A decision by the U.S. Senate to restrict the ability of financial institutions to select a credit rating agency to evaluate their bonds may throw open the market to increased competition.
Sean Egan, principal at Egan-Jones Ratings Co., a Philadelphia-based ratings firm, says he's confident that if the Senate measure is adopted in the final financial reform law, the ratings business may be changed dramatically. The ratings business is now dominated by three firms: Standard & Poor's, Moody's Corp. (MCO) and Fitch Ratings.
The Big Three 'Written Into Guidelines'
"Currently you have a situation that makes it very difficult for firms to compete, because basically, S&P and Moody's are written into most investor guidelines," Egan says. "This action will increase competition because you have a board made up of investors that will be selecting ratings agencies based on the most timely and accurate ratings. You have to assume they are not going tot default to S&P and Moody's in all cases."
The Senate voted 64-35 on Thursday to adopt an amendment proposed by Sen. Al Franken, D-Minn., that restricts the ability of financial institutions to choose their own ratings firms to rate their bonds.
Instead, under the amendment, the Securities and Exchange Commission will establish an independent board, whose majority will represent investors -- but also include a representative of ratings agencies and financial companies -- that will assign which ratings agency will evaluate each new bond.
Debt Raters Given Partial Blame for Financial Crisis
The amendment was a response to the financial crisis of 2007-2008, which many critics contend was caused in part by ratings agencies giving their top ratings to mortgage-backed securities that turned out to be much less creditworthy and were eventually downgraded to junk status. The main three ratings agencies are paid by the financial institutions that hire them, a relationship that has been denounced in Congress as too cozy.
Egan says the ratings agencies were focused primarily on maintaining their revenue base "and the best way to do that is to supply the ratings that the issuers wanted. Oftentimes, what the issuer wants is not parallel with what the investors and their beneficiaries want," he says.
Egan's firm takes a different approach: It charges investors, not the issuers, for its credit ratings. Egan maintains this "provides a timely, accurate assessment of true credit quality" that the three largest credit agencies don't offer. Egan-Jones has about 500 corporate clients, he says.
Earnings May Fall at S&P, Moody's, Fitch
Increased competition wouldn't be good news to the main ratings agencies, which are immensely profitable. Moody's, for example, earned $687.5 million in 2009. Standard & Poor's -- part of McGraw-Hill (MHP), which doesn't break out S&P's profit -- had revenue of $1.7 billion in 2009, down from $2.2 billion in 2007 when mortgage-backed bond issuance was at its peak.
The ratings agencies predictably were less than thrilled about the Franken amendment. Edward Sweeney, spokesman for S&P, says the amendment could result in a number of unintended consequences.
He says credit rating agencies would have "less incentive to compete with one another, pursue innovation and improve their models, criteria and methodologies." This could deprive investors of "valuable, differentiated opinions" about credit risk, according to Sweeney, who adds that having the ratings assigned by a third party could lead investors to believe the resulting ratings were endorsed by the government.
Is Structured Finance Dead?
The Franken amendment was also limited in scope -- it applies only to so-called "structured securities" such as the mortgage-backed bonds that were so popular two years ago. But because that market imploded, issuance of structured bonds has dwindled to very low levels today.
"They've killed the golden goose with those ratings," Egan says. "A cynic could say that structured finance is dead. Is the Senate going to address the new type of financing? This should be extended across all areas."