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On Nov. 21 a court-appointed trustee estimated that at least $1.2 billion is unaccounted for at failed brokerage MF Global. Sunk by some risky bets on European sovereign debt, the firm run by former New Jersey Governor Jon Corzine filed for Chapter 11 bankruptcy late last month, the eighth-biggest failure in U.S. corporate history. While that’s tragic for some clients, it’s an outright embarrassment for the three largest ratings firms, Standard & Poor’s, Moody’s Investors Service (MCO), and Fitch Ratings. They all rated MF Global investment grade a week before its bankruptcy. “Where is the outrage?” asks James H. Gellert, chief executive officer of Rapid Ratings, which had rated MF Global at junk for two years. “Things have gotten absurd.”
The House Financial Services Subcommittee on Oversight and Investigations will hold a hearing on Dec. 15 to investigate the collapse of MF Global. The panel will also probe the role of credit ratings firms, says a staff for a representative on the panel who asked not to be identified as plans haven’t been completed. (The ratings agencies’ mishandling of the Enron and Worldcom bankruptcies also prompted congressional hearings.)
Despite playing a starring role in the 2007-09 financial crisis by handing out sterling ratings to precarious subprime mortgage securities, Moody’s, S&P, and Fitch enjoy a 97 percent-plus market share in the global ratings business and some of the best profit margins in the U.S., according to data compiled by Bloomberg. The predicted regulatory backlash never materialized: The dominance of the big three is unchallenged, as is their ability to secure fees from the banks and companies that they rate.
With little competition, Moody’s and S&P have boosted fees at a faster rate than inflation. Moody’s raised its rates by 5 percent on average this year, and may impose a similar increase in 2012, CEO Raymond W. McDaniel Jr. said at a recent investor conference. S&P raised its standard fee to rate corporate bonds by about 4 percent this year, according to Michael Meltz, a JPMorgan Chase (JPM) analyst in New York. Shares of Moody’s are up 23 percent this year, while McGraw-Hill (MHP), parent of S&P, is up 20 percent. (Fitch is owned by France’s Fimalac, whose stock is down 12 percent this year.) The S&P 500 index over the same period is down 5 percent.
The three big rating companies still have huge sway over the markets. S&P’s August downgrade of the U.S. sovereign credit rating was a big contributor to the $9.7 trillion loss in global equities last quarter. More recently, S&P roiled markets in Europe when on Nov. 10 it accidentally released a message to some of its subscribers saying it had downgraded French debt from its top AAA rating.
The top three deny that their ratings are compromised by their fee arrangements. They also say they’re adequately regulated. “Over the past year, regulators around the world have put into effect new regulations for credit ratings agencies and have proposed additional regulations as well,” says Ed Sweeney, an S&P spokesman. Fitch spokesman Daniel Noonan and Moody’s spokesman Michael Adler say their firms have supported many of the regulatory reforms, and have put in place internal checks and balances. None of the firms would comment on the MF Global bankruptcy.
Columbia University securities law professor John C. Coffee believes the changes enacted don’t go far enough. “Nothing has happened—and nothing may,” he says.
The reason has a lot to do with the sheer complexity of the $40 trillion global debt market, which encompasses corporate, sovereign, municipal, and structured finance. Debt issuers and institutional investors don’t want to accept the responsibility or cost of analyzing every new debt issue for creditworthiness. Debt-strapped governments don’t want to play that role either. In that sense the ratings companies are still valued by market participants and government regulators. “Many investors buy blindly based on the ratings,” says Glenn Reynolds, co-founder and CEO of CreditSights, a New York credit research shop that has been critical of the big three. “That was the whole game. And that was the incentive for the agencies to reverse-engineer ratings to support a pipeline of structured, toxic, fee-generating, mortgage sludge.”
Moody’s, S&P, and Fitch continue to count on the issuing companies, banks, and municipalities to pay them to rate their bonds—an arrangement that critics say creates an untenable conflict of interest. (Only three of the nine nationally recognized statistical ratings organizations depend on the fees of investing clients such as fund managers and traders.) To mitigate that problem, the Dodd-Frank financial overhaul makes it illegal for issuers to share nonpublic information with raters without triggering broad disclosure rules, on the principle that equal access to issuer data should foster competition in the ratings arena. The law seeks to wean federal government bodies from dependence on ratings and also makes it easier to sue credit raters.
Yet in a September review, the SEC reported that adherence to these new rules was mixed and that the industry was “trending even more toward” the issuer-pay business model. Sean Egan, founding principal of Egan-Jones Ratings, a rating firm in Haverford, Pa., that derives its revenues from fees paid by investors, says reforms must attack the model directly. “The Gordian knot must be cut—that is, issuers cannot select rating firms, or the race to the bottom will continue,” says Egan. “Otherwise, aside from the big three incurring relatively minor legal fees, nothing has changed.”
To address the problem, U.S. Senator Al Franken (D-Minn.) has been petitioning the SEC to implement his amendment to Dodd-Frank, which calls for an independent, self-regulatory board to administer a system in which issuers are assigned a credit ratings firm to provide an initial rating. “We need to reward accuracy and break up the oligopoly of the big three,” says Franken. “What I’m creating,” he says, “would let smaller firms prove themselves.” (Europe is currently considering the mandatory rotation of credit raters on issuers.)
Gellert of Rapid Ratings argues that Washington should instead focus on ensuring that firms stand by all of their ratings. Specifically, he wants them to be required to either affirm or adjust their ratings quarterly. “That,” he explains, “will force them to both think twice about their initial ratings, and to keep scrutinizing them,” as opposed to the benign neglect that led to episodes like S&P, Moody’s, and Fitch still having MF Global at investment grade just days before the firm failed.
Reynolds of CreditSights believes that real reform of the system is also inhibited by fears that radical changes would drive the big three out of the municipal credit ratings business at the worst possible time. “Congressmen could wake up to hundreds of issues in their state or district seeing ratings withdrawn.”
William J. Harrington, a former senior Moody’s analyst-turned-whistleblower, opted for a metaphor to describe what’s wrong with the industry in an August letter to the SEC: “The rationale seems to be that, as the fox did so well in guarding the previous henhouse, why not commission it to design a new one, enlist it to take the daily beak count, and designate it Hen’s Delegate to the U.S. Poultry Association?”
The bottom line: Even with calls for reform and better regulation, not much has changed in the ratings business, starting with the business model.