The invisible hand of the free market is about to deliver a one-two punch to Standard and Poor’s and Moody’s Investors Services.

On Friday, President Bush signed the Credit Rating Agency Reform Act of 2006, essentially opening up the credit rating industry to more competition, and abolishing the Securities and Exchange Commission’s authority to designate credit-rating agencies as “nationally recognized rating agencies (NRSROs).” 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.”

The law also 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 SEC has granted only five the designation NRSROs: Moody’s, S&P, A.M. Best, Dominion Bond Rating Service, and Fitch Ratings. Moody’s and S&P control 80 percent of the market, according to the House committee that worked on the original bill.

The law is designed to curb alleged abusive practices cited by members of Congress and corporate trade groups, including 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.

“Importantly, the new law gives the SEC the tools necessary to hold recognized rating agencies accountable if they fail to produce credible and reliable ratings,” declared Jim Kaitz, president of the Association for Financial Professionals (AFP), in a statement. AFP represents 15,000 members working in corporate treasury and financial management functions.

“The dominant rating agencies failed millions of investors by neglecting to lower their ratings on Enron, WorldCom and other companies headed for bankruptcy, ” said Alabama Republican Senator Richard Shelby, chairman of the Senate Banking Committee and sponsor of the legislation, after the bill was signed. “The absence of timely downgrades in these cases was a product of an industry that was beset by conflicts of interest and a lack of competition ÂÂÂÂ Ultimately, this compromised the integrity of the market and investors paid the price,” he concluded.

S&P, which voiced its objection to the original House bill, has argued that the legislation represents an unconstitutional infringement of the company’s free speech. In recent testimony before Congress, S&P general counsel Rita Bolger said the bill represents a licensing regime that “is not constitutionally viable. Publishers are free, by longstanding 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.” See this link for a good example.

The Congressional Budget Office estimates that implementing the registration and enforcement requirements of the law would cost $3 million over the 2007 to 2011 time period.