Fixing the ratings game

Plenty of companies want to compete with Moody's, S&P, and Fitch, but are restricted from doing so. Investors are paying the ultimate price, writes Fortune's Katie Benner.

By Katie Benner, Fortune reporter

(Fortune Magazine) -- The country's leading ratings agencies - Moody's, Standard & Poor's and Fitch - are under attack these days for fueling the subprime mortgage meltdown with excessively high ratings on mortgage-backed bonds that turned out to be bad bets.

The problem, critics say, is that the three agencies are rife with conflicts of interest. They're paid by the bond issuers to evaluate the risks of their debt offerings, base those ratings on information they receive from the issuers, and are insulated when, as in the case of the low-income housing market, investors get burned.


But the Big Three aren't the only ratings agencies out there. In fact, there are hundreds of companies that rate securities and, unlike Moody's & Co., are paid by investors, not the issuers. With the trio now fending off criticisms and lawsuits related to their role in the subprime mess, you'd think now would be the perfect time for a lesser-known name to rise to the top.

Don't hold your breath. Regulators have long kept other agencies from competing with Moody's, S&P and Fitch, despite their supporting roles in high-profile blowups like Enron and the 1997 Asian financial crisis.

How? By requiring that only firms that the Securities and Exchange Commission designates as Nationally Recognized Statistical Ratings Organizations (NRSRO) can be the final word on credit quality. And the only U.S. ratings agencies recognized as NRSROs are Moody's, S&P and Fitch.

The NRSRO designation makes them key players in the Wall Street machine. Pension funds, banks, money market funds, and insurers can only buy debt rated "investment grade" by an NRSRO. State and federal laws also regulate bank debt based on NRSRO credit ratings.

Since the NRSRO designation is the only one that matters to world's largest investors and financial institutions, Moody's, S&P, and Fitch essentially have a lock on the trillions of dollars in debt issued each year.

Not surprisingly, smaller ratings agencies are crying foul. "If we get our ratings wrong, we lose customers. But that's not the case with the NRSROs. They still make money," says Sean Egan, co-founder of Egan Jones Ratings. Egan Jones has spent 10 years and about $600,000 in legal fees fighting for NRSRO designation.

The Federal Reserve has released studies showing that Egan Jones provides ratings that are more timely and accurate than those of Moody's et al. Egan, for instance, warned investors about Enron, WorldCom and Global Crossing months before the companies cratered.

By contrast, the three main agencies didn't warn investors about Enron until four days before the energy giant filed for bankruptcy in 2001.

As Moody's, S&P and Fitch take heat for their conflicts of interest, critics say the SEC deserves blame for their irrationally exuberant ratings too.

"As a government agency, the SEC isn't terrible," says Jon Macey, who teaches corporate securities and corporate finance at Yale Law School. "But on this issue it has got a lot to apologize for."

Macey says firms seeking NRSRO status have long faced a chicken-and-egg problem. In order to be considered for the designation, the SEC requires a firm to be "nationally recognized" as an "issuer of credible and reliable ratings" by "the predominant users of securities ratings." But since predominant users, like pension funds, are required to use NRSROs, smaller firms have a hard time meeting the "nationally recognized" threshold.

"It's like saying that, in order to start a magazine, you have to have circulation," explains Macey.

European securities regulators and bankers have long pressured the SEC to break up the Moody's et al. oligopoly - or make it more accountable for issuing bogus ratings.

The Credit Rating Agency Reform Act of 2006 was meant to address critics and make the NRSRO designation process far less onerous. Among other things, the new law gives the federal securities regulators 90 days to approve or reject applications for NRSRO status. And to become an NRSRO, firms no longer need to prove to the SEC that they're already nationally recognized as a ratings agency.

The SEC insists that the application process is vastly improved, boasting that seven firms have been labeled NRSROs since the law passed. While that might seem like a step in the right direction, all seven were already NRSROs before the 2006 law: Moody's, S&P, Fitch; three international ratings agencies; and one that specializes in insurance.

The SEC says it's reviewing a handful of applications from ratings agencies, but won't identify any by name. Egan Jones is one of them, but the 90-day limit for the SEC to act hasn't passed.

For all the SEC's talk of improvements, critics say the NRSRO process is as opaque as ever. "It's very expensive to get approval and there is an apparent arbitrariness and uncertainty," says Christopher Whalen, who runs his own ratings and research firm Institutional Risk Analytics.

Whalen says Egan Jones, a competitor, is a prime candidate for NRSRO status. "Sean Egan should have gotten it long ago. He'll prove whether or not the SEC is serious about creating more competition."

And if Egan Jones is denied? Says Whalen: "It will reinforce that the ratings business is a monopoly." Top of page