Opening Up the Credit-Rating Club?

Federal regulators are likely to pave the way for new entrants

For years, the credit-rating agencies have operated almost like members of an exclusive club. Only three companies are authorized by federal securities regulators to appraise the creditworthiness of corporate and governmental bond issuers, creating a troika that wields enormous influence over the investment decisions of institutions and individuals. But that cozy arrangement may be about to change.

Why? The agencies' performance through the past year's wave of corporate scandals has been sharply criticized. First, Congress, bondholders, and others fumed that the raters kept Enron Corp. at investment grade until just four days before it filed for bankruptcy in December, 2001. Then, as other companies ran into trouble, the agencies took heat for slashing ratings too quickly.

Such criticisms led Congress--through the Sarbanes-Oxley corporate reform law--to direct the Securities & Exchange Commission to study the effectiveness of the ratings agencies. Their report is due back by the end of January. In the wake of hearings held on Nov. 15 and 21, the SEC looks likely to pave the way for new entrants. Says one SEC insider: "It's not in our interest to have a regime in place that unnaturally limits competition."

The existing agencies--Moody's Investors Service, Standard & Poor's (which, like BusinessWeek, is a unit of The McGraw-Hill Companies), and Fitch--owe their elite status to an accident of regulation. In 1975, the SEC ruled that brokerage firms had to discount below-investment-grade bonds when calculating their assets, and that the bond ratings must come from a "nationally recognized statistical ratings organization" (NRSRO). Without defining the term, the SEC anointed Moody's, S&P, and Fitch as the sole NRSROs.

The franchise has made all three highly profitable--a fact that became crystal clear last year when Moody's released its earnings for the first time ever, following its spin-off from Dun & Bradstreet in 2000. Until then, numbers for the sector had been hard to come by. But given the 50% operating margins Moody's boasted in 2001, it's little wonder that smaller credit-raters covet NRSRO status. Says Glenn L. Reynolds, CEO of CreditSights Inc., an independent credit research firm: "It's like getting a free pass to an ATM machine."

Would-be competitors who think they can do a better job--including Egan-Jones Ratings, Lace Financial, and A.M. Best--find ammo for their cause in a September survey by the Association for Financial Professionals. The poll found that 29% of financial execs who work for companies with rated debt believe their ratings are inaccurate, while 40% think it takes too long for changes in the company's finances to show up in the rating.

The three leaders have been circumspect about increased competition. S&P President Leo O'Neill says he would welcome newcomers, provided they offer high-quality, independent research. While Moody's President Raymond W. McDaniel says his company is "neither in favor nor opposed" to more competition, he worries that "new entrants may compete in the market by offering higher ratings" than the leading players.

The three gripe that they've come under withering and often unfair criticism since Enron broke. Execs insist they were doing their best amid the chaos of the corporate meltdowns. "We are looking at the fundamental credit quality of companies we rate, and sometimes that changes more rapidly in periods of market volatility," says McDaniel.

Despite the carping, the SEC is unlikely to throw the gates open to all comers. The commission's big fear: Issuers would be tempted to shop for the highest ratings. A more likely scenario: The SEC will clarify the now-opaque process of gaining NRSRO status, and a few rivals will be admitted to the club.

Will a jolt of competition make for more accurate and timely ratings? That depends on whether the newcomers can gain more than a toehold in a market so dominated by two behemoths that even No. 3 Fitch, has had a tough time competing. "You can't just put ratings out there and expect people to follow them. You have to have a reputation for reliability," says Stephen W. Joynt, Fitch's president and CEO. It took Fitch more than four years and investments of $40 million to become profitable. The smaller fry may get in on the action, but they'll still have their work cut out for them.

By Amy Borrus, with Mike McNamee, in Washington

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