The role of credit ratings agencies has been—ostensibly—to assess loss and default probabilities on fixed income investment vehicles.
Regulatory pressures against the ratings agencies are mounting, with action by the SEC and Congress already in progress.
Encouraging further analysis and in-depth evaluation of debt obligations' loss potential is ultimately good for capital markets.
After the financial crisis, national credit ratings agencies are realizing how it feels to be downgraded—but there's no alphabetical risk designation to indicate where they may stand when the dust settles. When credit ratings failed to accurately reflect the risk of many investments—specifically in the much-publicized mortgage-backed securities arena—investors, lawmakers, and industry professionals alike clamored for a reevaluation of the issuing agencies' authority.
Historically, the role of credit ratings agencies has been to assess loss and default probabilities on fixed income investment vehicles—from corporate bonds and asset-backed securities to sovereign debt. The industry is dominated by three US-based players: Standard & Poor's, Moody's Investors Service, and Fitch Ratings. Around since the early 1900s, these companies were designated as Nationally Recognized Statistical Rating Organizations (NRSRO) in the mid-1970s—and are now registered with the SEC according to the provisions of the Credit Rating Agency Reform Act of 2006.
Pressure to place blame for recent, extensive investment losses continues to mount, and major ratings agencies are feeling the heat. (The current outcry, however, isn't new—ratings agencies and their alleged failings dominated headlines in the wake of the Enron and WorldCom collapses earlier this decade.) In recent months, challenges to these agencies' authority have begun stacking up—the SEC voted to remove credit ratings references from some securities laws and the House Financial Services Committee passed a proposal to set new rules for the agencies. As part of the broader financial reform effort, this proposal would require the appointment of outsiders to the companies' respective boards, allow the SEC to test methods used by the agencies, and punish reckless behavior.
Additionally, a draft bill introduced by Senate Banking Committee Chairman Christopher Dodd would expose the agencies to investor lawsuits for reckless ratings and beef up regulation. Citing a loss of credibility among the ratings agencies, the National Association of Insurance Commissioners (NAIC) voted to ignore ratings on residential mortgage-backed securities when determining regulatory capital ratios—instead favoring the selection of an "independent third party" to estimate losses.
As debate over how to reform the current credit rating structure rages on, businesses are moving forward—some even completing bond offerings and deals without the support of credit ratings—a development nearly impossible to imagine just a couple years ago. While unrated deals have thus far been relatively small, if the trend continues, it could indicate ratings are no longer absolutely necessary for successful bond sales.
A broader financial reform bill will probably hit many roadblocks in coming months. Nonetheless, it's likely the finished product will feature increased regulation for the credit ratings agencies. Encouraging further analysis and in-depth evaluation of debt obligations' loss potential is a positive for the market—we're all for increased transparency and information; it's one of the only types of financial regulation worth supporting.
But, by and large, it's best to not worry much about the ratings agencies either way. With the tentacles of the government already tightening their hold, folks should realize there isn't much competition there to begin with—it's just those three and that's all. And to believe those three organizations can detect a systemic debt problem any better than the market is a fantasy.