House Approves Rating Agency Shakeup

In a move that could drastically alter the landscape for Moody's and S&P, the House passes a bill intended to open up the credit rating business to more firms.

The U.S. House of Representatives approved a bill Wednesday — aimed squarely at Moody’s and Standard & Poor’s — that would alter the regulatory landscape for all credit-rating agencies.

The “Credit Rating Agency Duopoly Relief Act of 2006″ was approved by a 255-166 vote. If the bill also passes the Senate, the Securities and Exchange Commission’s ability to designate credit rating agencies as NRSROs, or “nationally recognized rating agencies,” will be abolished. Instead, a credit rating company with three years of experience that meets certain standards would be allowed to register with the SEC as a “statistical ratings organization.”

At the same time, the bill grants the SEC new authority to inspect credit rating agencies, although the commission would have no say over their rating methodologies.

Of the more than 130 credit-rating agencies, the Securities and Exchange Commission has granted only five the designation of Nationally Recognized Statistical Rating Organizations (NRSROs): A.M. Best, Dominion Bond Rating Service, Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s. Moody’s and S&P control 80 percent of the market, according to the House committee that moved the bill out to a full House vote.

Rep. Michael Fitzpatrick, a Republican from Pennsylvania who sponsored the bill, says he believes it would allow more qualified firms to enter the industry, improve ratings through competitive forces, and lessen the probability that another corporate scandal could occur without raising red flags.

“It is extremely disturbing that the two largest credit-rating agencies, Moody’s and S&P, rated Enron and WorldCom at investment grade just prior to their bankruptcy filings,” said Fitzpatrick in a statement earlier this month. “The lack of competition in the credit-rating industry has lowered the quality of ratings, inflated prices, stifled innovation, and allowed abusive industry practices and conflicts of interest to go unchecked.”

Among the abusive practices alleged by Fitzpatrick and other members of the house are the practice of sending a company unsolicited ratings with a bill; notching, which occurs when a firm lowers ratings on asset-backed securities unless the firm rates a substantial portion of the underlying assets; and tying ratings to the purchase of additional services.

The bill was strongly supported — and, in part, written — by the Association for Financial Professionals. Testifying before Congress recently, AFP president James A. Kaitz said the SEC’s existing recognition process had created an “artificial barrier” for other companies that wanted to enter the rating agency business. “This barrier has lead to a concentration of market power with the recognized rating agencies and a lack of competition and innovation in the credit ratings market,” he said.

Treasurers, who make up the bulk of AFP’s membership, are the finance executives who tend to deal most directly with the credit rating agencies. According to Kaitz’s testimony, the registration criteria in the bill is based on AFP’s recommendations.

S&P, which objects to the bill, has argued it represents an unconstitutional infringement of the company’s free speech. In recent testimony before Congress, S&P General Counsel Rita M. Bolger said the bill represents a licensing regime that “is not constitutionally viable. Publishers are free, by long-standing case law, to freely disseminate their opinions. And rating agencies are members of the financial press, the financial press being equally protected by case law.”

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