Rating Firms Seem Near Legal Deal on Reforms
Under fire for the high ratings they awarded to subprime mortgage securities, three large credit rating firms are close to announcing a broad deal with the New York attorney general to reform some of their core business practices, according to people briefed on the investigation.
Most significantly, the rating firms are considering changing how they charge fees for ratings to make it harder for investment banks to play the firms against one another to obtain a better rating, these people say, adding that negotiations are ongoing and the deal could still fall apart.
As part of the deal being discussed, the firms — Standard & Poor’s, Moody’s Investors Service and Fitch Ratings — would also aid Attorney General Andrew M. Cuomo’s broader investigation into how Wall Street packaged mortgages into securities, in exchange for immunity from prosecution. And the rating agencies will establish new standards for how investment banks review mortgage loans.
Mr. Cuomo has been investigating the once-booming and lucrative mortgage business for about a year. He is focusing on whether investment banks withheld critical information about the home loans they were packaging into bonds to be sold to investors like hedge funds, insurance companies and pension funds.
As part of that investigation, Mr. Cuomo this year secured the cooperation of Clayton Holdings, a firm that reviews loan files on behalf of investment banks. His office has not formally charged any investment banks with wrongdoing.
Regulators have struggled to assign blame for the mortgage debacle, at times pointing to everyone and no one in particular. Many institutions were involved in making loans, evaluating the debts and packaging them into securities. But rating firms played a critical role by awarding mortgage-backed securities triple-A ratings, a gold standard that allowed investors like pension funds and insurance companies to buy them.
For decades, critics have charged that the nation’s rating agencies faced conflicts of interest because they are paid by the investment banks or corporations whose securities they are rating. Before the 1970s, bond investors paid for ratings directly.
Furthermore, critics say banks can shop for the best rating because they pay only after the deal is closed. If the banks are unhappy with the rating assigned by one firm, they can take it to a different rating company before the bond is issued, without letting investors know.
Under the proposed deal with Mr. Cuomo, a rating agency would charge fees in stages for various analytical tasks — not just the rating, which acts as a sort of grade for investors. They will also disclose every three months all deals that they were asked to rate and all the deals they end up rating, providing investors more information than is now available.
Lynn E. Turner, a former chief accountant for the Securities and Exchange Commission, said the change appeared to have merit but it would not eliminate the core conflict of interest.
“It aids transparency but it doesn’t solve the problem, because the same people — the issuers — are paying for the services, as opposed to the old model where the investors paid for the services,” he said. “The old model was a better model.”
If they agree to Mr. Cuomo’s deal, the ratings firms will require the investment banks to give them the diligence reports. They will also set the standards by which those reports are produced, in an effort to assure that the information is useful and relevant.
The president of S.& P., Deven Sharma, said in a statement that his company was working with Mr. Cuomo on measures that “will help ensure our ratings process continues to be of the highest quality.” Officials at Fitch and Moody’s declined to comment.
On June 11, the S.E.C. is expected to release a proposal to revise rules for ratings firms. The agency may propose that the firms publish a history of their ratings and that they publicize the fact that mortgage securities ratings are more volatile than ratings assigned to bonds issued by companies or municipalities.
It is unclear how much the proposed deal advances Mr. Cuomo’s case against the banks. Armed with the powerful Martin Act, the attorney general could potentially bring civil or criminal charges against firms if he could prove that they withheld material or significant information from credit rating firms and investors.
In the past, the investment banks have asserted that they provided adequate disclosures about the risks posed by the loans but that many investors did not bother to carefully evaluate securities they were buying. And the ratings firms argued they were not provided the due diligence reports produced by companies like Clayton.
Some of the firms have said that they have since found that there was significant fraud in the making of the loans that backed some of the worst-performing securities — fraud that no one detected until it was too late.