings.
To address the Dodd-Frank Act’s requirement for SEC to remove any  references to or requirements of reliance on credit ratings in its rules and  substitute alternative standards of credit worthiness that it deems  appropriate, the Chairman of the Securities and Exchange Commission  should:    develop and implement a plan for approaching the removal of NRSRO  references from SEC rules to help ensure that (1) any adopted alternative  standards of creditworthiness for a particular rule facilitate its purpose  and (2) examiners have the requisite skills to determine that the adopted  standards have been applied.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of the report to the SEC Chairman for her review and  comment. SEC provided written comments that are summarized below  and reprinted in Appendix III. We also received technical comments from  SEC that were incorporated, where appropriate.
In its written comments, SEC agreed with our findings. With respect to our  recommendation that addresses concerns about the current registration  process, SEC stated that SEC staff intend to develop proposals to  provide Congress with technical assistance for how the relevant  portions of the Securities Exchange Act of 1934 could be amended to  address the issues we identified with the registration process for  NRSROs. Regarding our recommendation to develop and implement a  plan for the establishment of the Office of Credit Ratings, SEC stated that  it anticipates drawing upon our findings as it staffs this new office. SEC  stated that it is in the process of hiring staff to meet its new  responsibilities under the Dodd-Frank Act relating to NRSROs and has  allocated between twenty-five and thirty-five positions to this new office.
With respect to the recommendations related to improving the  comparability of the NRSROs required disclosures of performance  statistics, SEC noted the Dodd-Frank Act mandates that it adopt rules that  require NRSRO disclosures of performance-related data to be comparable  among NRSROs in order to allow users of credit ratings to compare the  performance of credit ratings across NRSROs. SEC stated that our review  of the existing disclosure requirements will be helpful to SEC staff in  developing recommendations for the Commission in response to the  congressional mandate.
With respect to the recommendations related to addressing limitations in  the required 10-percent and 100-percent rating history disclosures, SEC  noted that on August 27, 2010, it published on its Web site the list of XBRL  tags that NRSROs must use for these ratings history disclosure  requirements.  SEC believes this step may address some of the our  concerns regarding its guidance as to the data fields NRSROs must use for  these disclosures. We encourage SEC to evaluate the extent to which these  tags address the limitations we identified, and, to the extent that they do  not, to take further action. As we discussed, these limitations render  current ratings history disclosures largely unusable.
With respect to our recommendation regarding SEC’s approach to address  the Dodd-Frank mandate that it remove NRSRO references from its rules  and substitute alternative standards of credit worthiness that it deems  appropriate, SEC agreed that any proposed alternative standards of  creditworthiness for a particular rule should facilitate its purpose and that  replacing NRSRO ratings with alternative standards will require that SEC  ensure that examiners have the requisite skills to determine that the  adopted standards have been applied. SEC stated that it has already hired  senior examiners with specialized expertise and skills and that it  continues to increase its expertise in these areas through its recruiting and  training programs.
We are sending copies of this report to interested congressional  committees and the Chairman of SEC. The report will also be available at  no charge on the GAO Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or williamso@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs can be found on the last  page of this report. GAO staff who made major contributions to this report  are listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: To discuss the implementation of the Credit Rating Agency Reform Act of  2006 (Act), focusing on Securities and Exchange Commission (SEC)  rulemaking and SEC’s implementation of the registration and examination  programs for Nationally Recognized Statistical Rating Organizations  (NRSRO), we reviewed the rules SEC has adopted to implement the Act,  including the NRSRO registration program and its oversight of NRSROs.  We reviewed the SEC’s Inspector General’s August 2009 audit report for  findings and recommendations pertaining to SEC’s NRSRO registration  program as well as SEC’s July 2008 public report discussing its findings on  examinations of selected NRSROs. We also reviewed copies of the  Division of Trading and Markets’ (Trading and Markets) internal  memoranda to SEC documenting its review of NRSRO applications and  internal memoranda outlining additional NRSRO monitoring. We obtained  and reviewed the Office of Compliance Examinations and Inspections  (OCIE) guidance for conducting an NRSRO examination and reviewed  completed NRSRO examinations. To understand additional changes to  SEC’s oversight of the NRSROs, we reviewed the recently passed Dodd- Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank  Act). We conducted interviews with Trading and Markets regarding the  NRSRO application review process, and SEC’s Division of Investment  Management (Investment Management) and the Financial Industry  Regulatory Authority (FINRA) to obtain information on SEC’s process for  registering investment advisors and FINRA’s process for registering new  broker-dealer members, respectively. We also conducted interviews with  OCIE staff regarding the NRSRO examinations that were initiated after the  Act’s passage and obtained information from OCIE on its staffing of the  NRSRO examination team.
To evaluate the performance-related NRSRO disclosures that the Act and  SEC rules require, we analyzed SEC rules requiring NRSRO disclosure of  performance statistics and ratings history samples. First, we analyzed and  compared the 10 NRSROs’ 2009 disclosures of performance statistics,  focusing on the corporate and structured finance asset classes, and we  reviewed voluntary disclosures of additional performance statistics by 5 of  the NRSROs. We also reviewed the Dodd-Frank Act to understand its  directive to SEC to ensure the comparability of NRSRO performance  disclosures. Second, we assessed NRSRO ratings history data disclosed by  the 7 issuer-pays NRSROs pursuant to SEC’s 10 percent disclosure  requirement. From each NRSRO’s Web site, we obtained its 10 percent  random samples of outstanding ratings. We downloaded these data in  February and March 2010. To assess the reliability and usability of the  samples for generating comparative performance measures, we reviewed  the samples and obtained information from each of the NRSRO’s on the  methods used to draw and maintain the samples. We identified a number  of issues that led us to determine that the data were not in a format that  allowed us to generate comparative performance statistics. For example,  we found that the data fields required by the rule were not always  sufficient to identify a complete rating history for ratings in each of the  seven samples and did not give us enough information to identify specific  types of ratings for making comparisons. We also could not consistently  identify the beginning of the ratings histories in all of the samples.  Furthermore, we found that the guidance provided by SEC to NRSROs for  generating the random samples does not ensure that the method used will  result in samples that are representative of the population of credit ratings  at each NRSRO. Since it was impossible to compare performance statistics  across NRSROs in any reliable manner, we focused on identifying the  issues we encountered when reviewing the available data and attempting  such comparisons. We also analyzed SEC’s 100 percent disclosure  requirement by reviewing the rule and obtaining information from Trading  and Markets and two NRSROs on its implementation. As this rule did not  become effective until June 2010, we did not review the data disclosed by  NRSROs pursuant to the rule, with the exception of one NRSRO. We  conducted a limited review of the data disclosed by this NRSRO to  determine the extent to which the data included ratings of issuers rated  prior to June 26, 2007. As part of this objective, we also assessed the  NRSROs’ disclosures of total outstanding ratings required on Form  NRSRO. We reviewed these disclosures and SEC’s instructions pertaining  to these disclosures and obtained information from the NRSROs on their  methods for determining total outstanding ratings.
To evaluate the potential regulatory impact of removing NRSRO  references from certain SEC rules, we reviewed SEC’s proposed rules to  remove references to NRSRO ratings, focusing on proposed amendments  to rule 2a-7 under the Investment Company Act of 1940 (Investment  Company Act) and Securities and rule 15c3-1under the Securities  Exchange Act of 1934 (Exchange Act) and the comment letters submitted  to SEC on these proposals. We reviewed multiple studies pertaining to the  use of ratings in regulations. To understand the extent to which NRSRO  ratings are used in U.S. federal securities, banking, and insurance laws,  rules, and regulations we obtained a copy of a Joint Forum report  documenting their use. To understand how the ratings were used in the  rules and the regulatory impact the removal of the ratings might have, we  reviewed OCIE’s examination guidance for reviewing for compliance with  rules 2a-7 and 15c3-1. We also reviewed the 65 examinations of money  market funds OCIE completed in FY 2003-2009, which reviewed funds for  compliance with rule 2a-7. We did so to understand how examiners  ensured that funds complied with the rule’s two-part test for determining if  a security was eligible for purchase and how the removal of NRSRO  ratings might affect oversight of this determination. We reviewed the  Dodd-Frank Act to understand its directive to SEC and other federal  agencies to remove NRSRO references from their rules regulations. We  also interviewed staff from Investment Management to better understand  the purpose of rule 2a-7, and how the removal of references might affect  oversight. We conducted interviews with OCIE staff, Trading and Markets  staff, and market participants and observers about the pros and cons of  utilizing NRSRO references in, and the potential impact of removing them  from, regulations.
To evaluate the impact of the Act on competition among NRSROs, we  reviewed proposed and final SEC rules intended to promote competition  among rating agencies, as well as the comment letters SEC received in  response to those rules. We reviewed SEC’s 2008 and 2009 mandated  annual reports on NRSROs, including SEC’s studies on competition in the  credit rating industry. We used the Herfindahl-Hirschman Index (HHI) to  track industry concentration over time. The HHI is a measure of industry  concentration that reflects both the number of firms in the industry and  each firm’s market share. It is calculated by summing the squares of the  market shares of each firm competing in the market. The HHI reflects both  the distribution of market shares of the top firms and the composition of  the market outside the top firms. The HHI is measured on a scale of 0 to  10,000, with larger values indicating more concentration. According to the  Department of Justice and Federal Trade Commission, markets in which  the value of the HHI is between 1,500 and 2,500 points are considered to be  moderately concentrated, and those in which the value of the HHI is in  excess of 2,500 points are considered to be highly concentrated, although  other factors also play a role.
Calculating the HHI requires defining what constitutes the industry and  specifying our measure of market share. We define the relevant industry as  the set of credit rating agencies that have NRSRO status, and we use a  variety of market share definitions to ensure that any trends in industry  concentration we observe are robust to alternative specifications of  NRSROs’ market shares. A firm’s market share typically is measured in  terms of dollars, as either its sales or revenue as a fraction of total sales or  revenue for all firms in the industry, or in terms of quantities, as its output  as a fraction of total output produced by all firms in the industry. We  measured an NRSRO’s overall market share as its revenue as a share of  total revenue for the industry. We measured an NRSRO’s market share  overall in each asset class as the number of debt-security issuing  organizations or entities it rates as a percent of the sum of the numbers of  organizations that each NRSRO rates, in which the number of  organizations rated is our proxy for output. Finally, for the ABS asset  class, we measured an NRSRO’s market share as the dollar value of new  U.S. issuance it rated as a percentage of the sum of the dollar value of  issuance each NRSRO rated. We then calculated the HHI using these  definitions of market share.
We obtained the revenue data for 2006–2009 from the NRSROs’ initial and  annual Form NRSRO filings. We obtained the number of organizations or  entities that issue debt securities and are rated by the NRSROs per asset  class for 2006–2009 from 9 of the 10 NRSROs. We obtained data on the  dollar amount of new U.S.-issued asset-backed debt rated by NRSROs for  2004—June 2010 from an industry newsletter that tracks asset-backed  securitization. Because these data came from private firms, we were able  to conduct only limited assessments of the data’s reliability. We were not,  for example, able to conduct our own reliability tests on the data. For the  revenue data obtained from the NRSROs’ responses to Form NRSRO, we  interviewed the staff from Trading and Markets to determine the steps  they took to ensure the data represented the firms’ total revenues. As such,  we determined that the data were sufficiently reliable for our purpose,  which was to show the relative concentration of the NRSROs in the  industry. For the data we obtained from the NRSROs on the number of  rated organizations or entities that issue debt securities, we specified the  methods by which the NRSROs were to count and classify the ratings. We  did this to ensure consistency in the data across the NRSROs. We also  examined the data, both within and NRSRO and among NRSROs, to  determine whether there were any illogical trends that would indicate the  date had been prepared incorrectly. As such, we determined that the data  were sufficiently reliable for our purpose, which was to show the relative  concentration of the NRSROs in the industry. For the data we obtained  from the private firm tracking the dollar value of rated new U.S. asset- backed securitization, we obtained information from the firm on the  processes and procedures used to collect and manage the data. We  determined that the data were sufficiently reliable for our purpose, which  was to show the relative concentration of the NRSROs in the industry. We  also used these data to generate a series of descriptive graphs showing the  NRSROs’ market coverage, that is, the percentage of new U.S. asset- backed issuance that each rated. We also believe that the data are  sufficiently reliable for this purpose.
We also reviewed academic studies on competition in the industry. We  identified three studies that analyze data to assess the impact of the  number of rating agencies on some aspect of the credit rating industry. We  identified these studies by searching databases of both unpublished  working papers and papers published in refereed academic journals and  by searching the bibliographies of studies we found in the databases. The  three studies we identified are all unpublished working papers. We  reviewed these studies and determined they did not raise any serious  methodological concerns. However, the inclusion of these studies is purely  for research purposes and does not imply that we deem them to be  definitive. Finally, we obtained the views of SEC’s Office of Risk Analysis,  the NRSROs, credit rating agencies that are not registered NRSROs,   institutional investors, issuers, and industry experts on the impact of the  Act on competition.
To provide an overview of proposed alternative models for compensating  NRSROs and an evaluative framework for assessing the models, we  identified proposals on alternative models for compensating NRSROs by  reviewing white papers submitted to the SEC roundtable on credit rating  agency oversight, academic and other white papers, and interviewed the  authors of the proposed models. We obtained the views of Trading and  Markets, SEC’s Office of Risk Assessment, and NRSROs. We also spoke  with credit rating agencies that are not registered NRSROs, institutional  investors, issuers, and academic and industry experts. To develop the  framework for evaluating the models, we reviewed prior GAO reports and  obtained the views of market participants and observers to identify  appropriate factors for inclusion. We then convened a panel of GAO  experts (financial markets specialists, economists, an attorney and a social  scientist) to review the framework and incorporated their comments.  Finally, we solicited comments from NRSROs, proposal authors, industry  experts, and trade associations and incorporated them as appropriate.
We conducted this performance audit from May 2009 to September 2010 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.
section_title: Appendix II: Other Registration Processes Provide Greater Flexibility to the Regulators
paragraphs: Other registration programs for securities market participants allow  regulators to exercise greater oversight over applicants than does the  registration program for Nationally Recognized Statistical Rating  Organizations (NRSROs) while maintaining an efficient and transparent  registration process. More specifically, in the Securities and Exchange  Commission’s (SEC) Division of Investment Management’s (Investment  Management) registration programs for investment advisors and the  Financial Industry Regulatory Authority’s (FINRA) Registrant Application  process for broker-dealers, staff can request additional information from  the applicant in specific circumstances, extend the review process, and  reject an application for a broader set of reasons.
SEC’s registration process for investment advisers is authorized by section  203 of the Investment Advisers Act of 1940 (Investment Advisers Act),  which identifies generally the type of information required in an  application for registration as an investment adviser and prescribes a time  frame, 45 days, by which SEC must act on an application. Investment  advisers apply by completing and submitting Form ADV, which requires  information such as the type of company that is applying, what businesses  it will be involved in, its assets under management, its employees and  clients, compensation and ownership arrangements, any financial industry  affiliates, and whether the adviser or any person associated with the  adviser is subject to certain disciplinary events. SEC must grant  registration to applicants if it finds that the requirements of section 203 are  satisfied. After instituting a proceeding to determine whether registration  should be denied, SEC must deny a registration if it does not make such a  finding or if it finds that if the applicant were so registered, its registration  would be subject to suspension or revocation.
Although Investment Management oversees the rules and policies  regarding the registration of investment advisers, the Office of Compliance  Inspections and Examinations (OCIE) is responsible for reviewing the  application materials and evaluating whether the application is complete.  If additional information is necessary to consider the application or clarify  inconsistencies in the information provided, OCIE contacts the applicant  with questions and requests additional information. If additional  information is required, applicants submit an amended Form ADV,  triggering a new 45-day review period. Investment Management officials  characterized the process as efficient, and stated that OCIE completes  application reviews in an average of 30 days, with variations due to factors  such as volume of applications and complexity. Staff stated that  incomplete applications can be placed in a postponed status. When  postponed, OCIE contacts the applicant through an official letter, which  typically states that SEC received the application and describes the parts  of the filing that need to be corrected or completed. While staff await a  response from the applicant, the running of the 45-day review period is  automatically suspended pending receipt by SEC of the additional  information necessary to complete the application. Staff said that  sometimes an applicant may never provide the requested information or  correct the deficiency in the application. In these situations, OCIE  considers the application incomplete. Once a complete application is  received, a review of disciplinary information is completed to determine if  there is a reason to recommend to SEC to deny, condition, or limit the  registration. If there is none, the application is approved.
FINRA’s registrant process also imposes a time frame on FINRA staff for  reviewing broker-dealer applications for registration. Under FINRA Rule  1014, FINRA staff must make a decision no more than 180 days from the  filing date unless requested by the applicant and to which FINRA  otherwise agreed. Broker-dealers applying for registration must submit an  application providing information demonstrating they meet the 14  standards specified by the FINRA rule. These include that they have  adequate financial and managerial resources, supervisory systems, and  compliance procedures designed to detect and prevent violations of  securities laws and related rules; recordkeeping systems that enable  compliance with regulatory recordkeeping requirements; and staff  sufficient in qualifications and number to prepare and preserve required  records. FINRA’s Department of Member Regulation reviews and either  approves, approves with restrictions or denies broker-dealer member  applications, and staff have the authority, if there are any questions, to  make additional requests for information. The department also conducts a  membership interview to further clarify the application material, after  which additional information is requested and thereafter, a final decision  is made. According to FINRA officials, staff frequently have additional  questions. For example, staff may have factual questions about capital,  employee registrations, leases, or the location of the broker-dealer facility.  While FINRA officials said that at no point should a decision on an  application take more than 180 days unless agreed to by the applicant and  agreed to by FINRA, they also stated that if staff did not receive, within  prescribed timeframes, the information they requested to satisfy any  questions they would, absent good cause, reject or lapse the application.  They also can reject an application at the time it is initially filed if that  application has a material deficiency (i.e. was not substantially complete);  for example, if staff were unable to tell what the applicant’s business was  going to do, how the business would be supervised, or who was intending  to fund the broker-dealer. If applicants disagree with the department’s  decision to deny or restrict an application, they can appeal internally to  FINRA and then to SEC, and finally in Circuit court. According to FINRA  officials, the department reviews more than 200 new member applications  in a year and decisions often take less than 180 days. They estimated that  about 80 percent are completed within 180 days. FINRA officials stated  that the process allows FINRA to restrict certain activities and deny  unqualified applicants.
Both FINRA’s registrant application process for broker-dealers and SEC’s  registration process for investment advisors require applicants to provide  specific information and utilize deadlines to ensure an efficient process.  However, unlike the NRSRO registration program, staff of these programs  are provided the authorities necessary to clarify any outstanding questions  they have regarding an applicant and to delay approving that applicant  until the staff are satisfied that the applicant has met all of the necessary  requirements.
section_title: Appendix III: Comments from the Securities and Exchange Commission
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the individuals named above, Karen Tremba, Assistant  Director; Lucas Alvarez; William Chatlos; Rachel DeMarcus; Courtney  LaFountain; Elizabeth Jimenez; Stefanie Jonkman; Matthew Keeler; Omyra  Ramsingh; and Barbara Roesmann made key contributions to the report.