Monday, April 16, 2007

Reform unlikely to dent rating agencies' armour


By John Dizard, Financial Times
Published: Apr 16, 2007

In the middle of one of their more impressive disasters, the rapid meltdown of "investment grade" paper made of chopped-up subprime mortgages, the credit rating agencies are within a few weeks of having their monopoly formally blessed by the SEC.

The agencies - Moody's, S&P and Fitch, along with their counterparts in Canada and Japan - are always good for a mocking aside among Wall Streeters, as if they're an ethnic group stereotyped as mentally inferior. The agencies are famous for missing disasters-in-the-making, such as Enron, Worldcom, and now the subprime mortgage mess.

Yet we should all be as stupid as they are. Hereditary peerages have been nudged out of the House of Lords, the Big Three American auto companies may bumble on only at Toyota's sufferance, but the ratings agencies have survived what might have been a serious attack on their monopoly. In fact, their position is stronger than ever.

The Credit Rating Agency Reform Act of 2006, which was signed by President Bush in September, is now being implemented through the SEC's rule making process. The rating agencies kicked and screamed and testified throughout the "reform" process as if they were actually threatened by it. They may even have believed they were.

No, forget that thought. They aren't really that stupid.

Their monopoly status has been protected up to now by the SEC's designation of them as Nationally Recognised Statistical Ratings Organisations. There wasn't a formal proceeding to be "recognised", just a long, long, series of "no-action" letters that meant that their ratings counted, and those of others did not. Others could apply to be NRSROs, but somehow, nothing would be done with the applications.

The effect of the "reform", codified in the new law, is to formalise the position of the rating agencies. The idea of the law was to increase competition. The way it's written, and the way it's being implemented by the SEC, will be to admit one or two small, new entrants, and then to slam the door shut.

The SEC's proposed rules (196 pages of spritely government prose) is to say: yes, we will consider letting you compete with Moody's and S&P. But you must replicate their entire structure, balance sheet, and staffing. You must have this in place, without being recognised by us, for at least three years, all the while somehow charging for this un-"recognised" service.

It's as if Apple were to be permitted to compete with IBM only if it first replicated IBM's bureaucracy. Even defence contractors face more of a competitive threat.

The oddest proposed requirement is a non-specific one for "financial resources". Either rating agencies should have no capital requirement, since they have no liability for their ratings, or a requirement for hundreds of billions of dollars of capital, in case they are legally liable. Anything in between is just a gratuitous barrier to entry.

This is particularly ludicrous given that the ratings agencies assert that they are are immune from legal liability for their work, since as "First Amendment" people, the ratings opinions are protected speech under the Constitution.

Sean Egan, the chief executive of the Egan-Jones rating agency in suburban Philadelphia, expects his company's application for NRSRO status to be approved shortly after the rules are published. It's been at the SEC for nine years, but what with one thing and another, the SEC didn't get around to formally considering it until now. Unlike Moody's, S&P, and Fitch, all of Egan-Jones' revenues come from investors who subscribe for its service, not the issuers.

"There was a lot of pressure to reform the system as a result of Enron and Worldcom," Mr Egan says. "At the beginning of the discussions about the new law, there was talk about disallowing compensation from issuers, but that went by the wayside. That is the core conflict, which will continue to exist."

The agencies reply by pointing to their ever-lengthening codes of conduct. Anthony Miranda, at Moody's, says its code "is very specific in detailing how we do business. We model it to mitigate any conflict of interest. We are very attentive to reputational risk".

There's no reason to doubt the sincerity of Moody's, or the other NRSROs. However, human nature being what it is, as Mr Egan says, "People do respond to incentives." And one big incentive is to keep the issuer-customer happy.

However, while the agencies have dodged any slow-moving bullets that could have come from the SEC, there's another threat on the horizon. I understand that there are US states' attorneys-general who are looking over losses to state investment funds from what had been considered "investment grade", subprime housing based paper. As one person familiar with the lawyers' thinking says, "you could argue that the rating agencies voided their First Amendment protection when they got too involved in the underwriting process this cycle. They weren't placing the securities, but they could have gotten too involved in structuring these deals behind closed doors".

This would only be determined to be the case, if it were, after long, long rounds of litigation. But the attorneys-general have a lot of time, a hunger for headlines, and staffs with nothing really better to do than litigate against rich Wall Street institutions.

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