- The Washington Times - Wednesday, November 27, 2002

Say the words "credit rating agency" in the company of Wall Street buy side analysts and you will probably get a snicker or a sigh. But credit rating agencies have been given the regulatory ability to arbiter markets, in part because the agencies deemed by the Securities and Exchange Commission (SEC) to be nationally recognized have final say on what is "investment grade." And they are privy, at least in theory, to confidential corporate information that they don't directly share with the market at large.

Given the market-moving power of these nationally recognized credit rating agencies, of which there are only three, it is fortunate that Congress asked the Securities and Exchange Commission (SEC) to review the regulatory haven in which they operate. Last Thursday, the SEC held the second and last scheduled public hearing on these agencies, in which credit-rating and corporate executives, fund managers and academics participated. In January, the SEC is slated to send Congress its study on the agencies.

About half of Americans own equity and a great many own debt (corporate and otherwise), often as part of a retirement fund. Credit ratings, therefore, have broad social and market significance. But skepticism regarding the accuracy of ratings spans a wide range of industries.

At the SEC hearing, panelists voiced frustration with the regulatory lock that nationally recognized statistical ratings organizations (NRSRO) have on the market. Moody's, Standard & Poors and Fitch are the only NRSROs. By law, money-market fund managers must invest only in financial instruments deemed by the three NRSROs to be high-quality, short-term instruments. So, even if investors look askance at these ratings, they have currency regardless of their accuracy because they establish which assets fund managers may purchase.

Fund managers are, in effect, forced to subscribe to the research services of the NRSROs, in order to try to anticipate which way the agencies may be leaning before they announce a rating. Even more troubling, these agencies charge the companies they rate, and get about 90 percent of their revenues from these fees. Most credit rating agencies that aren't deemed by the SEC to be nationally recognized make their revenue through subscriptions.

"We don't have a choice of subscribing to a broader universe" of credit rating agencies, said Stephanie Petersen, head of Charles Schwab's Portfolio Management Money Fund. "We become captives of those agencies," she said, adding, "the price competition between them just doesn't exist."

The perception that NRSROs hold sway over a regulatory protected racket erodes investors' already precarious confidence in the market in the wake of the Enron and WorldCom implosions. But the SEC has an admittedly tricky task in identifying appropriate reform. In deciding which credit raters will become NRSROs, the SEC looks at the market's acceptance of an agency's ratings, along with its research methodology and resources. While this criteria seems to make sense, it has made the market excessively tight, since it is difficult for independent agencies to gain market acceptance if they lack the NRSRO label. For the lucky three in the club, becoming nationally recognized is a self-fulfilling prophecy.

The SEC could broaden the NRSRO sphere, though, by adjusting its criteria a notch. Many independent credit raters have made inroads in the market by specializing in a certain sector or industry. If market acceptance of these ratings for niche areas is high, then the SEC should let the agencies brandish NRSRO credentials for their area of specialization.

Fresh competition would reinvigorate the ratings industry at a critical time for markets. The SEC's regulatory framework has become especially anachronistic in view of the multiple mergers in the NRSRO sphere, which brought the number of competing NRSROs to just three. Given a more dynamic industry, credit raters will soon recover some of their lost credibility.


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