More than 30 years ago, the Securities and Exchange Commission required securities dealers to evaluate investment risk using ratings from only a handful of providers, designated as nationally recognized statistical rating organizations. Unintentionally, the SEC in effect established a government-accredited oligopoly with virtually insurmountable barriers to entry.
Now, the regulator is looking at reversing time by expanding the number of top-tier raters beyond Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. Those three are currently considered NRSROs, along with seven other firms that the Big Three dwarf in size and impact. During a roundtable today, the SEC commissioners explored how improving competition could possibly lead to more accurate ratings.
The largest firms have been criticized for not acting quickly enough to accurately depict the creditworthiness of complex financial products tied to the subprime-mortgage market before the financial crisis hit. In retrospect, these securities clearly had a higher risk of default than the agencies reported at the time.
Ideas posed by academics, trade lobbyists, and the raters themselves during the meeting could lead to changes in the way companies view the agencies that grade the creditworthiness of their bonds. Several of the ideas could threaten the livelihood of some of the NRSROs. And some of the proposals — such as taking out NRSRO references in various government regulations for various investing groups — could poke a hole in the power investors give the raters’ reviews.
Among the proposals to make the raters more accountable and their business more transparent were these: require all firms, even those whose business relies on subscription fees, to publicize their ratings or publicly track their accuracy over time; create an independent review board to oversee the agencies, similar to the Public Company Accounting Oversight Board’s role over auditing firms; require issuers to rotate rating agencies every three years; and eliminate the NRSRO reference from regulations that govern the types of investments banks, insurance companies, and other regulated entities can make.
It’s unclear which direction the SEC will take and whether it will propose new regulations on top of the five rulemakings for the ratings industrty that it has made in the past two years. However, from the discussion today it appears the SEC is not done with this subject. In her opening statement, SEC chairman Mary Schapiro said, “the role of credit rating agencies must be an area for our intense review as we think about how to promote investor protection and market integrity, and restore confidence in our financial system.” Dan Gallagher, deputy director of the SEC’s trading and markets division, said the commission will consider the points raised at the hearing during the year.
Much of the discussion centered around the Big Three agencies’ conflicts of interest and whether it’s possible to overcome a business model that relies on fees from securities issuers seeking the highest possible ratings and that may shop around among firms to get the best possible rating. “The issuer-pay model, if left alone in the form it is today, is broken,” said Damon Silvers, associate general counsel for the AFL-CIO and deputy chair of the Congressional Oversight Panel, which oversees the Treasury Department’s Trouble Asset Relief Program. The panel has suggested to lawmakers that a PCAOB-type board be created to keep the raters in line.
Sean Egan, managing director of Egan-Jones Ratings, pressed the SEC to require that all NRSROs adopt his business model, which relies on subscriber fees, an argument he has made for many years. He claims his firm’s ratings are more accurate than issuer-pay competitors because his analysts’ views aren’t tainted by the people paying his bills.
Not surprisingly, Egan’s belief that the SEC could cure the ills of the rating industry by changing business models doesn’t wash with the larger firms, whose leaders tried to convince the SEC that all the options for running a ratings business have conflicts of interest. For example, S&P president Deven Sharma noted that Egan’s business is also conflicted since some investors may want lower ratings for some securities so that they can later realize a higher return.
Egan called that argument “a red herring” that couldn’t withstand scrutiny. His firm is rarely aware of its clients’ investment interests and positions and therefore can’t be swayed by their preferences, he said. “It’s misleading, disruptive, and unproductive to say that there are conflicts of interest on both sides when the reality is there are none if you’re doing your job properly,” he added.
During the meeting, S&P’s spokesman sent out an e-mail further disputing Egan’s claims, saying that a small number of large investors could “attempt to wield significant influence over a rating” at an agency that relies on subscriber fees.
To be sure, the largest rating agencies won’t take it kindly if they’re forced to change their business model. In fact, they’ve already tried Egan’s way. Moody’s relied on investor fees for 50 years, until the 1970s, when technology made it easy for subscribers to reproduce the firm’s work and they became increasingly reluctant to pay for the service. CEO Raymond McDaniel says that the change actually resulted in more accurate ratings for corporate bonds.