The investigation of Moody's, Fitch and Standard & Poor's started in August 2007, as the crisis in subprime residential mortgages in the US became a widespread concern in the markets.
The report identifies significant failings in several areas, but one of its main observations is that the growth in RMBS and collateralised debt obligation (CDO) deals that were submitted for ratings from 2002 onwards meant the agencies struggled to keep pace. While staffing levels increased incrementally with growth in RMBS, the same cannot be said of CDOs, said the SEC.
"With respect to CDOs ... two rating agencies' staffing increases did not appear to match their percentage increases in deal volume," says the report. "The structured finance products that the rating agencies were asked to evaluate also became increasingly complex, including the expanded use of credit default swaps to replicate the performance of mortgage-backed securities."
The report also states that internal documents show two rating agencies issued ratings on some products even though outstanding issues were raised during the analysis of the deals.
The SEC also anonymously quotes an email from an analytical manager in an agency's CDO group referring to an "even bigger monster - the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters. ;o)" in a footnote in the report.
Other emails refer to pressures related to the sheer volume of deals. It also refers to documents that show that "out of model" rating adjustments were often made, meaning rating agencies' full criteria for ratings were not wholly disclosed in many cases. In addition, the report identifies an issue of "less robust" surveillance procedures and documentation compared with initial ratings processes.
"We've uncovered serious shortcomings at these firms, including a lack of disclosure to investors and the public, a lack of policies and procedures to manage the rating process, and insufficient attention to conflicts of interest," said Christopher Cox, chairman of the SEC, in a release issued on July 8.
The regulator had already required the agencies to register in September last year, and has now recommended action be taken on each of the points raised. Among other things, the SEC will monitor staffing and resources, including surveillance, disclosures relating to processes and methodologies, the conflict of interest arising from the fee structure and the internal auditing processes.