After Early Criticism, Will Rating Agencies Beat Heat?

By Julavits, Robert | American Banker, January 2, 2003 | Go to article overview

After Early Criticism, Will Rating Agencies Beat Heat?


Julavits, Robert, American Banker


Anger over the rash of sudden corporate failures in the last two years has prompted sweeping reforms in investment banking, stock research, accounting, and corporate executive suites. But the sweep is not over.

Ratings agencies are next in line, as observers complain that the system dominated by Moody's Investors Service Inc., Standard & Poor's Corp., and Fitch Inc. has failed investors by being too slow to downgrade corporations that were disintegrating in the public spotlight.

Last month, the SEC held hearings on the ratings system and is required by the Sarbanes-Oxley law to report to Congress in late January.

But as the public wearies of scandal stories and the economy slowly improves, the rhetoric is losing some of its lick.

Some vocal critics of the current system fear the ratings agencies and other yet-to-be-targeted entities may avoid being forced to make wholesale changes to their businesses.

Meanwhile, it is not clear what the SEC hearings accomplished, and by the time the report is completed, a war with Iraq and other concerns could push legislative reform of the ratings system to the bottom of the agenda.

Only Moody's, S&P, and Fitch have full ratings status -- officially called Nationally Recognized Statistical Rating Organizations. That designation was created by the SEC in 1975 to let firms rate the quality of bonds bought and sold by brokers. Several have applied for NRSRO status but just those three have gotten it.

Smaller ratings firms that have been shut out of the business of rating securities issued by corporations are the most bitter. The SEC "has allowed the ratings industry to consolidate into two and a half firms, and none of them are doing a particularly good job of representing investors," said Sean Egan, the president of Egan-Jones Ratings Co. in Wynnewood, Pa. "The industry needs to be reformed."

In Washington circles there have been calls for reform. In prepared testimony in March before the Senate Committee on Governmental Affairs, then-SEC Commissioner Isaac C. Hunt Jr. said, "We believe it is an appropriate time and in the public interest to reexamine the role of rating agencies in the U.S. securities markets and to conduct a public examination of the potential need for greater regulation in this area."

In December, the American Enterprise Institute, an inside-the-Beltway think tank, called on the SEC to create competition by relaxing the standards it uses to designate credit rating firms as NRSROs.

Egan-Jones is among those that have filed an application to be an NRSRO. That was in 1998 and it has not heard back. Lace Financial Corp.'s eight-year wait ended with rejection in 2000.

In 1994 the SEC solicited public comment on whether the commission should continue using the NRSRO designation, but a spokesman for the agency said a decision is still pending. Some say that Moody's and S&P have an almost Microsoft-like grip on the business of rating securities (Fitch is considered a distant third) and that this limited competition gives the firms little incentive to improve.

Barron H. Putnam, the president of Lace Financial, a Frederick, Md., niche ratings company for the financial services industry, said the business has to be overseen by a designated regulator. "A lot of people have been burnt by poor ratings --there should be some accountability," Mr. Putnam said. A regulator would give investors "someone to complain to."

Arguing in favor of the current system is that added competition would make issuers more inclined to shop for the firm that gives them the best ratings. Also, some proponents of the status quo say, approving more ratings firms would dilute individual ratings and confuse investors trying to compare securities.

Reform would not necessarily solve all of investors' problems anyway. Karin S. Thorburn, the associate director of the Center for Corporate Governance at the Tuck School of Business Administration at Dartmouth College in Hanover, N. …

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