The U.S. House of Representatives voted last Wednesday to reform the credit ratings industry. Observers in the asset securitization industry responded with a mixture of relief, dismay, and by setting up a potentially bitter fight to bring changes to a previously untouched segment of the financial services industry.
The Credit Rating Agency Duopoly Relief Act of 2006 sets out to improve competition, transparency and accountability among credit rating agencies. In short, the bill removes the Securities and Exchange Commission (SEC) from the process involved in approving certain rating agencies as nationally recognized statistical rating organizations (NRSROs), by replacing its current process for NRSRO approval with a more thorough and transparent registration process. It proposes stringent requirements to which rating agencies must adhere if they want to attain NRSRO status, and proposes that they be subject to SEC examinations and enforcement actions.
Currently, the SEC recognizes Moody's Investors Service and Standard & Poor's, Fitch Ratings, Oldwick, N.J.-based A.M. Best Co., which rates the insurance industry and Toronto-based Dominion Bond Rating Service. While more than 130 credit rating agencies exist, only these five are designated as nationally recognized statistical rating organizations by the SEC, according to Rep. Michael Fitzpatrick's (R-Penn.) Web site. Fitzpatrick sponsored the bill, complaining that the SEC's current method of conferring NRSRO status on rating agencies is oblique and creates an artificial barrier to entry for respectable companies. The bill eliminates the SEC's old requirements and allows rating agencies that have operated for three years, and meet its standards to register with the SEC as NRSROs.
"H.R. 2990 breaks the current duopoly by creating a clear, defined and accountable registration process for ratings firms which will create competition, increase the quality of ratings and provide better information for investors," Fitzpatrick said in a statement. The Congressman drew support from Financial Services Committee Chairman Michael Oxley (R-Ohio), a prominent figure in corporate sector reform.
"As a free market supporter, I believe the removal of the SEC's staff designation process benefits investors by removing an artificial barrier to entry and improving the quality of ratings," Oxley said in a statement. "The legislation introduces competition and appropriate SEC oversight that would make the industry more transparent and accountable."
The legislation is a welcome relief from the oppressive presence of the two major rating agencies, according to some. "The [nationally recognized statistical ratings organization (NRSRO)] system has grossly distorted market pricing and turned issuers and investors alike into price-takers with virtually no free market choice," Glenn Reynolds of credit research firm CreditSights wrote in a research note last Wednesday.
Opposition to the bill
Although it opposes Congressional intervention on the issue, Moody's supports increased competition, accountability and transparency in the industry, in the form of a voluntary framework similar to Europe's International Organization of Securities Commission (IOSCO) code, said the agency's vice president of communications, Fran Laserson. After two years of scrutinizing the rating agency environment, IOSCO deemed formal legislation an unnecessary form of regulation.
"Moody's' code of conduct is patterned very much on the IOSCO code of conduct," Laserson said.
Other opponents to the bill said that rating agencies have never been caught up in any wrongdoing that would warrant such government oversight. Moreover, rating agencies operate primarily by publishing their credit opinions. Passing laws that restrict or mandate their operations is tantamount to violating the firms' freedom of expression under the First Amendment, according to Mark Adelson, head of structured finance research at Nomura Securities. Formerly, Adelson was a managing director at Moody's.
Particularly troubling, says Adelson, is a section that outlines four prohibited practices. The first bans rating agencies from asking for payment for unsolicited ratings; secondly, it prohibits pressuring a credit rating client to buy other services offered by a rating agency in order to receive a beneficial rating; thirdly, no rating agency can lower a rating on a pool of securities or money-market instruments, or threaten to do so, because the underlying assets do not carry its rating. The fourth disallows threats to change a credit rating based on whether the client will pay for the rating or another service offered by the rating agency. By ruling out the second and fourth practices, Congress appeared to be steering rating agencies clear of the conflicts of interest that might stem from offering consulting services aside from their core credit rating business, said Adelson.
"One thing about making a publishing company register with the government is that pretty soon you go from restricting those companies that have opinions about credit to those that have commercial opinions, to those with political opinions," Adelson said. "You're talking about requiring people who publish ideas to register with the government."
Nevertheless, say some, rating agencies should come under government oversight because they play a crucial role in the financial services sector, by issuing opinions on trillions of dollars worth of securities.
"Accountability is key, and they've had no accountability for a very long time," said George Ashur, ABS credit head at Fortis Investments. "We the practitioners are required to double ourselves in two. Anything that enhances accountability and solidifies it for rating agencies is good."
While passing the bill, the House rejected amendments from Democratic Congressmen that would have retained the NRSRO designation, but set a bar for the quality of companies that attain it. That amendment, from Rep. Paul Kanjorski (D-Ohio), proposed requiring the SEC to complete its definition of an NRSRO and make the process public within 180 days of enactment.
After passing the House with a 255-166 vote, the legislation heads to the Senate, which will consider its own version of the bill later this year.
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