Kroll Says S&P, Moody’s Putting Profits Ahead of Accuracy

Jules Kroll, a former private investigator who started a bond-rating company after the financial crisis, said the largest credit-rating firms are again putting profits ahead of accuracy amid record demand for corporate debt.

“They’re selling themselves out just as they did before,” the chief executive officer of Kroll Bond Rating Agency Inc. said today at a U.S. Securities and Exchange Commission roundtable in Washington. “If you want to see the next tsunami, wait for the outcome in high yield and watch what washes up on shore.”

Companies are issuing speculative-grade bonds at a record pace even as yields on the debt have fallen to unprecedented lows with the Federal Reserve holding its benchmark interest rate near zero for a fifth year. Douglas Peterson, president of Standard & Poor’s Ratings Services, declined to comment on whether the market is in a “bubble.” Prices reflect excess liquidity, he said in response to a question from SEC Commissioner Daniel M. Gallagher.

Regulators met today to discuss the merits of a plan to create a board that would select ratings firms to grade structured products, which was proposed by Senators Al Franken from Minnesota and Roger Wicker of Mississippi in the 2010 Dodd-Frank Act. The proposal was intended to mitigate conflicts of interest that stem from issuers of debt shopping around for the most advantageous grades.

‘New Conflicts’

Peterson said that plan would introduce “new conflicts” and would be slow to implement.

“A government assignment system could create uncertainty, could slow down markets, and disrupt capital flows at a time when we could least afford it,” Peterson told the group.

Franken pressed the SEC to change the system, noting his plan had bipartisan support in the Senate before it was watered down in a conference committee. He blamed the ratings companies for not doing their jobs, contributing to a housing crash that caused millions of Americans to lose their employment.

“My plea today is that you take action,” Franken said. “If we maintain the status quo we are leaving ourselves far too vulnerable to another catastrophe.”

S&P, Moody’s Investors Service and Fitch Ratings, the three-biggest credit graders, were “key enablers of the financial meltdown,” the Financial Crisis Inquiry Commission, created by Congress with a 10-member bipartisan board, said in its January 2011 report. “This crisis could not have happened without the rating agencies.”

Cutting Reliance

The commission’s report also blamed the crisis on lenders’ irresponsible and sometimes fraudulent practices, regulators’ inattention and overconfidence, and the recklessness of borrowers and investors.

Representative Scott Garrett, a New Jersey Republican, said the SEC should focus on finishing regulations that strip out references to credit-rating companies from its rulebooks. The regulator is required under Dodd-Frank to remove language that refers investors to the rating firms’ grades when selecting safe investments.

“I do not believe that having the government assign which firms will do the ratings is the right answer,” Garrett told the roundtable participants. “By removing the government good housekeeping seal of approval, we can increase competition among ratings agencies and lessen reliance on ratings.”

‘Constitutionally Vulnerable’

Kermit Roosevelt, a professor of constitutional law at the University of Pennsylvania, said a system that strictly forbid bond issuers from picking and paying a company to rate the securities could be unconstitutional.

“That is a prohibition on speech, and that I think is more constitutionally vulnerable,” Roosevelt said.

Companies have sold $162.9 billion of speculative-grade bonds in the U.S. this year, up from the $132.8 billion sold by this time in 2012, when a record $358.9 billion was issued, according to data compiled by Bloomberg.

Yields on speculative-grade bonds, rated below Baa3 by Moody’s and lower than BBB- at S&P, touched a record low 5.98 percent on May 9 before climbing to 6.07 percent as of yesterday, according to the Bank of America Merrill Lynch U.S. High Yield Index.

Mitigating Conflicts

The SEC’s roundtable also explored why a two-year-old program designed to mitigate conflicts of interest and improve competition has seen limited use. The program requires issuers to disclose to all credit-rating companies, through a secure website, the same information that is provided to a firm hired to issue the rating.

An upstart credit-rating firm could use the data to issue ratings as it seeks to break into a market dominated by S&P, Moody’s, and Fitch. While the program has generated comments about ratings by competing firms, it hasn’t produced a single rating by unhired firms, which aren’t required to issue a grade, according to the SEC.

“It is not the best use of our resources as we’re trying to build out our ratings platform,” said Joseph Petro, managing director at Morningstar Credit Ratings LLC.

SEC Commissioner Troy A. Paredes also questioned why ratings companies would issue ratings for which they aren’t paid. Issuing negative comments about a deal “may not be the best way to get business in an issuer-pay setting,” Paredes said.

Franken Alternative

Lawrence White, an economics professor at New York University’s Stern School of Business, said the SEC should eliminate a requirement that companies rate at least 10 percent of the transactions they view on the website.

“It only serves to inhibit potential raters from even looking at the existing bundles of information,” White said.

Tom Deutsch, executive director of the American Securitization Forum, said the program could be improved by requiring disclosure when an issuer shopped for ratings. The ASF, an industry group that lobbies for issuers, argues the SEC’s voluntary program can be strengthened and be an alternative to Franken’s proposal, which it opposes.

“I don’t think any parts of the market would have serious concerns with that,” Deutsch said.

To contact the reporters on this story: Dave Michaels in Washington at dmichaels5@bloomberg.net; Matt Robinson in New York at mrobinson55@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net; Maura Reynolds at mreynolds34@bloomberg.net

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