When the top brass of the world’s three biggest credit rating agencies were summoned to Washington by the Senate Finance Committee for a public grilling on a gray morning in late April, only one CEO showed up. To the growing ranks of skeptics of the credit rating industry, this seemed a blatant sign of a deeply entrenched arrogance rooted in an oligarchy of firms that for too long had not been held accountable for its work.
For months an international hue and cry had been raised in response to the subprime mortgage crisis. Critics at home and abroad were becoming increasingly vocal in lambasting the bond rating agencies, arguing that they had failed miserably at their duties by overvaluing all sorts of bad debt and issuing ratings that had led unsuspecting investors astray and perhaps even ruined some. Included in the broadsides were assertions that the agencies were guilty of conflicts of interest, issuing ratings on pools of structured debt that the agencies themselves had helped construct in hopes of expanding their market share.
The big bond rating agencies’ influence on investors is hard to overstate. Historically, they have been a crucial source of information for mutual funds, foundations, pension funds, hedge funds, even mom-and-pop bond buyers. But the recent criticism generally has it that the rating agencies — vital as they are — are often misinformed and seldom up to date.
Democrat Charles Schumer, the senior senator from New York, was livid at the April hearing, demanding to know why the chief executives of Moody’s and Standard & Poor’s hadn’t shown (Stephen Joynt of Fitch Ratings was the sole big-three CEO in attendance). “This is really serious stuff, the whole world is focused on these issues,” Schumer fumed. “For the CEOs not to come is very disappointing. They should be here.”
S&P and Moody’s, it seemed, had blundered by sending, respectively, an executive vice president and a managing director. Deference to the powers that be, after all, is probably the wisest strategy when the tide of public opinion turns. Detractors of the credit rating agencies have since called for management changes, and in early May, Brian Clarkson, COO and president of Moody’s, resigned. In recent years he had gained a certain notoriety for imposing new methodologies that assigned higher ratings to many mortgages and helped Moody’s increase its share of the market. His departure was met with approval by Schumer, among others, who said it gave Moody’s “a fresh chance to root out the practices that presented blatant conflicts of interest.”
Already, anger at the rating agencies resembles that directed against the big auditors that approved the books at Enron Corp. shortly before the huge energy company went belly-up in 2001, costing investors and employees billions. That scandal led to the Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board and led to tough new auditing and governance regulations. A similar backlash may be in store for the rating agencies.
There could be additional consequences. The Securities and Exchange Commission is investigating possible wrongdoing, as are a number of congressional committees. At issue is whether the agencies were guilty of something like what Wall Street firms did during the dot-com boom, when they routinely issued buy ratings on the very companies that paid them for their investment banking services. Collectively, ten firms agreed in 2002 to pay a $1.4 billion fine and to sever the ties between their research departments and their investment banking operations.
There is no question that the rating agencies contributed to the subprime crisis. First, they issued generally overly optimistic ratings on subprime debt. That encouraged a broad swath of investors to buy into such investments. Second, their subsequent downgrades, in which subprime holdings received junk ratings, created a cascading effect as many institutional investors — because of regulatory requirements — were no longer able to hold the securities once they dropped below investment grade. These securities streamed into a glutted market in which prices had already tanked. Losses begot losses, and the credit markets collapsed.
The three main agencies enjoy a unique and privileged position as gatekeepers to the financial markets. “There is no competition to speak of, no liability, and even if their reputation is poor, you have to use them,” says John Coffee, a highly regarded expert on securities law at Columbia Law School.
This oligopoly exists in part because the SEC for a long time kept the credit rating business a closed shop. The commission introduced the Nationally Recognized Statistical Rating Organization imprimatur in the 1970s for agencies whose credit ratings were recognized by regulators. But the SEC was slow to accept new players --— it didn’t precisely define the criteria for being an NRSRO until 2003, two years after Enron’s demise -— and the number of qualifying agencies dwindled through mergers, from seven in the 1980s to the big three as this decade began. Competition among the top players was further dampened by the fact that many bond issuers typically seek at least two ratings on their securities; Moody’s, S&P or Fitch were likely to get a piece of the action on any deal, regardless of whether they deserved it.
After Enron, and particularly after the passage of the Credit Rating Agency Reform Act of 2006, the SEC began recognizing new NRSROs, and six small ones have joined the big three: A.M. Best Co.; Dominion Bond Rating Service; Japan Credit Rating Agency; R&I (Rating and Investment Information); Egan-Jones Ratings Co. and LACE Financial. The 2006 act gave the SEC sweeping new powers over the agencies, which the regulator in its own plodding way is just beginning to implement. SEC chairman Christopher Cox has promised that the commission will propose several new rules this summer. Chief among them: a requirement to disclose past performance.
The SEC may also prohibit such conflicts of interest as an agency’s offering consulting services to companies whose bonds it is rating. And it may require disclosure of details on the underlying assets behind a rating and how the agencies keep their business departments from influencing ratings analysts, as well as greater transparency on analytical methodologies and procedures used to monitor ratings and keep them up to date (staleness of ratings is a main criticism of the agencies).
Lawmakers, for their part, have expressed outrage over the rating agencies’ failure to do due diligence on the underlying assets of the mortgage securities they rate. They leave that to other parties like the mortgage originator or the underwriters. Congress is likely to insist that the rating agencies at least dip into the asset pool and verify some of the documents in question, perhaps through the use of third-party experts on due diligence.
Even regulators and critics outside the U.S. are weighing in. The Madrid-based International Organization of Securities Commissions in March proposed several changes to how rating agencies are regulated, including requirements for an independent review of methodologies and a ban on analysts’ proposing structural changes to products they are asked to rate. “The role played by credit rating agencies in the development of the market for structured finance products has raised serious issues for regulators globally,” says Michel Prada, chairman of the IOSCO committee that produced the recommendations. “These changes are required in order to ensure that investors and the financial markets can have confidence that credit rating agencies are producing clear, well-researched ratings, free from bias, that can be easily understood by their users.”
The proposed reforms may portend a larger crackdown. Among the questions being asked is whether the rating agencies are guilty of bad judgment or if something more sinister is afoot. One area the SEC is exploring is whether the rating agencies followed their own protocols on rating mortgage securities or whether they were led astray by conflicts of interest. The potential for such conflicts is much greater in rating mortgage securities than in rating corporate or government bonds, the other two main categories of debt. No single corporate or municipal debt issuer has enough market share to give it the heft to sway rating agencies. But most mortgage security products were issued by a handful of powerful investment banks, including Bank of America, Bear Stearns Group, Citigroup, Deutsche Bank, Merrill Lynch & Co. and Wachovia Bank. These firms could avail themselves of the agencies’ commercial services and consult with them about their methodologies and then adapt a product to achieve an investment-grade rating.
These structured finance products represented a strong growth sector for the rating agencies. An analysis by Frank Partnoy, a University of San Diego corporate law professor, shows that Moody’s revenue more than doubled from 2000, when it went public, to 2004, in large part because the agency built up its structured products business. By September 2005, Partnoy notes, Moody’s, with 2,500 employees, had a market capitalization of $15 billion — the same as Bear Stearns, which had 11,000 employees.
As pools of debt that included subprime mortgages but carried triple-A ratings were unmasked last year, calls for reform of the rating agencies multiplied. SEC chairman Cox offered some of the most critical testimony in an appearance before the Senate Banking Committee in February.
“Regulators, including the commission, have increasingly used credit ratings as a proxy for objective standards for monitoring the risk of investments held by regulated entities,” he said. “The recent market disruptions highlight the limitations of this arrangement.”
It’s unlikely that credit rating agencies will be the only ones to feel the hammer, says Richard Baker, the former Republican congressman from Louisiana who recently became chief executive of the Washington and New York–based Managed Funds Association, the main voice of the hedge fund industry. “There’s enough fault to go around at every level in the marketplace,” he adds. The mortgage originators, the investment banks that packaged the securities, the underwriters, the auditors and the investors all played a role in creating the crisis, Baker and other critics say.
If ever there was a favorable time for reform, this is it, though defenders of the status quo say alternatives won’t be easy to find. “The great attraction of ratings is that they are simple,” notes Paul Coughlin, executive managing director for corporate and government ratings at S&P. “They digest a lot of complex information.”
The allure of ratings, in other words, is that they are user-friendly, though Coughlin and others say they have far greater value than that. A rating agency’s analysis of a particular security, say those who provide them, can contain details that go beyond the risk of default, which is all a credit rating measures, though investors often pay little attention to the fine print. “People still
want to know, Is it single-A or double-B,” Coughlin says.
One of the reforms the SEC is floating is the use of a different scale of symbols for different types of assets — corporate bonds, munis, collateral debt obligations and so on. Coughlin counters that almost all the feedback S&P has received suggests that investors prefer the single scale.
The rating agencies for their part say they want to better educate investors. “Regulatory references to credit ratings don’t dictate investment strategy,” says Deborah Cunningham, chief investment officer for money markets at Pittsburgh-based Federated Investors and co-chair of a task force formed by the Securities Industry and Financial Markets Association, a New York trade group that represents the industry. Cunningham says the ratings are one investment factor among others: “It’s not the end of the process.”
Columbia law professor Coffee cautions that, although reforms can bring new entrants to the field, true competition will probably increase only slightly. “It’s hard to build the reputational capital,” he says. Skeptics need only consider the much-ballyhooed reforms imposed on the auditing industry after the Enron debacle, which set off the collapse of Arthur Andersen, one of the original big-eight accounting houses. Coffee notes that today four firms dominate the industry.
