New Limits on Credit Rating Agencies Proposed

New rules to tighten regulation of credit rating agencies, which were blamed for failing to properly assess the risk of mortgage-backed securities prior to the collapse of credit markets last fall, are being proposed by the Obama Administration.

The proposed legislation, which the administration presented to Congress on Tuesday, seeks to provide investors with more information on how financial products are rated while tightening oversight of credit rating agencies and reducing financial markets' reliance upon them.

It also seeks to reduce conflicts of interest between credit rating agencies and the companies whose products they rate, as well as giving the Securities and Exchange Commission greater authority over rating agencies.

Addresses factors linked to subprime meltdown

Credit rating agencies have been blamed for failing to properly evaluate the risk of subprime mortgages and an overheating housing market in their assessments of mortgage-backed securities in recent years. Many of these were rating as low-risk and even AAA investments despite containing significant numbers of subprime mortgages that were propped up by an expanding housing market and growing economy. Once the economy and housing market cooled, many of these mortgages went into default, undermining the value of the investments and triggering an overall collapse of credit markets.

Among its provisions, the legislation would seek to crack down on "ratings shopping," in which the issuer of a financial product obtains preliminary ratings from several ratings agencies, but only purchases and discloses the highest one. The legislation would require disclosure of all preliminary ratings so an investor could see how much discrepancy there is in the ratings.

Calls for simplified disclosure

The legislation also calls for a fuller and more simplified disclosure of the various factors affecting the risk of a rated financial product, and an end to the use of similar credit ratings for products with inherently different levels of risk, such as corporate bonds vs. asset-backed securities.

Credit rating agencies would also be barred from acting as consultants to companies that contract for credit rating services, similar to the restrictions currently placed on accountants and other professional service providers.

Limits on fees, "revolving doors"

Other provisions would address potential conflicts of interest arising from the way fees are paid or business relationships, and "revolving door" conflicts occurring when rating agency are hired by the companies whose financial products they assessed.

The legislation would also establish a dedicated office within the Securities and Exchange Commission to strengthen supervision of rating agencies and carry out the new regulations. It would also direct the Government Accountability Office (GAO) to prepare a study on reducing the overall reliance on credit ratings agencies in financial markets.