Break Up the Ratings Oligopoly!

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The Justice Department’s landmark lawsuit against Standard & Poor’s has captured headlines and broken the facade of rating-company immunity. But the threat to bludgeon, if not bankrupt, S&P through litigation masks the failure of the Securities and Exchange Commission to reform the raters.

Imposing a settlement of more than $1 billion on S&P may appease the popular cry for the rating companies to pay for their shortcomings in understating financial risks, yet will do nothing to fix the distorted incentives that shape the industry.

Instead, the SEC should take bold steps to use its regulatory authority to transform the industry and break up this entrenched oligopoly in which three firms -- S&P, Moody’s Investors Service and Fitch Ratings -- provide 96 percent of all ratings and frequently mimic each other’s grades.

The Justice Department’s case against S&P amounts to an indictment of the issuer-pays business model for ratings. S&P, like its leading rivals, is selected and paid by debt issuers. The Justice Department alleges that S&P tilted its ratings to favor the hands that fed its lucrative mortgage-backed securities business, helping to fuel the financial crisis.

The catch is that litigation is a blunt and inadequate tool to deal with this systematic conflict of interest that arguably inflates all issuer-paid ratings. Although the government may win in the court of public opinion by airing S&P’s dirty laundry, it faces an uphill fight to prove that senior management knowingly committed fraud.

Colorful E-Mails

The lawsuit’s long list of colorful e-mails by underlings isn’t tantamount to fraudulent corporate policy. At best, evidence of internal debates and policy paralysis at S&P about how to deal with the crisis merely mirrored the inaction and indecision of government regulators. S&P, of course, faces incentives to settle the case to resolve this blight on its business. But a monetary penalty will do little to address the industry’s ills.

Fixing the raters requires action from the SEC, which so far has delayed, if not scuttled, the most significant feature of rating-company reform: the Dodd-Frank Act’s mandate to replace the issuer-pays system for ratings of asset-backed securities. The SEC has spent 2 1/2 years engaging in the classic Washington avoidance strategy of conducting studies on potential alternatives rather than implementing changes. Further delay, or more studies, is pointless.

The SEC should embrace the Dodd-Frank Act’s mandate by creating an independent board to select which rating companies will evaluate specific asset-backed securities. That will put an end to issuers shopping for the company that will award the highest ratings. A user fee imposed on issuers or a transaction tax on purchasers could finance the selection and compensation of rating companies and eliminate the issuer-pays conflict of interest.

This experiment, if successful, could be gradually expanded to ratings of all debt securities. The potential downside is that the leading rating companies may continue to dominate any selection process that an independent board sets up, and they might undercut performance standards by mimicking each other’s ratings. Alternatively, the three main raters may leverage their strong brand value to bypass any constraints that the system imposes and continue to contract directly with issuers.

For this reason, the SEC should go a step further and break up the oligopoly to create meaningful competition.

Unique Leverage

The SEC has a crucial trump card because raters must be certified as Nationally Recognized Statistical Rating Organizations in order to issue evaluations of the creditworthiness of many forms of debt. This requirement provides the SEC with unique leverage to encourage divestitures by the leading rating companies.

The SEC could, for example, create separate certifications for rating categories of debt, such as government and corporate bonds, and bar raters from issuing evaluations for more than one asset category. Leading rating companies would then have a choice of vacating segments of the market or spinning off parts of their business into freestanding companies.

Smaller raters or new entrants could focus on a debt sector in which they could build experience and legitimacy and more plausibly compete over time. The result would be to create a new landscape in which a larger number of businesses would compete based on the quality of their ratings, rather than their willingness to cater to the interests of issuers.

The odds are that the Justice Department’s lawsuit will do little to change a problematic business model. Let’s just hope that the attention it focused on the rating companies spurs the SEC to do its job and embrace the mantle of reform.

(Jeffrey Manns is an associate professor of law at George Washington University. The opinions expressed are his own.)

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Jeffrey Manns at

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