The conflict of interest in the issuer-pays ratings model came under scrutiny during Congressional hearings in October over the failure of rating agencies to correctly assess the strength of structured credit products based on mortgage securitisations.
Jerome Fons, a former chief economist for Moody's Investors Service's mortgage-backed securities group, told the House Oversight Committee: "A large part of the blame can be placed on the inherent conflicts of interest found in the issuer-pays business model and rating shopping by issuers of structured securities."
The new rules will address this by imposing new 'Chinese walls' within the agencies. The agencies will no longer be allowed to rate securities if they have advised on their structuring; no-one within the agencies involved in developing ratings methods will be allowed into fee negotiations; and gifts from issuers to analysts will be banned.
Additionally, the SEC will also compel agencies to publish samples of their ratings – current and historical – for each major asset class. Agencies rating structured products will also have to provide all the information involved in the rating to their competitors.
The Commission said the rules were intended to "address concerns raised about the policies and procedures for, transparency of, and potential conflicts of interest relating to, ratings of residential mortgage-backed securities backed by subprime mortgage loans and collateralised debt obligations linked to subprime loans".
The crisis revealed there were significant differences between structured finance products and corporate bonds with the same credit rating. Most importantly, ratings of structured finance deals tended to be much more volatile. Rating agency Standard & Poor's said in July it would consider incorporating credit stability into its ratings, which would lead to sharp downgrades for many structured products.
Another S&P proposal, to distinguish structured finance ratings from other ratings by using a suffix, was not enforced by the SEC – to the delight of the Commercial Mortgage Securities Association, an industry lobby group. It commented: "Ratings differentiation... would create confusion, uncertainty and implementation issues that could affect liquidity."
But the new rules left untouched another major issue relating to ratings agencies – their apparent use of stricter standards for municipal debt than for corporate debt. This anomaly, among other effects, produced an important market for monoline bond insurers, which were paid to wrap municipal bonds up to AAA standard. But it also led to several lawsuits against the agencies this summer, with claims they operated a double standard that penalised municipal bond issuers dearly in monoline insurance premiums and credit enhancements. Moody's said in March this year it would shift to uniform rating standards for corporate and municipal debt.