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Big Three still play God

By Michael Coote

Friday 28th February 2003

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Seismic emanations of the US sharemarket collapse are spreading collateral damage to hitherto unsuspected places.

One repercussion of the US Sarbanes-Oxley Act ­ purpose-designed to clean and disinfect the Augean stables of post-Enron markets ­ is that local lawyers could find themselves manacled in regulatory torture dungeons if they contribute to legal documents that end up in front of the US Securities & Exchange Commission (NBR, Feb 21). Needless to say, lawyers are already squealing before the first turn of the thumbscrew.

Ratings agencies may be in for a good racking too, according to a report in the Economist. March will be the month in which the SEC issues an important paper on rating agencies. Three key matters will be tackled: whether there is adequate competition in the ratings market, whether agencies have conflicts of interest and whether there is sufficient regulation and transparency applicable.

Ratings agencies owe their existence to regulation. They were ushered into their golden era by the US with its Investment Company Act 1940.

That act specified money market funds were allowed to invest only in high-quality paper. Such paper came to be known as investment grade. The SEC added its weight to the ratings market by creating the category of "nationally recognised statistical rating organisations" (NRSRO).

So far only three companies have qualified to become an NRSRO: Moody's, Standard & Poor's and Fitch. As a result, they have come to dominate the world ratings market. Competition concerns have arisen at the regulatory privilege that protects the Big Three from would-be rivals.

The SEC has made matters worse in that it keeps top-secret the criteria that an NRSRO must meet. The results have been Kafkaesque. One failed applicant, Sean Egan, managing director of Egan-Jones Rating Co, was told by an SEC bureaucrat, "We won't tell you the criteria; otherwise you might qualify."

Moody's, Standard & Poor's and Fitch have been gold-plated as brands courtesy of the SEC and stand to reap a windfall once Basel 2 reforms come into effect in 2007 and banks are obliged to get their credit portfolios rated. The Economist looked at the matter mainly from the point of view of competition in the US. But there are international trade rules to consider as well.

Arguably the SEC has created an artificial trade barrier to foreign rating agencies that want to operate in the US with SEC accreditation. It is one thing to shut out the rascals and quite another to exclude the honest dealers.

But whether rating agencies are honest dealers has come under question. Like auditors, agencies are paid by the companies they rate and provide ancillary services. Auditors have been told they can no longer consult to an audit client.

So why aren't rating agencies subject to the same constraint? Belatedly the SEC has decided to run its ruler over that question as well.

As might be expected from a regulator, the SEC will examine also whether more rules are needed. Many, including the Economist, argue the opposite. Freeing up the ratings market by deregulation would subject agencies to the keenest discipline of all in market forces. Those agencies that were not reliable in ratings would soon find they had no customers.

There are concerns the SEC will be too soft on rating agencies ­ after all it is their judge and jury and carries the moral hazard for whatever it recommends. The Big Three will be hoping, no doubt, for as little change as possible to their licences to print money.

Even the Big Three are not infallible. They missed spotting the onset of the 1997 Asian crisis and failed to notice Enron and WorldCom were going belly up. In that they kept good company with the IMF and auditors like Arthur Andersen. But then their ratings are often misunderstood for what they represent.

A rating is not a guarantee of payment from a debt security but a coding that expresses a defined range of default probability. A bond rated as top A grade could still fall over while one rated as a low B grade could perfectly well pay off. It all comes down to the integrity of the bond issuer and that is something that precedes and is independent of a third-party credit rating.

However, the cart has come before the horse as credit ratings have assumed leading importance in asset selection. In structured finance products, which are based on pools of debt assets, the designers start with the credit ratings they want for the bond tranches to be sold to the public and work backward to underlying asset selection. Also the credit ratings of the resulting structure are not promises of repayment ­ rather they signal who gets hit first as defaults in underlying assets are assigned sequentially to particular tranches of the structure's bonds.

At present the Big Three get to play God because of their pre-eminence over competitors. Many companies carry significant risk to investors because they have punitive covenants on debt that are triggered by a credit-rating downgrade.

Tranz Rail is one such local example of the long reach of the raters. The company was recently in strife over its debt covenants and might have been derailed because of them.

It remains to be seen what the SEC will do to when it finally goes public on how it rates the raters and what their market will look like in future. The simplest change would be to publish the NRSRO criteria and accept any agency that complied.

Any radical changes, at this stage about as likely a junk bond being upgraded to AAA, could change the way analysts and investors worldwide assess their choices. Accordingly, the end of March will be keenly awaited for the message from on high.

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