The U.S. Securities and Exchange Commission uncovered a total of 487 instances over the past six years in which the nation’s SEC-registered credit-rating agencies were deemed by agency staff to be in non-compliance with federal securities laws or related SEC rules, a recent SEC staff report reveals.
The bulk of the violations, which were uncovered during mandated annual SEC examinations, fell into three categories as follows: internal supervisory controls, 42.3%; adherence to internal policy, procedures and rating methodologies, 30.6%; and conflicts of interest, 11.5%. The report focuses on the nine rating agencies that as of year-end 2021 were registered with the SEC as “nationally recognized statistical rating organizations,” or NRSROs.
The report includes an analysis of essential-findings trends from examinations conducted between 2016 and 2021. It does not identify specific agencies or alleged violators by name, nor does it detail in aggregate any corrective actions ordered by the agency — although it does provide a few case examples absent credit-rating agency identifiers.
“For purposes of this report, the staff considers an ‘essential finding’ to be any instance of apparent non-compliance by an NRSRO [credit rating agency] with the federal securities laws or related commission rules applicable to NRSROs.”
The SEC report offers a portrait of the regulatory process ongoing behind the scenes in the rating-agency world, which is a key to maintaining transparency for investors and issuers across a range of markets. The sectors highlighted in the rating-agencies report include securities issued by corporations, the U.S. government, insurance companies and financial institutions as well as asset-backed security issuances and transactions in the private-label residential mortgage-backed securities (MBS) sector.
In addition to the tally of essential-findings violations data, the SEC report also provides an assessment of the ESG bond-rating environment and a market-share ranking of rating agencies in the residential MBS space. ESG securities such as bonds are backed by collateral, like mortgages, that can be defined as meeting environmentally sustainable, socially responsible, or good governance (ESG) criteria.
“Generally, the purpose of NRSRO examinations is to promote compliance with applicable federal securities laws and rules by identifying potential instances of non-compliance of NRSROs with their statutory and regulatory obligations and encouraging remedial action,” the SEC report states. “When appropriate, the staff may refer findings to the commission’s Division of Enforcement for investigation.”
The SEC report, released quietly in January with the vanilla-sounding title of the “Office of Credit Ratings Staff Report on Nationally Registered Statistical Rating Organizations,” is provided to Congress annually as required under the Credit Rating Reform Act of 2006. The report does break down the number of essential findings, or violations, from 2016 to 2021 by rating-agency size categories — with small agencies recording 195 alleged violations over the period; medium-sized agencies, 145 and large agencies, 147.
“From 2016 to 2021, the large NRSROs had an average of 8.2 essential findings per exam cycle, the medium NRSROs had an average of 8.1 essential findings per exam cycle, and the small NRSROs had an average of 8.6 essential findings per exam cycle,” SEC staff note in the report. “…The large NRSROs report employing 4,691 credit analysts (including supervisors), which is approximately 83.7% of the total number employed by all of the NRSROs. The small and medium NRSROs, in the aggregate, employ approximately 16.3% of all credit analysts employed by NRSROs.”
The large NRSROs, according to the SEC report, are Fitch Ratings, Moody’s Investor Service and S&P Global Ratings. Medium-sized rating agencies include A.M. Best Rating Services, DBRS Inc. and Kroll Bond Rating Agency (KBRA). The small NRSROs are Egan-Jones Ratings Co., HR Ratings de Mexico and Japan Credit Rating Agency Ltd.
The SEC report also indicates that the number of essential-finding transgressions from “the 2016 examination cycle was higher in several review areas, which was likely related to the new and amended rules that became effective in 2015.”
“Essential findings have generally decreased in subsequent exam cycles,” the SEC report continues, “which indicates the NRSROs’ greater awareness of applicable laws and their obligations as regulated entities.”
A chart in the report shows that the range of essential-finding violations in 2016 averaged between 14 to 18 across the small, medium and large agency categories. For 2020, the range drops to an average of between four to seven violations across the three agency-size categories.
For 2021, based on the chart in the report, the average number of essential findings across the three agency categories declined even further — ranging on average between two to four violations across the three agency-size sectors. The biggest improvement over the period was seen in the large agency category sector, which had an average of 18 violations in 2016. That had declined to an average of about four essential-finding violations in 2020 and two in 2021.
Case Examples
The SEC report on credit rating agencies details a handful of case examples that better illustrate the nature of the alleged essential-finding violations discovered by SEC examiners — though, again, the examples do not include identifying information about the specific rating agencies or bond issuances. In the case of one large NRSRO, the SEC staff report indicates that the agency failed to report an allegation of fraud, for example.
“The NRSRO issued a credit rating on a bond after the underwriter for the bond communicated to an analyst of the NRSRO an allegation of potential fraud relating to the authenticity of a letter of credit upon which such credit rating was based,” the SEC report states. “The staff also noted that the NRSRO did not withdraw the credit rating for some months during which the NRSRO had knowledge of a potential fraud.”
In another case involving a medium-sized rating agency, the SEC report noted the following:
“On some occasions, an analyst participated in a rating committee while holding securities of the rated entity in a managed account. The staff recommended that the NRSRO establish, maintain, and enforce written policies and procedures reasonably designed to address and manage conflicts of interest with respect to securities held in employees’ managed accounts.”
Finally, in another example highlighted in the report involving a small NRSRO, SEC staff found the credit rating agency’s conflict-of-interest policies lacking.
“The NRSRO’s policies and procedures did not appear to be reasonably designed … to prevent the occurrence of the prohibited conflict of interest,” the SEC staff report states. “…The NRSRO’s policies and procedures allowed employees to receive gifts with a specified limited dollar amount but did not limit such gifts to items provided in the context of normal business activities, such as meetings.”
Market Share
The SEC report also examines market-share information for residential mortgage-backed securities, or MBS. The report defines MBS as “securities secured by U.S. first-lien mortgages on residential properties.” However, it excludes Fannie Mae and Freddie Mac issuances as well as “securities secured by non-performing or re-performing mortgages; subprime [or non-prime] mortgages; … mortgages financing single-family rental businesses [investment properties]; and refinancings of previously offered securities.”
That definition means the MBS deals analyzed in the SEC report were limited to private-label issuances secured by prime mortgages, such as high-balance mortgages or jumbo loans, for example. Through the first six months of 2021, the market share leaders based on prime residential MBS issuance, the SEC report shows, were as follows:
- Fitch, 48 deals with an aggregate issuance volume of $21.9 billion — or 68.1% market share based on loan-pool value.
- Moody’s, 39 deals valued at $21.8 billion — 67.9% market share.
- KBRA, 22 deals valued at $9.1 billion — 28.1% market share.
- DBRS, seven deals valued at $3.1 billion — 9.6% market share.
- S&P, six deals valued at $2.3 billion — 7.2% market share.
The report also shows that the prime residential MBS deals reviewed by the five rating agencies over the first six months of 2021 (a total of 72 deals valued at $32.2 billion) eclipsed the value of deals rated during all of 2020 (80 deals valued at $30.1 billion). In some cases, however, the SEC report stressed, more than one NRSRO may have rated a particular transaction, accounting for market-share figures exceeding 100% on a combined basis as well as any discrepancy between individual agency figures and MBS market totals.
“The highest market shares for the U.S. MBS segment have been achieved by two of the large NRSROs [Fitch and Moody’s],” the SEC report states. “KBRA and DBRS had achieved market shares of over 40% in this segment in 2019 but have since seen their market share decrease in 2020 and the first half of 2021.”
Still, KBRA and DBRS, according to the SEC, were quite active in residential MBS-issuance categories not included in the analysis. “For example, DBRS rated 69% of the re-performing mortgage transactions that priced in the first half of 2021,” the SEC staff report states.
“Additionally, DBRS and KBRA were active rating securities backed by subprime [now typically referred to as non-QM] mortgages and risk-transfer securities [such as agency credit-risk transfer deals] during the first half of 2021. For securities backed by subprime mortgages, DBRS rated 32% and KBRA rated 28% that priced during the first half of 2021; for risk-transfer securities, DBRS rated 50% and KBRA rated 14% that priced during the first half of 2021.”
ESG Analysis
Another area of overview in the report is ESG-related products and services offered by credit-rating agencies and their affiliates. The SEC staff report found some issues of concern on that front.
“Development in the area has grown rapidly, and competition has increased among NRSRO and non-NRSRO providers, leading the [SEC] staff to identify several areas of potential risk to NRSROs,” the SEC report states “These include the risks that, in incorporating ESG factors into ratings determinations, [credit rating agencies] may not adhere to their methodologies or policies and procedures, consistently apply ESG factors, make adequate disclosure regarding the use of ESG factors applied in rating actions, or maintain effective internal controls involving the use in ratings of ESG-related data from affiliates or unaffiliated third parties.”
Potential for conflicts of interest also exist, according to the SEC analysis, in cases where a credit rating agency “offers ratings and non-ratings ESG products and services. “
“Standardization has been a challenge, so an issuer may look to present their own [ESG] program a certain way based on how they do things,” said Roelof Slump, managing director of U.S. RMBS at Fitch Ratings, in a prior interview focused on the ESG market. “The issuers are not necessarily all working … to come up with one standard for the overall market.
“… The lack of standardization is something that’s been an obstacle, but it is still very early on [in the U.S.]. Europe is much further along on these things.”
The SEC report notes that KBRA recently published a white paper focused on the ESG market revealing that it “believes that ESG factors that impact credit risk need better disclosure….”
The KBRA report itself said ESG investing may have noble goals, such as moving the world toward a low-carbon economy, supporting social inclusion, and reducing inequities.
“However, the current challenges associated with ESG ratings may be leading to market distortions and difficulty in distinguishing bad ESG actors from good,” the KBRA white paper states. “There is no universally agreed upon standard by which E, S, and G factors are weighted, or, in many cases, even measured.
“Given the myriad risks and challenges, it is hard to imagine a single ESG score that encapsulates an issuer’s E, S, and G profile, because those things mean different things to different people.”
