- Thursday's downgrade of Ireland is more of a confirmation of what is already widely known by the market.
- A provision in the Dodd-Frank financial overhaul bill strips Fitch, Moody's, and S&P of the legal protection they've long enjoyed as ratings agencies.
- Fitch, Moody's, and S&P—which control 97 percent of US ratings—are no longer protected by the first amendment or by securities laws that declare their opinions can't be wrong.
Earlier this week, Ireland took an important first step toward passing a "tough and ambitious" austerity budget. While the budget passed parliament, it still faces final approval early in 2011, followed by a general election likely to occur in March 2011. Without question there are hurdles ahead for Ireland to clear, but markets cheered the news on Wednesday as European stocks ended the day at their highest levels in two years.
In other Irish news, on Thursday, Fitch Ratings downgraded Ireland to BBB+ from A+. It's hardly surprising—global markets largely ignored the news. The downgrade is simply confirmation of what is widely known and already largely reflected in bond yields. Ironically, while the rating agencies comment on Irish troubles, they're facing a potential downgrade of their own in the US.
A provision in the lumbering Dodd-Frank financial overhaul bill strips Fitch, Moody's, and S&P of the legal protection they've long enjoyed as ratings agencies. According to the bill, "Activities of credit rating agencies are fundamentally commercial in character and should be subject to the same standards of liability and oversight as apply to auditors, securities analysts and investment bankers." In effect, Fitch, Moody's, and S&P cannot claim First Amendment protections (or other legal cover) for their ratings. As it stands today, legally, their opinions cannot be wrong.
The bill also ends the rating agencies' special oligopoly. Previously, by law, banks could only buy securities stamped "investment grade"—and the stamp had to come from one of a very few designated ratings agencies. (Effectively, one of the big three since Fitch, Moody's, and S&P currently control 97 percent of US ratings.) Dodd-Frank ends that requirement—and good riddance. The oligopoly is essentially an expensive, inefficient way for issuers to receive what was effectively a meaningless rubber stamp about potential creditworthiness. Need proof? Even after 2008 and the problematic nature of the credit ratings were on full display, did the ratings agencies warn investors in advance with a cautionary downgrade of Greek or Irish debt? Nope. They were still very late to the party in downgrading any of the PIIGS.
So what replaces the existing oligopoly? That remains to be seen—the Dodd-Frank legislation allows new entrants in the field. Competition is good! Usually. However, if indeed a rating agency's opinion "can't be wrong," that may be rather off-putting to firms looking to enter the ratings arena. Or, to offset the increased liability of issuing a rating, the fees raters charge to issuers could rise dramatically. (Perhaps another hurdle to new debt issuance?) New credit standards will be developed over the next two years, so it remains to be seen what will be required.
Still, if Dodd-Frank spells the end of the current government-controlled rating oligopoly, that's a legislative consequence we cautiously applaud. Stay tuned to see if the next iteration is an improvement or Frankenstein's monster.