Challenging times for credit ratings monopoly

The ratings market has been dominated by S&P and Moody's, but investors are now calling for a greater choice

Ten years ago, LACE Financial, a small Maryland-based company that issues credit ratings for banks and other financial institutions, asked US regulators for some recognition. It wanted status as a "nationally recognised statistical ratings organisation" (NRSRO) - a coveted designation that it believed would enable it to compete better with larger rating agencies such as Moody's Investors Service and Standard & Poor's.

In the eight years it took for the Securities and Exchange Commission (SEC) to decide on its application, LACE says it received only two letters from the regulator: one acknowledging acceptance of its application in 1992 and another in 2000 denying it NRSRO status.

While Moody's and S&P dominated the market for credit ratings throughout the 1990s, LACE remained exasperated by its inability to compete on the same basis. It was only last month, when the SEC threw the floor open for public debate on the role of the credit rating agencies for the first time, that the frustrations harboured by LACE and other small agencies were at last allowed to be aired.

For decades, the US credit ratings market has been ruled by the NRSRO agencies, Moody's and S&P, while a third NRSRO designee, Fitch Ratings, has struggled to break what it describes as a "dual monopoly".

S&P and Moody's have a combined global market share of almost 80 per cent, while Fitch has just 14 per cent. Moody's revenues quadrupled from less than $200 million (€198.2 million) in 1990 to $797 million in 2001, while S&P took some $870 million in revenue last year. Investors readily relied on the analyses of the two leading agencies and did not seriously question their ratings practices until Enron collapsed late last year.

Moody's and S&P still had Enron rated as "investment grade" - supposedly a sign of strong creditworthiness - a week before it defaulted. In the post-mortem of Enron, the agencies insisted they could not be expected to detect fraud. Yet the failure of the agencies to inquire more closely into the energy company's off-balance-sheet transactions has spurred greater scrutiny by investors and regulators of the credit ratings business.

Over the past year, the NRSROs have made minor changes to their practices to improve their analysis and pacify investors but their dominance has not been challenged. That may soon change as regulators consider opening the market to more competition - a move already demanded by some of the US's biggest corporate bond issuers.

"I would be happier if I had six [agencies to choose from]," Mr Malcolm Macdonald, treasurer of Ford, told the SEC at a hearing on the role of the rating agencies last month. "I would like the idea that if I found one incompetent, I could get rid of them."

The SEC held the hearings after the passing of the Sarbanes-Oxley Act earlier this year. The Act requires the SEC to undertake a study of the rating agencies and report back to Congress and the president by January 26th.

Ms Annette Nazareth, director of the SEC's division of market regulation, conceded at the hearings that the debt markets remained a "dark corner" of the securities industry, lacking the equity markets' transparency.

In the past, NRSRO status has been held by as many as seven companies but that number has fallen to three in recent years as agencies have merged or been acquired.

Barron Putnam, LACE president, told the SEC that the greatest barrier to entry into the rating industry was "the SEC itself" because its rules restrict some companies and investors from using the ratings of non-NRSRO agencies.

The SEC has acknowledged this barrier to entry but is grappling with how exactly to open up the market. It has several options. It could simply give more companies NRSRO status. The badge is considered a sign of credibility.

"There are still companies that would like to see us with the NRSRO designation before they'll do business with us," says Mr Larry Mayewski, chief rating officer at AM Best, which rates insurance companies.

Other companies that have tried, unsuccessfully, to obtain NRSRO status include Egan-Jones Ratings and the Dominion Bond Rating Service.

Egan-Jones, which rated Enron at "junk" status a month before Moody's and S&P did so, interprets the acronym NRSRO as "No Room - Standing Room Only".

The current NRSROs say they are not frightened of more competition but stress that any newcomers would need a proven record in rating debt to be accepted by the markets. "The more rating agencies the better," says Mr Leo O'Neill, president of S&P. "The market will decide if they are recognised or not."

Extending the number of official rating agencies could encourage "ratings shopping" - an issue the existing NRSROs are keen to publicise. "Historically, new market entrants and marginal participants have sought to make their products more attractive to issuers by offering higher ratings than do more established market participants," Mr Raymond McDaniel, Moody's president, said in his submission to the SEC.

Other options available to the SEC include providing smaller agencies with some form of limited recognition, acknowledging their expertise in select areas such as banking. This option, however, is not popular with the smaller agencies, which do not want to be considered "second-class".

The SEC could also get rid of the NRSRO designation altogether, although some investors counter that the rating agencies need more regulation, not less.

The question of accountability has loomed large in investors' minds this year owing to the extraordinary volatility in the corporate bond markets and the record level of bond defaults. The NRSRO agencies, which a year ago were criticised for not downgrading troubled companies fast enough, have more recently been accused of being too quick to take action and of exacerbating volatility in the markets.

The other message to the SEC hearings was that investors would like more transparency in the ratings process. The NRSROs are exempt from regulation fair disclosure - the SEC ruling that requires any dissemination of material information to be made public.

The exemption allows the NRSROs to obtain confidential information from debt issuers and use this in their analysis without disclosing it publicly. Investors say they become worried when they see the agencies taking ratings actions without explaining their reasons clearly. "We don't like the agencies having access to information that we do not," says Ms Cynthia Strauss, director of taxable bond research at Fidelity Investments Money Management. "We want companies to make public what they disclose to the agencies."

There is no easy solution for improving transparency because issuers say that if they are not allowed to disclose the information privately, they would not disclose it at all for fear of releasing information that could be used by their competitors.

The SEC is, meanwhile, scrutinising the NRSROs for potential conflicts of interest. The NRSROs receive most of their revenues from the issuers whose debt they rate. Fees received by Moody's for rating corporate bonds range between $25,000 and $125,000, while fees of $500,000 for rating structured finance transactions "are not unusual", according to the agency.

"The fact that the agencies have a business model that allows them to get paid regardless of the quality of product they deliver to the market - all the while insulated from securities litigation and competitive inroads by new market entrants - makes for a great equity story but not necessarily a very good market watchdog," Mr Glenn Reynolds, chief executive officer of independent credit research firm CreditSights, told the hearings.

The NRSROs admit that the model represents a "latent" conflict of interest because the burden rests with the agency to maintain its independence. But they claim that the ratings they assign are not affected by commercial relationships with issuers and that there is no relationship between their analysts' compensation and the revenues they receive from issuers.

They say that if their independence were compromised, so too would their reputation.