New Law Promotes Credit Rating Agency Competition

Before recessing for the mid-term elections, Congress enacted the “Credit Rating Agency Reform Act Of 2006,” S. 3850. The law is the culmination of reform efforts over the regulation of credit rating agencies. Sen. Richard C. Shelby, (R-AL), introduced the bill September 6th, and less than a month later it was enacted. President George Bush signed it into law on Sept. 29th.

The new law is a response to many in the financial community who advocated reforming the system of rating the credit worthiness of debt instruments such as bonds. A credit rating is a credit rating agency’s assessment—with respect to the ability and willingness of an issuer—to make timely payments on a debt instrument over the life of that instrument. Investors use ratings to help price the credit risk of fixed-income securities. Firms that provide such ratings are called Nationally Recognized Statistical Rating Organizations or NRSROs. Currently, there are only five NRSROs: S&P, Moody’s, Fitch, Dominion Bond Rating Service Limited and A.M. Best Company. According to testimony delivered before the U.S. Senate, the credit rating industry is an extremely concentrated industry. The largest rating agencies—S&P and Moody’s—have approximately 80 percent of industry market share, as measured by revenues. S&P and Moody’s rate more than 99 percent of the debt obligations and preferred stock issues publicly traded in the United States. Hearing witnesses testifying before the U.S. Senate expressed concern about this level of concentration and called S&P and Moody’s a “partner monopoly.”

How credit ratings have permeated the functioning of the debt industry was revealed during testimony on the bill. The Senate notes on the bill state; ”Over the past few decades, financial regulators have increasingly used credit ratings to help monitor the risk of investments held by regulated entities and to provide an appropriate disclosure framework for securities of differing risks. In fact, ratings by NRSROs today are widely used as benchmarks in federal and state legislation, rules issued by financial and other regulators, foreign regulatory schemes, and private financial contracts. Most of these laws and regulations define eligible portfolio investments for institutional investors as those rated in one of the highest investment grade categories by at least one NRSRO. Today, it has become standard industry practice for most issuers to purchase ratings from two or more rating agencies.”

Further, Senate notes revealed problems in the current credit rating system. “SEC examiners found (i) potential conflicts of interest resulting from the issuer-paid business model of the NRSROs; (ii) that NRSRO marketing of supplementary, fee-based services, including corporate consulting, exacerbated the inherent conflict in the NRSRO business model; (iii) the potential for the NRSROs, given their substantial power in the marketplace, to improperly pressure issuers to pay for ratings and purchase ancillary services; and (iv) evidence relating to whether NRSROs were adequately protecting confidential information. The examinations suffered from an overall lack of cooperation offered by the NRSROs with respect to document production. In addition, SEC examiners found evidence that the NRSROs were possibly in violation of Section 17(b) of the Securities Act of 1933, with respect to disclosure of fees from issuers.”

Testimony before the U.S. Senate also revealed that it was virtually impossible for other firms to become “nationally recognized” in order to become a NRSRO. “The most important requirement for acquiring the coveted status presents an obvious `Catch 22′: to get the designation you must be nationally recognized, but you cannot become nationally recognized without first having the designation.” Several witnesses testifying before the U.S. Senate noted that the standard has served as a substantial barrier to entry, and that greater competition would benefit investors by generating more innovation and higher quality ratings at lower costs. The Credit Rating Agency Reform Act establishes a new registration process setting a clear path to being designated as a Nationally Recognized Statistical Rating Organization (NRSRO).

Conflicts of interest between credit agencies and the companies they rate were cited as one of the main reasons that these agencies missed the financial warning signs emanating from such companies and ENRON and Worldcom. These conflicts of interests resulted primarily from rating agencies increasingly marketing ancillary, fee-based consulting services to the very firms whose debt instruments they were rating. The Credit Rating Agency Reform Act Of 2006 addresses these potential conflicts of interest by requiring registration form disclosure of any conflict of interest relating to the applicant’s issuance of credit ratings, and by requiring the SEC to adopt rules prohibiting conflicts of interest or requiring the management and disclosure of such conflicts.

If the law produces its intended affects, in the months ahead there should eventually be more NRSROs, more competitive rates for their ratings services and fewer appearances of conflicts of interest between NRSROs and the company’s whose debt instruments they rate.

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