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ICI Calls for More Credit Rating Agencies: Says More Competition Would Make Ratings More Credible

Credit raters' credibility came under fire once again this month as Investment Company Institute President Paul Schott Stevens called for increased competition among and oversight of credit rating agencies.

Calling for Congress to act where the Securities and Exchange Commission has stalled, Stevens was one of several witnesses to urge members of the U.S. Senate Committee on Banking, Housing, and Urban Affairs to create laws to open the industry, which financial services professionals depend upon when making almost any investment decision. Money market funds especially, a $2 trillion marketplace, depend on these ratings since regulations preclude their holdings from falling below a certain rating.

Right now, only five companies carry the SEC designation of Nationally Recognized Statistical Rating Organization, or NRSROs, the largest of which are Standard & Poor's and Moody's Investor Services, both of New York.

"I firmly believe that robust competition for the credit rating industry is the best way to promote the continued integrity and reliability of their ratings," Stevens said during Senate testimony. "Unfortunately, the current designation process does not promote - but, in fact, creates a barrier to - competition."

The biggest barriers to competition are the 1975 standards the SEC uses when designating NRSROs, a process that even SEC Commissioner Cynthia Glassman called "Kafkaesque" in a speech last year.

Under the existing guidelines, a company must display a uniform procedure by which they evaluate companies and provide a record of on-target ratings. They must also prove they are nationally known, but the Department of Justice has called that test "an insurmountable barrier."

Pending rule changes at the SEC would increase the agency's oversight of existing NRSROs and encourage new ones by changing the designation of the first "R" in NRSRO from "recognized" to "registered."

But those changes, some of which were first proposed five years ago, have been slow in coming. Despite some commissioners' support, no action is scheduled on the matter, according to SEC spokesman John Heine.

"The actual result of the SEC's actions, and in recent years, inaction, has been to create what is in effect a government-sponsored cartel," said Alex J. Pollock, a resident fellow at the pro-business and conservative Washington-based American Enterprise Institute.

Besides Standard & Poor's and Moody's, that cartel consists of Fitch Ratings, which likewise has headquarters in New York, Toronto-based Dominion Bond Rating Service and A.M. Best Co., which is based in Oldwick, N.J., and the most recent company to earn the coveted SEC designation, in March 2005.

While earning the NRSRO title may be thorny, the benefits of holding it are great. "It's like the Good Housekeeping seal of approval for capital markets," said Larry Mayewski of A.M. Best.

Because the SEC endorsement is so well trusted, many other regulatory agencies and financial service companies have made NRSRO-company issued ratings a requisite when doing business.

"Mutual funds employ credit ratings in a variety of ways - to help make investment decisions, to define investment strategies, to communicate with their shareholders about credit risk and to inform them about the process of valuing securities," Stevens said. "Maintaining the integrity and quality of the credit ratings process is therefore essential to sustaining investor confidence and to promoting the proper functioning of our capital markets."

Stevens proposed that Congress pass a series of laws to increase competition and ultimately improve credit rating report quality.

The first step is to improve the process by which NRSRO status is conferred. Currently, there is no clear procedure. Companies apply and then wait for a "no-action" letter. Often, the process is a lengthy one that can be discouraging to NRSRO hopefuls. In the case of A.M. Best, for example, designation took two years and nine months from the initial request, according to Mayewski.

After awarding the title, however, the SEC maintains little oversight, Stevens said. "Currently, the SEC has little basis on which to assess the continued credibility and reliability of credit ratings issues by an NRSRO after it has received its designation through the no-action process," he testified.

The danger of this lack of oversight was perhaps most glaringly revealed during the implosions of energy giant Enron and WorldCom, both of which received positive NRSRO-issued ratings shortly before collapsing into bankruptcy.

Under the current system, NRSROs are required to report to the SEC only when they undergo "material changes" that affect their ability to adequately evaluate companies.

"Given the heavy financial impact that a loss of a NRSRO designation would have on a rating agency, NRSROs have a strong disincentive to report any such changes," Stevens told Congress.