Rating the rating agencies

Hoping to improve the oversight of the industry, regulators are likely to address issues of competition and the way many leading firms do business.

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By David Ellis, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- Just when their missteps in the ongoing financial crisis appeared to have faded, credit rating agencies are finding themselves back in the spotlight once again.

On Wednesday a mix of academics, investor groups and top executives from the nation's leading three rating agencies - Moody's (MCO), Fitch Ratings and McGraw Hill's (MHP, Fortune 500) Standard & Poor's - will rendezvous in Washington as part of a Securities and Exchange Commission-sponsored roundtable discussion about oversight of the embattled industry.

The meeting will mark the latest efforts by regulators to keep a closer eye on a business that has been widely blamed for contributing to the ongoing financial crisis. Critics have maintained that many of the rating agencies were slow to lower the debt ratings for troubled financial firms and warn of the risks of bonds and other securities tied to subprime mortgages.

The rating agencies themselves have already responded to some of the criticism. Some have overhauled their rating models, others have even gone so far as to add warning labels to many of the toxic securities that resulted in billions of dollars of losses for investors.

Regulators have been pushing through changes as well. In December, the SEC detailed a set of new rules that would limit, among other things, rating agencies from grading securities in instances where they made recommendations to the issuer or a bank that underwrote the security.

But many have argued that regulators have not gone far enough to fix the industry. They add that faster and more sweeping reforms are needed.

"Incremental changes unfortunately have not worked," said Jim Kaitz, president and CEO of the Association for Financial Professionals. Kaitz is among those speaking at Wednesday's hearing and whose organization represents more than 16,000 finance professionals. "Hopefully this will be an opportunity for a real discussion on how to make some dramatic changes to the ratings process."

To be sure, many investors are still seething at the rating agencies for failing to predict the risk associated with the many of the complex mortgage-backed securities that have plummeted in value alongside the broader housing market.

According to a survey published this month by the CFA Institute Centre for Financial Market Integrity, 60% of the 1,100 members polled believe that assessments published by credit rating agencies are not valid and are not helpful in making investment decisions.

A more competitive landscape

One issue that is expected to come up for debate at Wednesday's hearing is whether the field should be widened to more players in order to make the industry more competitive.

According to some estimates, there are dozens of rating agencies in existence, but only a fraction are designated a Nationally Recognized Statistical Ratings Organization, or NRSRO, by the SEC.

That designation, while seemingly esoteric, holds a lot of sway within the investment community. Many large institutional investors, such as insurers and pension plans, cannot invest in debt unless it is rated "investment grade" by an NRSRO.

While the SEC has broadened the field of companies that carry this seal of approval from the three leading firms to ten since the crisis gained momentum, some experts believe more firms are deserving of the designation. What's more, it would encourage competition and quite possibly improve the ratings process.

"That is what is going to give us more comfort about reliable and accurate ratings," said Kaitz. "As long as there are three major rating agencies in the world, that is never going to happen."

One way to do business?

Many experts contend that regulators also need to discuss whether the long-standing business model employed by many of the top rating agencies needs fixing.

Unlike many smaller rivals, which rely on investors paying for ratings, firms like Standard & Poor's and Fitch are paid to grade debt by the underwriter of the securities.

Critics charge that this system fostered all-too-cozy relationships between rating agencies and issuers, and blinded the ratings firms to the risks of the debt they were analyzing.

Still, there has been much resistance by many of the large firms to change. They argue that there is room for more than one way for a rating agency to run its business, conceding that regulation requiring greater transparency would help offset those concerns.

In a paper published last week, Standard & Poor's stood by its so-called "issuer-pay" model, maintaining that this allows the company to cover the highest level of securities across all asset classes. By forcing all ratings firms to abide by one business model, they argued, it could prove detrimental to the market.

Even relatively new upstarts like RapidRatings International, a New York City-based independent rating agency which has been operating since 2002 and has investors pay it for ratings, acknowledge that one model may not work for everyone.

"There has to be room for more than one business model," said James Gellert, who serves as president and CEO of RapidRatings and is also scheduled to speak at Wednesday's event.

Alternative proposals have been floated recently, including the creation of a government-run ratings agency, which would be funded by a tax on issued debt or investors who subscribe to these ratings. That pool of funds would then be divvied among rating agencies to perform credit assessments.

But with a guaranteed revenue stream from the government, many fear that it would provide little incentive for the agencies to do a thorough job rating issued debt.

As a result, Wednesday's roundtable discussion may ultimately serve as a forum for potential solutions as regulators mull more changes for the industry.

One participant, Joseph Grundfest, a former SEC commissioner and currently a professor of law at Stanford University, said he plans to propose an investor-owned and controlled agency at the meeting.

Under this model, investors would not only rate issued debt, but their assessments would accompany assessments published by traditional ratings agencies. The structure, he notes, would force firms to compete by providing the best information possible to the marketplace.

"The dominant rating agencies have very large market shares," he said. "Unless you change the fundamental economics of the industry, that won't change." To top of page

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