Are Rating Firms Getting a Free Pass?

S&P, Moody's, and Fitch helped precipitate the financial crisis. But the regulatory backlash has been mild

Illustration by Topos Graphics

By Roben Farzad

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, 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 analyst in New York. Shares of Moody’s are up 23 percent this year, while McGraw-Hill, 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.”