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1 [1] (April 9, 2024)

handle is hein.crs/govepqa0001 and id is 1 raw text is: Congressional Research Se informing the legisiitive debate since 1914 Updated April 9, 2024 Credit Rating Agencies: Background and Regulatory Issues Credit rating agencies (CRAs) provide investors with evaluations of the creditworthiness of debt (i.e., how likely a debt is to be repaid in full) issued by a wide spectrum of entities, including corporations, sovereign nations, and municipalities. Their ratings are typically a letter hierarchical format (e.g., AAA as the safest, and progressively lower grades-AA+, AA, AA-, A+, A, A-, BBB, all the way down to D-representing greater risk). For regulatory and investment purposes, ratings are placed into two broad categories. Investment grade debt is rated BBB- or Baa3 (depending on the CRA) or higher. Noninvestment grade debt (also known as high yield or junk bonds) has a rating below these benchmarks and is generally associated with higher risk firms. This In Focus examines CRAs, their regulation, and related policy issues. Background and Early Regu ation In 1975, the Securities and Exchange Commission (SEC) adopted the designations of nationally recognized statistical rating organizations (NRSROs). NRSROs were originally used to help determine capital charges on different grades of debt securities held by broker-dealers under the SEC's net capital rule (Rule 15c3-1 under the Securities Exchange Act of 1934). The net capital rule is aimed at ensuring that broker-dealers maintain sufficient liquid assets to promptly satisfy their liabilities if needed. When the SEC began using ratings to enforce the net capital rule in 1975, the SEC staff, in consultation with agency commissioners, determined that the ratings of the three dominant agencies-Standard & Poor's (S&P), Moody's, and Fitch-were nationally used and were thus generally considered NRSROs with respect to SEC enforcement of the net capital rule. Between 1975 and 2000, the SEC added four more NRSROs to the original three. The SEC never defined the term NRSRO or specified how a CRA might become one. Its approach was essentially described as one of we know it when we see it. As of March 2024, there were 10 NRSROs-three categorized by the SEC as large (S&P, Moody's, and Fitch) and garnering 91% of revenue-three as medium, and four as small. In 2006, Congress passed the Credit Rating Agency Reform Act (P.L. 109-291), which amended the Securities Exchange Act of 1934 to try to improve ratings quality for the protection of investors by fostering accountability, transparency, and competition in the credit rating industry. Among other things, P.L. 109-291 added Section 15E to the Securities Exchange Act, which established SEC oversight over those CRAs that register as NRSROs. It also provided the SEC with examination authority and established a registration program for CRAs seeking NRSRO designation. NRSRO applicants and registered NRSROs were required to disclose ratings performance, conflicts of interest, and the procedures used to determine ratings. Under the law, the SEC was also authorized to conduct annual deficiency and compliance examinations at NRSROs, which are not publicly identified. The Financial Crisis and Dodd-Frank Changes In the run-up to the financial crisis of 2007-2009, the provision of investment grade ratings by the three dominant CRAs-S&P, Moody's, and Fitch-for structured finance securities was widely seen as a critical part of the process of structuring the residential mortgage-backed securities (MBS) and collateralized debt obligations that held subprime housing mortgages. The issuance of private MBS reportedly grew from $126 billion in 2000 to $1.145 trillion in 2006. Various reporting, including the 2011 Financial Crisis Inquiry Report, argued that the three leading CRAs fundamentally failed in their ratings of these securities, exacerbating the market collapse. During the housing boom preceding the financial crisis, the CRAs often gave top-tier AAA ratings to many structured securities only to downgrade many of them later to levels often below investment grade. CRA ratings on corporate bonds reportedly did not encounter the same problems. Criticism of the CRAs, however, was not universal. A frequent defense of their failings was that their rating missteps could be traced in part to their view that rising housing prices would be sustained, a perspective also said to be held by a number of respected financial market observers at the time. Critics of CRAs argue that overly favorable ratings were in place heading into the crisis because of the issuer-pays model used by the CRAs. CRAs are typically paid by the issuers of the securities being rated by the agencies, which many see as a conflict of interest (Financial Crisis Inquiry Report, 2011). Rating structured finance became a substantial revenue generator for the CRAs. For example, according to some reporting (Morgenson, New York Times, 2008), by the first quarter of 2007, such ratings constituted 53% of Moody's total revenue. In addition, ratings shopping-wherein structured finance issuers shopped for CRAs offering potentially more favorable ratings-may have played a role (Zhou and Kumar, 2012). Other possible causes of the allegedly inflated structured product ratings included the following: * The CRA industry is highly concentrated (Financial Crisis Inquiry Report, 2011). According to recent SEC data, S&P, Moody's, and Fitch issued about 95% of outstanding ratings. * Despite high profits, the CRAs reportedly suffered from inadequate staffing, exercise of due diligence, and use of internal controls and a failure to properly update their rating models (Brookings, 2017).

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