Credit rating agencies (CRAs) provide investors with evaluations of the creditworthiness of debt (i.e., how likely a debt is to be repaid in full) issued by a wide spectrum of entities, including corporations, sovereign nations, and municipalities. Their ratings are typically a letter hierarchical format (e.g., AAA as the safest, and progressively lower grades—AA+, AA, AA-, A+, A, A-, BBB, all the way down to D—representing greater risk). For regulatory and investment purposes, ratings are placed into two broad categories. Investment grade debt is rated BBB- or Baa3 (depending on the CRA) or higher. Noninvestment grade debt (also known as "high yield" or "junk" bonds) has a rating below these benchmarks and is generally associated with higher risk firms. This In Focus examines CRAs, their regulation, and related policy issues.
Background and Early Regulation
In 1975, the Securities and Exchange Commission (SEC) adopted the designations of nationally recognized statistical rating organizations (NRSROs). NRSROs were originally used to help determine capital charges on different grades of debt securities held by broker-dealers under the SEC's net capital rule (Rule 15c3-1 under the Securities Exchange Act of 1934). The net capital rule is aimed at ensuring that broker-dealers maintain sufficient liquid assets to promptly satisfy their liabilities if needed.
When the SEC began using ratings to enforce the net capital rule in 1975, the SEC staff, in consultation with agency commissioners, determined that the ratings of the three dominant agencies—Standard & Poor's (S&P), Moody's, and Fitch—were nationally used and were thus generally considered NRSROs with respect to SEC enforcement of the net capital rule. Between 1975 and 2000, the SEC added four more NRSROs to the original three. The SEC never defined the term NRSRO or specified how a CRA might become one. Its approach was essentially described as one of "we know it when we see it." As of March 2024, there were 10 NRSROs—three categorized by the SEC as "large" (S&P, Moody's, and Fitch) and garnering 91% of revenue—three as "medium," and four as "small."
In 2006, Congress passed the Credit Rating Agency Reform Act (P.L. 109-291), which amended the Securities Exchange Act of 1934 to try to improve ratings quality for the protection of investors by fostering accountability, transparency, and competition in the credit rating industry. Among other things, P.L. 109-291 added Section 15E to the Securities Exchange Act, which established SEC oversight over those CRAs that register as NRSROs. It also provided the SEC with examination authority and established a registration program for CRAs seeking NRSRO designation. NRSRO applicants and registered NRSROs were required to disclose ratings performance, conflicts of interest, and the procedures used to determine ratings. Under the law, the SEC was also authorized to conduct annual deficiency and compliance examinations at NRSROs, which are not publicly identified.
The Financial Crisis and Dodd-Frank Changes
In the run-up to the financial crisis of 2007-2009, the provision of investment grade ratings by the three dominant CRAs—S&P, Moody's, and Fitch—for structured finance securities was widely seen as a critical part of the process of structuring the residential mortgage-backed securities (MBS) and collateralized debt obligations that held subprime housing mortgages. The issuance of private MBS reportedly grew from $126 billion in 2000 to $1.145 trillion in 2006.
Various reporting, including the 2011 Financial Crisis Inquiry Report, argued that the three leading CRAs fundamentally failed in their ratings of these securities, exacerbating the market collapse. During the housing boom preceding the financial crisis, the CRAs often gave top-tier AAA ratings to many structured securities only to downgrade many of them later to levels often below investment grade. CRA ratings on corporate bonds reportedly did not encounter the same problems. Criticism of the CRAs, however, was not universal. A frequent defense of their failings was that their rating missteps could be traced in part to their view that rising housing prices would be sustained, a perspective also said to be held by a number of respected financial market observers at the time.
Critics of CRAs argue that overly favorable ratings were in place heading into the crisis because of the issuer-pays model used by the CRAs. CRAs are typically paid by the issuers of the securities being rated by the agencies, which many see as a conflict of interest (Financial Crisis Inquiry Report, 2011). Rating structured finance became a substantial revenue generator for the CRAs. For example, according to some reporting (Morgenson, New York Times, 2008), by the first quarter of 2007, such ratings constituted 53% of Moody's total revenue. In addition, "ratings shopping"—wherein structured finance issuers shopped for CRAs offering potentially more favorable ratings—may have played a role (Zhou and Kumar, 2012). Other possible causes of the allegedly inflated structured product ratings included the following:
The Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) was enacted to help ensure that another financial crisis did not occur and to "promote the financial stability of the United States by improving accountability and transparency in the financial system." Among other things, the act provided for regulatory measures to address factors perceived as playing a role in the CRAs' alleged ratings inflation of structured securities.
The act contains provisions aimed at enhancing SEC regulation of CRAs. Among these, it established the SEC Office of Credit Ratings; imposed new reporting, disclosure, and examination requirements on NRSROs; required NRSROs to disclose their ratings methodology; required ratings analysts to pass qualifying exams and undergo continuing education; gave the SEC authority to deregister an NRSRO; and required that half or more (but not fewer than two) of the directors of an NRSRO's board, which approves NRSRO procedures and rating methodologies, be independent of the NRSRO.
In addition, in an attempt to help remedy the perceived issuer-pays model bias, the act directed the SEC to study alternative approaches to NRSRO compensation. After the study, the SEC was authorized to issue rules for a system that randomly assigned NRSROs to do initial credit ratings and then provide subsequent ratings monitoring for structured finance products. The 2012 SEC staff study found that the random assignment model could mitigate issuer-payer conflicts but also might fail to do so because issuers could continue "rating shopping" and hire other NRSROs to provide supplemental credit ratings. At the time, the SEC opted not to pursue rulemaking on the random assignment mechanism.
To help enhance CRA ratings' accountability, the act also assigned liability to NRSROs through the provision of private rights of action while no longer shielding them from "expert liability" status, which imposes liability on accountants and other experts for material misstatements or omissions in corporate registration statements. Historically, CRAs were shielded from that expert liability due to the view that their ratings issued were opinions and entitled to protection under the First Amendment.
In 2010, when newly subject to the expert liability status, the three major CRAs opposed giving their consent to their ratings appearing in issuer prospectuses and registration statements for asset-backed securities such as MBS. This raised the prospect of a shutdown of the securitization market. The SEC responded with "no action" letters that effectively indefinitely rescinded the NRSROs' "expert liability" status for ratings of asset-backed securities, and these rescindments are still in effect.
The act also attempted to reduce reliance on credit ratings by directing federal agencies to remove specific references to NRSRO-assigned credit ratings in their regulations and guidance while also adopting alternative schemes. In the ensuing years, most agencies have reportedly done so. However, a Federal Reserve response to the economic and financial turmoil from the COVID-19 pandemic stood in contrast to the move away from ratings references in regulation. In early 2020, the Federal Reserve created several emergency corporate lending facilities. Under them, a corporate recipient was required to have investment grade debt rated by "major NRSROs."
Later Market and Regulatory Developments
In February 2024, the SEC's annual report on NRSROs warned of several financial risks that staff found through their NRSRO assessments. One was that the increase in interest rates since 2022 had increased debt service payments for highly leveraged companies, putting them under financial stress and rendering NRSRO's monitoring of low-rated or highly leveraged companies an important area for SEC examination. Another area flagged for SEC examination was NRSRO's surveillance of collateralized loan obligations and securitizations backed by auto loans and consumer assets, given potential impacts on credit quality from the interest rate increases. In its examinations of NRSROs, the SEC also found a number of material deficiencies. These included nine instances of failures to sufficiently address conflicts of interest; eight findings implicating poor disclosure; six findings related to internal control issues; three findings on insufficient retention or production of records; and two findings regarding the misuse of material, nonpublic information—indicating that some problems still percolate within the industry.
On June 1, 2020, the SEC's Credit Ratings Subcommittee of the Fixed Income Market Structure Advisory Committee recommended some NRSRO reforms: (1) expanding NRSRO disclosure, (2) enhancing issuer—corporate and securitized—disclosures, and (3) adopting a scheme for bondholders to ratify issuer-selected NRSROs. On July 21, 2021, the House Financial Services Committee held a hearing that examined NRSROs. One academic witness at that hearing called for further reforms of NRSROs to address continued issues such as conflicts of interest through the issuer-pays model, lack of liability, high concentration, and lack of transparency in the industry.
The author gratefully acknowledges Gary Shorter, now retired, for his work on the original version of this product.