VideoHaving long bestowed upon corporate bonds a measure of credibility, embattled rating agencies are now fighting to retain their own. Cascading credit problems triggered by catastrophic (but highly rated) subprime-mortgage loans have prompted observers to ask whether the agencies furnish reliable benchmarks or perilous illusions of safety.
The Big Three — Moody's, Standard & Poor's, and Fitch — have suffered their share of black eyes over the years. In the 1980s, leveraged buyouts transformed double-A bonds to junk overnight. Later, dubious structured finance vehicles proliferated with few, if any, caveats. And Enron plunged into bankruptcy still sporting an investment-grade rating. But today, the subprime mess, a subsequent Securities and Exchange Commission investigation, and other problems have the agencies on the ropes like never before.
Even some of the agencies' executives concede that their once-commanding voice has lost authority. S&P's president recently advised investors to do "more of their own research," indicating that ratings should be merely a starting point for independent analysis.
Far more telling than the agencies' newfound modesty, however, may be the shift in corporate attitudes toward the very act of being rated. Earlier this year, when declining sales of its powerboat sand other leisure products prompted a significant downgrade (from BBB– to BB+), Brunswick Corp. essentially shrugged off its plunge into junk-bond territory. "We do not believe today's announcement by S&P will have any significant effect on Brunswick," the company reported.
Brunswick expressed a view taking hold more widely. "We're in the twilight zone of credit-rating agencies, where they have a complete lack of credibility in the marketplace, yet investors and issuers still have to use them," says James Kaitz, CEO of the Association for Financial Professionals. As both the SEC and European securities regulators weigh a variety of reforms, some debate not only what kind of future credit ratings have, but whether they have a future at all.
Feeling the Heat
In July the SEC announced the alarming results of an investigation. It faulted the way that S&P, Fitch, and Moody's handle ratings for residential mortgage-backed securities and collateralized debt obligations, two fast-growing structured securities. At the same time, Connecticut Attorney General Richard Blumenthal brought suit against the Big Three, alleging that they use a far more difficult rating scale for public versus corporate bonds in order to boost bond insurers' profits.
In contrast with official policy, the SEC charges, the three principal rating agencies failed to erect sufficiently sturdy Chinese walls between structured finance rating activities and fee negotiations. Conflicts of interest erased crucial boundaries between rating assessments and revenue consequences. In an uncovered E-mail, one analyst wrote, "I am trying to ascertain whether…we will suffer any loss of business because of our decision [to assign separate ratings to a product's principal and interest]." Other E-mails refer to a "paradigm shift in thinking" aimed at competition for market share and closing deals. Under market pressures, some adjustments altered analytic models, a ringing defeat for 2006 regulations that compelled rating agencies to reveal methodologies.
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."
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