In a letter received by DailyFinance, Deven Sharma, president of Standard & Poor's, outlined how the ratings agency plans to change its practices in the wake of the massive global credit meltdown. Along with Moody's (MCO), S&P, a division of McGraw-Hill (MHP), has been blamed for enabling the housing boom and subsequent bust through lax ratings criteria, which led to many structured financial products receiving top-tier AAA ratings.
The S&P and Moody's traditionally reserved the AAA rating for companies with unparalleled financial strength. Many institutional investors are restricted from purchasing debt that does not receive the rating. The ratings agencies' granting the status to securitized mortgages created a huge pool of investor demand, because the AAA securities still carried higher yields than similar corporate bonds.
Sharma's plan outlines four points: preventing conflicts of interest, increasing transparency of the ratings process, improving performance in structured finance ratings, and increasing accountability. S&P and Moody's are easy targets for conflict-of-interest accusations: their business model relies on getting fees from the debt issuers being rated, rather than from investors. Many critics charged that the ratings agencies were beholden to issuers of structured products, even though they were supposedly serving the investors.
Moody's, the only publicly traded pure-play on bond ratings, has been the target of short sellers, who argue that Moody's has devalued its brand through losses sustained on Aaa securities. Even so, Moody's and S&P each rate roughly 40 percent of issued debt; Fitch rates the remaining 20 percent. The ratings' agencies achieved their stronghold on bond issuers through accreditation from the Nationally Recognized Statistical Rating Organization, a label that the Securities and Exchange Commission grants to only ten firms.
The failure of the ratings agencies to predict the credit collapse has put its business models in peril, with calls for increased competition -- an empty threat, unless additional NRSROs are created, approved, and welcomed by investors. Sharma tried to address potential concerns, saying, "we are responding to those who believe ratings firms should be more accountable for their performance to investors and regulators, beyond the market scrutiny our ratings and criteria receive on an ongoing basis. We support these calls for accountability."
Considering that certain ratings from S&P and Moody's are incorporated into numerous contracts and investment fund prospectuses, it's difficult to see how a rapid shift from their services could occur
If Sharma's letter is well received, it will be even more difficult to see how the established ratings agency order will go away, even though it's been behind the curve since 2007. After all, S&P and Moody's may finally be getting out ahead of something: all it takes to motivate them to change is to threaten their existence.
James Cullen also edits and writes at CollegeAnalysts.com. He has no personal position in the stocks mentioned above.