Over Rated?

The subprime fiasco has put corporate credit-ratings on thin ice.

Gaming the system remains common, some critics charge. While investors don’t have direct influence over the analysts, their presence as the end user of a rating is felt, leading to perhaps unjustified delays in downgrades or reversals, says Jerome Fons, managing director of credit policy at Moody’s until August 2007. “It’s ultimately a no-win situation for the agencies, because every time you change a rating, you’re going to upset someone,” he says.

Moody’s, S&P, and Fitch have already agreed with New York State Attorney General Andrew Cuomo to halt a “don’t ask, don’t tell” policy that winks at the condition of mortgage pools supporting mortgage-backed debt. Agencies will also crack down on abusive “rating shopping” by charging fees to all customers whether or not they accept the ratings, and will adopt proposed SEC rules that improve the transparency of financial information.

European Union regulators are seeking new layers of oversight as well. Undercurrent plans, the Committee of European Securities Regulators would require a formal registration from each agency and would then monitor them for compliance with conflict of interest rules, among other actions.

That’s not good enough, say critics, who dismiss the proposed initiatives as temporary, Band-Aid measures. Josh Rosner, managing director at independent investment research firm Graham-Fisher, warns that rating agencies could still use semantics to bend rules about product categories or performance thresholds. The problem is, more may not be better. “It’s a fine line,” says Fons, “between a regulator saying ‘Do it this way’ and ‘Assign this rating.’” Some proposed legislation has gone so far as to prohibit Triple-A for structured products.

Competition from a cadre of new, nimble rating agencies could challenge the Big Three in certain industries or categories. The SEC has conferred its nationally recognized statistical rating organization (NRSRO) designation on 10 firms, among them Egan-Jones, Realpoint, and Lace Financial. But Moody’s alumnus Fons says the answer lies not in competition, but in monopoly. “In the best of all worlds, there would be just one not-for-profit rating agency, and they’d get it right,” he says. “Right now, rating agencies tend to compete not on the quality of ratings but on the quality of service to debt issuers.”

The perennial question as to whether rating agencies are biased because they are paid by the companies they rate has come up again. Attempts were made in the 1970s to charge investors, the consumers of the ratings information, for that data, but the effort floundered. Fons maintains that such a model is unfeasible because investors can’t provide the funding needed to maintain the leagues of analysts and high-touch company interactions that the agencies have developed.

Others maintain it’s the wave of the future. “The [investor-paid] model has been working really well for us for the past seven years, and I think it will go a long way toward improving investor confidence in the marketplace,” says Robert Dobilas, CEO of Realpoint, the most recently anointed NRSRO. He says Realpoint’s subscription revenue covered the firm’s ongoing costs by the end of its first year.

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