Are Rating Agencies Forever Broken?

The group that helped lawmakers write the Credit Rating Agency Reform Act says the law isn't being enforced — and worries that even better enforcement might not be enough to rebuild market confidence in ratings.

Credit rating agencies could be one of the few organizations blamed for the recent credit crisis that will escape the heavy-handed treatment now being threatened by federal regulators.

The most recent report of the President’s Working Group, chaired by Treasury Secretary Henry Paulson, obliquely threatened new or stricter regulation for many financial institutions, but side-stepped the question of rating-agency regulation. The report suggested rating agencies may be doing enough on their own by making voluntary fixes to the way they rate structured financial products.

It wasn’t long ago that the government tried a fix of its own, passing the Credit Rating Agency Reform Act of 2006. But that law has basically sat dormant, says the Association for Financial Professionals, which helped draft the legislation. And the regulator tapped to enforce the law — the Securities and Exchange Commission — has done little to use its new regulatory powers, the AFP charges.

In letters to Securities and Exchange Commission Chairman Christopher Cox, the AFP has pleaded with the commission to “aggressively exercise its regulatory authority.”

Since the creditworthiness of mortgage-backed securities began to crumble last year, lawmakers have criticized the rating agencies for miscalculating the risks of the structured products and for being too slow in updating their assessments. The criticism echoes the response to the agencies’ missteps when they identified Enron as a good credit risk just days before the scandal-ridden energy giant filed for bankruptcy nearly seven years ago.

As a longtime advocate for reforming the rating agencies, AFP President and CEO James Kaitz says he is at his wit’s end to see a repeat of those problems. “What more can be done? It’s frustrating, very frustrating,” he said to CFO.com.

Kaitz hopes the SEC will enforce the powers it was given under the Reform Act. Yet even Kaitz admits he’s not sure how to fix the rating agencies. “This has kind of left us scratching our heads, looking for alternatives,” he says. “If there were 50 players in this marketplace, we wouldn’t be having this discussion.”

In fact, the number of players is in the single digits. The SEC has designated nine agencies as national recognized statistical rating organizations (NRSROs); and three of them — Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s Ratings Services — control the bulk of the credit-rating business.

“You don’t need any more regulation,” Kaitz says. “The Reform Act of 2006 gave sweeping authority to the SEC.”

Yet, under the Reform Act, the SEC has relatively few obvious tools at its disposal. The regulator can penalize rating agencies for wrongdoing but cannot second-guess their opinions. It can also withdraw their NRSRO ratings, but that would be the equivalent of handing out a rating-agency death penalty in an industry that is already criticized for having too few players. The law does give the SEC responsibility for making sure that rating agencies file proper disclosures and are consistent in their policies, procedures, and methodologies — all areas the SEC staff has been investigating for the past several months.

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