The Securities and Exchange Commission’s (SEC) proposed rules for rating agencies received a mix review from market participants this week.

Most think the regulation, which would obligate the agencies to provide more transparency to their credit ratings, is a step in the right direction. But some say it doesn’t go far enough.

The rules, which were introduced on Sept. 17, would require the rating agencies to disclose the history of their ratings actions and the reasons behind them back to mid-2007, when the SEC gained authority to regulate the agencies by law. The SEC also wants the agencies, which are paid by companies to rate their securities, to notify other agencies when they are in the process of determining a rating. It’s also proposing to bar companies from “shopping” for the most favorable terms for their securities by requiring companies to disclose whether they have received preliminary ratings from other agencies. Under the proposal, the rating agencies would also have to publicly disclose every entity that paid for a credit rating and provide more information about income earned from the companies they rate.

“These proposals are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security,” SEC Chairman Mary Schapiro said in a statement. “That reliance did not serve them well over the last several years, and it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust.”

The Other Big Three

The “big three” rating agencies — Standard & Poor’s, Moody’s Investors Service and Fitch Ratings — got a bad rap following the subprime mortgage debacle, because they’d stamped triple-A ratings on collateralized debt obligations containing toxic loans. That bad rap resurfaced this week when an ex-Moody’s analyst, Eric Kolchinsky, reportedly leaked a document that said Moody’s gave a complex debt instrument a high rating in January 2009, knowing that it planned to downgrade assets that backed the instrument. Within months, the securities were put on review for a downgrade, according to the Wall Street Journal. Klochinsky is scheduled to testify on Sept. 30 before the House Committee on Oversight and Government Reform on reform for the ratings industry.

And that wasn’t the only crisis Moody’s had to deal with. The New York Insurance Department (NYID) suggested that it and other insurance regulators across the country could drop Moody’s from a list of acceptable rating organizations. The NYID reportedly said it became concerned with Moody’s after it turned down an invitation to attend a regulatory hearing that was scheduled to be held last Thursday. The NYID said it planned to question Moody’s about its ratings process, particularly prior to the credit crisis. The National Association of Insurance Commissioners, which oversees state insurance regulators, said in a March report that it wants to reduce its reliance on the ratings firms. The insurance industry has nearly $3 trillion of rated bonds, making it the largest sector of the U.S. financial services industry to rely on credit ratings.
Calls to Moody’s were not returned.

Many market participants, like Mark Pibl, a managing director at NewOak Capital, believe the SEC’s proposed regulation will equal cleaner ratings. “The new rules will provide greater transparency,” he said.

Yet many still said the regulation does not go far enough. “[The rules] still do not address some of the core reasons why the agencies got it wrong in the first place,” a New York-based investor said.

A number of market participants said the SEC is late in terms of making the rating agencies more transparent. “These rules are not profound because the rating agencies have been more conservative since the beginning of the crisis,” said a New York-based banker. “It’s only going to mean more information and more due diligence on their part, but it won’t have an impact on [the leveraged finance market].”

However, some market participants equate more due diligence to more work for the rating agencies; and they reckon the cost for that work will be passed down to the investor.
And some think an SEC’s initiative to increase competition by allowing new rating agencies and existing boutiques to challenge the dominant “big three” would be a disaster.

“The creation of multiple new rating agencies isn’t necessarily all good, and would likely have done nothing to avoid this crisis” said Gene Phillips, a director at PF2 Securities Evaluations and author of a report that outlines a different take on reform for the rating agencies (see below). “Among other things, it imposes an additional burden on the investor who now has to familiarize himself or herself with a host of new methodologies.”

More Is Not Merrier

Competition, Phillips added, resulted in the original decline in ratings standards, so adding more won’t help curb the problem of rating shopping. Some market participants said the number of new entrants could go as high as 30.

“We also worry that if the SEC was unsuccessful in regulating even the Big Three NRSROs, never mind the 20 or 30 proposed,” said Philips.

But not everyone thinks it’s a bad idea. “The rating agencies have a lot of egg on their faces,” another New York-based investor said. “I welcome more competition and better transparency. The sooner the better.”

David Wargin, an S&P spokesman said, “[S&P] will continue to work closely with the SEC, market participants and other government officials to promote transparency of our ratings and enhance our policies to meet the needs of investors and the global marketplace.”
A Fitch spokesman declined to comment.

The proposed changes are open to public comment for 60 days, allowing market participants to add their two cents to the discussion.

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