08/14/2009 05:12 am ET Updated May 25, 2011

SEC Chair Floats Ratings Agency Crackdown

The Securities and Exchange Commission chair Mary Schapiro floated the possibility of cracking down on a particularly egregious Wall Street habit at a congressional hearing Tuesday.

When banks prepare to sell a bundle of securities -- mortgage loans, credit default swaps or other exotic financial products, for example -- they generally get a preliminary grade from a rating agency like Moody's or S&P. That's where the conflict of interest gets hot. If the bank doesn't like the rating, it can simply take its substantial business elsewhere. "Rating shopping" leaves the agencies with a dangerous incentive to be liberal with their coveted AAA ratings. And it leaves investors unsure if that AAA rating is authentic or the result of a prolonged shopping spree.

There is currently no requirement that banks disclose to investors the preliminary ratings results.

Testifying before the Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises, Schapiro told the panel that she had directed her staff "to explore possible new regulations in this area, including limiting the potential for rating shopping."

Schapiro said that a "possible approach would be to require disclosure by issuers of all pre-ratings obtained from [ratings agencies] prior to selecting a firm to conduct a rating, as well as requiring [ratings agencies] to provide additional disclosures."

The commission, she said, has also recommended mandating disclosure of ratings history information for 100 percent of all credit ratings paid for by the issuer of a financial instrument. A bad rating, then, couldn't be easily buried.

Schapiro's proposal is a step in the right direction, says economist Dean Baker of the Center for Economic and Policy Research. "It seems the cleanest path would be to remove control of the hiring decision from the company getting its issue rated," Baker says. "If you don't remove the fundamental conflict of interest, then there will be a strong incentive to skirt the rules."

Adding to the fog surrounding credit ratings is the practice of banks not to disclose what information a bank gave to a ratings agency in order to obtain a certain rating. The market is simply asked to trust the ratings agency - the agency, that is, that was paid by handsomely by the bank to come up with a rating, possibly after others had rated the product poorly.

Schapiro, in her testimony before the committee, pushed for an end to that practice. Under her proposal, whatever information a bank gives to a ratings agency must also be given to other ratings agencies to double-check it.