Help not wanted? New ratings agencies should be allowed to challenge S&P, Moody's

Edward Hodgman

The intersection between the government and the credit ratings agencies is a familiar and frustrating place.

At first, it seems to make sense to have more ratings agencies assessing the soundness of large investment vehicles like corporate bonds and mortgage-based securities. Then when you get into the details, it becomes maddeningly complex. Finally, when you emerge at the other end, you feel like nothing will change, and you shake your head at the intransigence of government bureaucracy.

The bureaucracy – in this case, the Securities and Exchange Commission (SEC) – falls back on the need to do things by the book, and points out that Congress writes the book. So it appears that we'll be stuck with the same rigid, insular financial institutions we had before the Great Recession.

Gretchen Morgenson of the New York Times takes a close look at efforts by "upstart" companies to get into the game. The job of these agencies is to assess the likelihood that a bond issue for a major commercial or government project will be repaid. This kind of work has been synonymous for decades with just three words: "Standard," "Poor's," and "Moody's." And that's the problem. As Morgenson writes, "[g]iven that the financial crisis began unfolding more than five years ago, it is discouraging to see how entrenched the large and established ratings companies remain."

Though there are now eight other ratings agencies, S&P and Moody's are by far the best known, and it's extremely hard for new companies that have skill and experience in assessing bond offerings to get approved by the SEC. This certainly hurts the rest of us, though it helps anyone who works at S&P or Moody's. Morgenson writes:

Not only do these companies still hold sway in securities markets, they’ve also hung on to their lush profits from the glory days of mortgage origination. During 2005 and 2006, for example, Moody’s made $238 million by rating complex mortgage instruments. Investors who trusted those ratings lost billions.

The SEC says it's just following the rules set by Congress, which requires strict standards for certification of new ratings agencies. But since competition can create better results, why not accelerate their entrance? For example, could new rivals be allowed to work on a trial basis, with bond issuers obliged to contract with a fully-approved agency but having the option of also getting an opinion from an upstart company?  

It's likely that the newer entrant would try harder and charge less than the established agencies, and if its analysis matched or exceeded the soundness of theirs, that would mean increased competition. That might be just what S&P and Moody's need to raise their game and protect investors better than they have in the past.

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