On October 22, current and former CEOs of the ratings agencies were called to testify in front of the House Committee on Oversight and Government Reform.  Their incompetence was laid bare, and it is hard to imagine they left the hearing with more than a scintilla of self-respect intact.

The ratings agencies’ failings were exposed: conflicts of interest, sloppy procedures, broken risk management models, and an incredible level of incompetence among their staffs. 

None of this is news.  Those familiar with the history of the ratings agencies might have found these hearings highly amusing, but they would not have left feeling they’d learned any new information.

We are not offering the agencies any excuses or forgiveness.  But these hearings make it painfully obvious that another major player shares responsibility for their failings — the regulators themselves.

Regulators have known for a long time that the agencies were broken, but they did nothing to address the problem.

The agencies have been around for over 100 years, assessing the creditworthiness of corporations and their ability to service debt.  A key step in elevating the stature of the agencies was taken in 1975, when the SEC began using the agencies’ ratings in its rules.  The SEC adopted the term Nationally Recognized Statistical Rating Organization (NRSRO) for determining capital requirements for broker-dealers.

The NRSRO concept was gradually expanded by both the SEC and Congress to other regulatory purposes, including banking capital requirements and securities issuance.

Periodically, usually in conjunction with major corporate failures, the SEC has reviewed the role of the agencies.  For example, in 1988, an SEC report that investigated the failure of Washington Public Power Supply System (“WPPSS”) bonds said that “limitations in the rating process may have contributed to the continued high ratings of the WPPSS bonds.”

In 1994, the SEC solicited public comment on the appropriateness of the NRSRO designation.  It received 25 responses which “generally supported the continued use of the NRSRO concept.”  The Securities Industry Association (SIA), one of the 25 commentators, rejected the use of statistical techniques and advocated the continued use of the NRSRO designation because it “would give broker-dealers an objective, simple standard for determining the capital value of a debt instrument under the rule.  In contrast, a modeling approach involves a possibly intricate statistical configuration.”  The recent wave of failures among financial firms has proven that the NRSRO designation has done virtually nothing to provide an “objective, simple standard” — at least not a reliable one.

In 1997, the SEC considered proposals that would have tightened the standards and approval processes that applied to the NRSRO designation.  Among other things, it would have incorporated a process whereby the SEC could withdraw the NRSRO designation.  The Commission did not act on these proposals until 2006.

In 2002, the SEC again reviewed the role of the credit ratings agencies, specifically the issue of whether the NRSRO designation was preventing competition and inhibiting new entrants from entering the ratings business.  It concluded that it would “conduct a public examination of the potential need for greater regulation in this area.”

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