The staff of the SEC summarizes its findings as follows:

(1) there was a substantial increase in the number and in the complexity of RMBS (residential mortgage-backed securities) and CDO deals since 2002, and some of the rating agencies appear to have struggled with growth;

(2) significant aspects of the ratings process were not always disclosed;

(3) policies and procedures for rating RMBS and CDOs can be better documented;

(4) the rating agencies are implementing new practices with respect to the information provided to them;

(5) the rating agencies did not always document significant steps in the ratings process – including the rationale for deviations from their models and for rating committee actions and decisions – and they did not always document significant participants in the ratings process;

(6) the surveillance processes used by the rating agencies appear to have been less robust than the processes used for initial ratings;

(7) issues were identified in the management of conflict of interest and improvements can be made; and

(8) the rating agencies' internal audit processes varied significantly.

The SEC staff performs a disservice when they present these eight findings as if they are on an equal footing; clearly, they are not. The fundamental problem with credit ratings is the conflict of interest caused by the issuer's paying the rating agency. Because such a conflict of interest exists, various potential problems surface since employees—in particular managers and analysts—know how they are compensated. Even if the credit rating agency is smart enough to avoid direct linkages between compensation and ratings, there nevertheless is an association. All employees know that their continued employment, their salaries, and their promotions depend upon their contributions to the real business of the organization.

Thus, the seventh point made by the SEC staff is the most important finding, while the other items are mere artifacts of that institutional arrangement. Given the issuer-pay-model, we should expect less than complete documentation and disclosure because it enables the credit rating agencies to do what they can to maximize profits, so (2), (3), and (5) are not new insights. The money is generated at the initial rating, so why would anybody expect much surveillance (6) or internal auditing (8)? Why is increase in number and complexity of deals (1) even an issue as this is how investment banks make money? And what is the point of saying rating agencies are implementing new practices (4) as one would expect competitive enterprises to be innovating new ideas to compete in the market place? While these facts provide some detail about the practices in this industry, it doesn't get at the core problem.

Worse, these findings aren't much different from the 2003 SEC report on credit rating agencies entitled "Report on the Roles and Function of Credit Rating Agencies in the Operation of the Securities Markets." Why do government agencies continue to recycle inadequate analyses of problems instead of getting at the underlying issues? Has the SEC become powerless?

The staff produces a number of remedial actions throughout the report. With respect to the conflict of interest issue,

The Staff recommended that each [credit rating agency] examined review its practices, policies and procedures for mitigating and managing the "issuer pays" conflict of interest. In particular the Staff recommended that each [credit rating agency] examined consider and implement steps that would insulate or prevent the possibility that consideration of market share and other business interests could influence ratings or ratings criteria. (page 27)

I find this counsel so underwhelming. It would be like the NFL asking the New England Patriots to review its practices, policies and procedures to ensure that its coaches don't videotape the signals of other teams. Such a recommendation might be quickly endorsed by Bill Belichick, but who cares?

The real solution is simple and existed prior to 1970. Require the credit rating agencies to charge the users of its information instead of charging those they investigate. The conflict of interest is completely removed. Not only that, but you reinstate a market mechanism: if the users really want the information, they will pay for it. And if the market has sufficient competition, the price will be the value of the information.

Relevant SEC documents:

• Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies, Staff of the SEC (July 8, 2008)
• Report on the Roles and Function of Credit Rating Agencies in the Operation of the Securities Markets, SEC, as required by Section 702 (b) of the Sarbanes-Oxley Act of 2002 (January 2003)

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.