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SEC proposes new rules for credit-ratings firms

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Regulators took new steps Wednesday to overhaul the firms whose credit ratings inspired overconfidence in investments tied to toxic mortgages.

The Securities and Exchange Commission proposed rules meant to improve the system by which such firms as Moody’s and Standard & Poor’s assign ratings to bonds and other securities.

Rosy ratings have been cited as one of the main causes of the subprime mortgage bubble and the resulting meltdown in the financial system.

Some of the proposals advanced Wednesday are intended to address conflicts of interest that can compromise the objectivity of the ratings.

For example, if an analyst who helped assign a rating to a company is later hired by that company, the rating firm would have to conduct a “look-back” to determine if the rating was improperly influenced. If warranted, the firm would have to change the rating.

Similarly, rating agency employees who help shape the ratings would be prohibited from participating in sales or marketing for the ratings firm. But small rating firms could seek an exemption from that rule.

The proposals would not change what some say is the rating industry’s fundamental conflict of interest. Rating firms would still be selected and paid by the very companies they are rating or whose investment products they grade.

In the runup to the financial crisis, that arrangement prompted rating firms to chase clients and revenue by inflating grades, congressional investigators have alleged.

A recent report by the Senate Permanent Subcommittee on Investigations said that credit-rating agencies routinely assigned triple-A ratings — their highest grades — to risky securities.

At a subcommittee hearing, representatives of Moody’s and Standard & Poor’s said investment bankers engaged in “credit shopping” — seeking out the rating agencies that would give them the highest grades.

“When sound credit ratings conflicted with collecting profitable fees, credit-rating agencies chose the fees,” the Senate panel said.

Eventually, more than 90 percent of the triple-A ratings given to mortgage-backed securities in 2006 and 2007 were downgraded to junk status, the panel said.

The mass downgrading was a key trigger of the financial crisis, the panel said.

The five SEC commissioners voted unanimously to invite public comment on the proposed rules, which are subject to revision and a final vote.

The agency was acting at the behest of Congress, which demanded changes in the rating business as part of the Dodd-Frank law enacted last year in response to the financial crisis.

“Today’s proposals are part of a concerted effort by the SEC to enhance the credit rating industry in light of the financial crisis,” SEC Chairman Mary L. Schapiro said in a statement.

A spokesman for Standard & Poor’s said his firm has already taken many of the steps the SEC proposed.

“S&P supports the SEC’s efforts to increase accountability, transparency and oversight of credit rating firms while maintaining analytical independence,” spokesman David Wargin said in a statement.

Under the SEC proposals, rating agencies would have to disclose more standardized information about their track records, including how often companies or products that they rate end up defaulting on obligations.

Rating firms would have to test their analysts periodically to ensure their competence, and the teams responsible for individual ratings would have to include at least one analyst with at least three years of experience.

Ratings had become such a cornerstone of the financial system that many federal regulations mandated their use as benchmarks of investment quality.

Institutional investors such as banks, pension funds and insurance companies relied on ratings when making investment decisions, partly because laws and regulations restricted their ability to buy securities that were not deemed to be of investment grade.

The Dodd-Frank law ordered regulators to purge the rules of such references, and in other recent actions the SEC has set about rewriting the rules to avoid reliance on ratings.

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