Tuesday, July 8, 2008

SEC finds deficiencies in credit rating processes of Fitch, Moody's and S&P.

A few weeks back, this blog had talked about a proposal by the SEC to regulate the credit rating industry. In addition to this proposal, the SEC today released the findings of an investigation into the rating procedures followed by by 3 major credit rating agencies (Fitch, S&P and Moody's). Some very disturbing facts have come to light at the conclusion of this investigation:

1.The SEC staff's examinations found that rating agencies struggled significantly with the increase in the number and complexity of subprime residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDO) deals since 2002.

2. None of the rating agencies examined had specific written comprehensive procedures for rating RMBS and CDOs.

3. Significant aspects of the rating process were not always disclosed or even documented by the firms, and conflicts of interest were not always managed appropriately.

4. The internal audit processes followed at these firms varied substantially.Out of the 3 credit rating agencies, only one had adequate internal audit processes and management follow up. Out of the other 2, one had an inadequate one page check list kind of an audit that appeared inadequate and the other agency's internal audit resulted in plenty of critical findings but were never acted upon by the management.

5. Significant aspects of the ratings process were not always disclosed

6.The rating agencies did not always document significant steps in the ratings process - including the rationale for deviations from their models and for rating committee actions and decisions - and they did not always document significant participants in the ratings process.

The investigation also had access to emails and other communication between analysts at these firms. In one exchange, dated April 5, 2007, an analyst said the ratings model didn't capture "half" of the deal's risk but that "it could be structured by cows and we would rate it," according to the report.

With a virtual collapse of its internal control system(computer 'glitches', weak internal audits, conflicts of interest, inadequate documentation of the rating process coupled with zero public disclosure), it's a wonder there is even a shred of confidence left in the ratings produced by these three credit rating agencies. The SEC plans to take up a similar investigation for another seven agencies in the next few months.