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Upstart Credit Raters Say SEC Rule Gives Big Three an Advantage

Small Raters Say SEC Rule Gives Big Three an Advantage
The SEC released 517 pages of proposed rules in May that would require credit-rating firms to keep marketing and ratings departments separated, conduct more due diligence on assets, and establish a schedule for training and testing analysts. Photo: Rich Clement/Bloomberg

Small credit-rating firms complain that proposed rules requiring analysts to do more training are too costly and would help larger firms without addressing the errors that contributed to the financial crisis.

Lawmakers have criticized credit-raters for contributing to the 2008 credit meltdown by inflating ratings on mortgage securities. Last year’s Dodd-Frank Act mandated reforms including reducing conflicts of interest, vetting assets more thoroughly and better analyst training and testing.

The Securities and Exchange Commission released 517 pages of proposed rules in May that would require credit-rating firms to keep marketing and ratings departments separated, conduct more due diligence on assets, and establish a schedule for training and testing analysts.

Smaller firms say those rules hand an advantage to the three dominant players -- Standard & Poor’s Rating Services, Moody’s Investors Service Inc. and Fitch Ratings.

“This will only exacerbate existing competitive advantages,” Larry Mayewski, executive vice president of Oldwick, New Jersey-based A.M. Best Co., wrote in a letter commenting on the proposed rules. “These companies have enormous infrastructure and profit margin advantages that allow them to more easily absorb compliance costs and burdens.”

Conflict of Interest

Sean Egan, president of the Egan-Jones Ratings Co. of Haverford, Pennsylvania, which has 22 employees, said in an interview that the proposed training and testing rules do not address the fundamental conflict of interest at the heart of most credit raters’ business model: Raters are paid by the companies whose financial products they are rating.

“Better certification and education are not going to affect anything because the idea is based on a false premise,” said Egan, whose company uses a different model. “The people at the major rating agencies were very well educated and trained. The problem was they had the wrong incentives. The incentives were misplaced because of this conflict.”

In a report released earlier this year, the congressionally chartered Financial Crisis Inquiry Commission called the raters “key enablers of the financial meltdown” by providing inaccurate ratings of risky mortgage securities.

‘Race to Bottom’

A second report in April by the Senate’s Permanent Subcommittee on Investigation, led by Democratic Senator Carl Levin, found that S&P, Moody’s and Fitch Ratings engaged in a “race to the bottom” to assign top grades to mortgage-backed securities because of pressure from the banks that paid for the ratings.

The proposed SEC rules, which do not specify the frequency or content of the training, are scheduled to be finalized and ready for implementation in the first half of 2012. At least two of the big three ratings firms say they support the new rules.

Standard & Poor’s, a unit of the McGraw-Hill Companies, “strongly supports the ongoing education and development of analysts,” Deven Sharma, the rater’s president, said in an 84-page comment letter.

Moody’s has also supported the proposals.

“Moody’s has a robust continuing education program for analysts,” said Michael Adler, a spokesman. “We support the objectives of the proposed training requirements and we expect to fully implement them as they become effective.”

Judith Burns, an SEC spokeswoman, declined to comment.

Missing the Point

Some critics of the big raters say the rules, in addition to being burdensome for smaller firms, miss the point. “Training didn’t make our list of the top five problems with the agencies,” Phil Angelides, chairman of the Financial Crisis Inquiry Commission, said in an interview.

He said that “a relentless drive for market share” by the biggest ratings firms led to shoddy work, not lack of training or competence. “That competition trumped quality in their ratings, and that still remains unfixed,” Angelides said.

“Who can criticize good training?” he asked. “But we are still short of the fundamental reform that we need.”

The U.S. Justice Department is investigating S&P and Moody’s on whether they raised grades for complex securities to win business, according to three former employees who said they were interviewed by investigators last month.

Egan said his firm is paid by investors, not issuers of bonds. That, he said, was a better solution to the problems highlighted by the investigations.

Regulatory Burden

“This only increases the regulatory burden but it doesn’t end the conflict we’ve been talking about,” Egan said.

S&P spokesman Ed Sweeney said the firm has worked to keep the conflict in check.

“We have long had policies in place to manage potential conflicts of interest, including a separation of analytic and commercial activities, a ban on analysts from participating in fee negotiations, and de-linking analyst compensation from the volume of securities they rate or the type of ratings they give out,” Sweeney said in an e-mail.

James Nadler, president of Kroll Bond Rating Agency Inc., a new firm that issued its first assessments this year, said his firm initially tried to establish an investor-pay program before deciding that the issuer-pay model worked better. The firm itself is partially owned by institutional investors, he said, providing balance.

“These proposed rules add costs but they help ingrain a culture of looking at the markets in a better way,” Nadler said. “There’s nothing wrong with making sure the analysts are properly trained and supervised by analysts with a lot of experience. It’s better to have the greater awareness.”

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