Statement on Asset-Backed Securities and Credit Rating Agencies

The Commission will today [August 27, 2014] consider recommendations of the staff for adopting two very important final rules in different, but closely related, areas—asset-backed securities and credit rating agencies.

The reforms before us today will add critical protections for investors and strengthen our securities markets by targeting products, activities and practices that were at the center of the financial crisis. With these measures, investors will have powerful new tools for independently evaluating the quality of asset-backed securities and credit ratings. And ABS issuers and rating agencies will be held accountable under significant new rules governing their activities. These reforms will make a real difference to investors and to our financial markets.

We will first consider the recommendation related to asset-backed securities, and then we will consider the rules relating to credit rating agencies.

Asset-Backed Securities

Securitizations were an epicenter of the financial crisis. The process of transforming a pool of assets—too often low quality assets—into securities is well understood. Done correctly, securitizations can facilitate economic growth, providing critical liquidity to financial markets and help households and businesses get the capital they need. But, when done poorly, as during the years leading up to the financial crisis, securitization can destabilize markets by wrapping serious financial risks in a thin veneer of creditworthiness. When the true nature of these risks was revealed and asset values collapsed, investors in asset-backed securities suffered significant losses.

There were critical failures in the securitization market at a number of junctures. Credit ratings failed to accurately take into account the real risks underlying certain asset-backed securities. This significant failure was compounded because investors did not have the necessary information about the securitized assets and related risks to conduct the appropriate level of diligence on these assets on their own. And, even if they had been provided the necessary information, they were not given enough time to analyze the securitization transaction to make an informed investment decision. ABS issuers bear responsibility as well—they did not conduct sufficient diligence in designing their securities products. And there was not effective enforcement of the representations and warranties made about the assets underlying the securities.

These failures and lapses in our securitization markets are unacceptable.

Quite simply, the SEC must protect investors in asset-backed securities just as it does investors in any other security, ensuring that they have full information, the tools and time to understand potential investments and the nature and extent of associated risks.

The recommendation before us today squarely and firmly addresses these failures in the ABS markets that have historically been among the most significant markets in terms of their impact on the U.S. and the global economy. Most prominently—and consistent with our mandates under the Dodd-Frank Act—the final rule would require the disclosure to investors of extensive asset-level information for residential and commercial mortgage-backed securities, as well as securities backed by auto loans and leases. These disclosure requirements have been carefully calibrated to deliver the information that investors need to assess the credit risk associated with these assets while preserving the privacy of obligors.

The recommendation will also give investors more time to make informed decisions on investments in these securities.

Loan-level disclosures will be more accessible to investors by requiring the information to be in a computer-readable format, thus allowing investors to download and analyze the data more easily. Investors can take advantage of this greater transparency and time when conducting their independent due diligence on potential investments to develop better understandings of the credit risks in the pool.

Taken together, this set of reforms will greatly strengthen our rules applicable to the securitization market and address the significant failures that have hurt our economy. It is important, however, that we continue to monitor and assess the impact of these reforms, and consider further steps as necessary. In particular, we must continue to work expeditiously to complete final rules for the retention of credit risk by issuers of asset-backed securities, as required by the Dodd-Frank Act. The disclosures we are considering today will provide a critical foundation for those rules.

Credit Rating Agencies

We will now turn to the second item on today’s agenda: a recommendation to adopt a package of reforms that would establish new requirements for credit rating agencies registered with the Commission as nationally recognized statistical rating organizations (“NRSROs”), issuers and underwriters of asset-backed securities, and providers of third-party due diligence services on asset-backed securities. These reforms will implement more than a dozen of the Commission’s mandates under the Dodd-Frank Act.

The issuance of flawed credit ratings by certain credit rating agencies was a key contributor to the financial crisis. Investors purchased asset-backed securities—as well as other securities—in reliance on ratings they believed were based on independent, robust and methodical analysis. As is now well understood, that was all too often not the case. For example, in August 2007, the Commission staff initiated examinations of the three largest NRSROs that highlighted:

• Insufficient measures to prevent business interests from influencing credit ratings;
• Inadequate documentation and disclosure of rating methodologies and processes for addressing model errors;
• Inadequate surveillance and monitoring of outstanding ratings; and
• Insufficient resources for assessing the growing volume and complexity of structured finance products.

Since 2011, the Commission staff has undertaken annual examinations of each of the NRSROs registered with the Commission, as required by the Dodd-Frank Act. While the reports from these reviews have catalogued a number of improvements, they have also identified concerns that persist, including ones related to the management of conflicts of interest, internal supervisory controls, and post-employment activities of former staff of NRSROs.

NRSROs play a critical “gatekeeper” role in the debt market. Congress recognized this important function when it enacted the Dodd-Frank Act, where it identified the importance of credit rating agencies to capital formation, investor confidence, and the efficient performance of the U.S. economy.

The Dodd-Frank Act mandates that the Commission adopt rules governing NRSROs in a number of areas. Many of the required rules would be significant reforms standing alone. When combined, as they are today, these rules create an extensive framework of robust reforms. They will significantly strengthen the governance of NRSROs by addressing internal controls, conflicts of interest, and procedures designed to protect the integrity of rating methods.

The reforms will also significantly enhance the transparency of NRSRO activities and thereby promote greater scrutiny and accountability of NRSROs. Together, this package of reforms will improve the overall quality of NRSRO credit ratings and protect against the re-emergence of practices that contributed to the recent financial crisis.

Today, I would like to highlight just two of the reforms that I view as among the most important to achieving this goal.

First, the Dodd-Frank Act created a new statutory requirement that an NRSRO must establish, maintain, enforce, and document an effective internal control structure governing its implementation of and adherence to policies, procedures, and methods for determining credit ratings. It also requires the Commission to prescribe rules requiring an NRSRO to submit an annual internal controls report to the Commission attested to by the CEO or equivalent senior executive.

The recommendation before us today implements the statutory requirement for effective internal controls by establishing specific factors that the NRSRO must consider in developing and implementing its internal controls. But, there is no safe harbor. Rather, an NRSRO must consider the specified factors and other factors in developing its own effective internal controls, which will be tailored to its particular business and governance structure.

Importantly, however, for all NRSROs, the recommendation incorporates a strong reporting requirement that compels that an NRSRO describe each material weakness in its particular internal control structure, how each one was addressed, and a conclusion as to whether the internal control structure was effective.

The second set of reforms I want to highlight today are the measures to prevent the sales and marketing considerations of an NRSRO from influencing its production of credit ratings. The rule first provides that an NRSRO is absolutely prohibited from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating also participates in sales or marketing of a product or service of the NRSRO or its affiliate.

But there are other channels of such influence that are readily identifiable as outlined in the recommendation, namely:

• compensation arrangements or performance evaluation systems that incentivize analysts to produce inflated credit ratings to increase or retain the NRSRO’s market share;
• clients, such as rated entities, who may pressure analysts to produce inflated credit ratings to obtain or retain their business; or
• managers who are not involved in sales and marketing activities but may seek to pressure analysts to produce inflated credit ratings to increase or retain the NRSRO’s market share.

We must address these channels of influence if we are to prevent the full range of potential conflicts of interest that can lead to deficient credit ratings. Consistent with our mandate under the Dodd-Frank Act, the recommendation therefore also prohibits an NRSRO from issuing or maintaining a credit rating where an analyst involved in the production of the credit rating is influenced by sales or marketing considerations.

While I highlight these two aspects of this rulemaking, there are many other critically important requirements in the recommendation before the Commission today, ranging from rules that would address the revolving door between NRSROs and the entities they rate to policies and procedures to apply credit rating symbols consistently. This very strong package of reforms will improve the quality of credit ratings for the benefit of investors and the capital markets.

The SEC staff will be closely attending to the implementation of these reforms, and we will continue to actively assess potential further measures to enhance the integrity and independence of credit ratings.