The Securities and Exchange Commission is looking into the failure of credit-rating agencies to spot the impending collapse of Enron, WorldCom and others. The agencies can expect to be more tightly regulated in future

 

THE big credit-rating agencies are under the spotlight again. Their failure to detect early signs of trouble at Enron, WorldCom and other once high-flying companies has left regulators wondering where the agencies get their information from, how they analyse it and whether their opinions are worth the paper they are written on. Such anxieties led to a requirement in the Sarbanes-Oxley act—designed to raise standards of corporate governance in the wake of Enron’s demise—that the Securities and Exchange Commission (SEC) probe the agencies’ role. During two days of public hearings in Washington, DC, on November 15th and 21st, the SEC is asking out loud if the three biggest agencies—Standard & Poor’s (S&P), Moody’s Investors Service and Fitch Ratings—have become too big for their own (and everybody else’s) good.

It seems odd, after all, that issuers of debt securities should pay the agencies to rate them so that the buyers of their bonds can sleep soundly at night. But that is the way it has been almost since the turn of the last century. In a perfect world, of course, the investors who buy the bonds, and so need the comfort of a second opinion, would pay for the issuer to be rated. But nobody knows for sure who the investors are, or sometimes even who they are likely to be, until the securities are put on the market. Such quirks abound in financial markets.

The SEC hearings are focusing partly on criticism that the rating agencies are venturing into territories for which they are ill-equipped and where they are able to add little or no value. The agencies’ traditional role of rating debt securities has been stretched to cover a growing list of exotic instruments dreamt up by investment banks, including such things as collateralised debt obligations, which are a way of taking a bundle of credit risks and slicing them into layers that carry different levels of risk.

Rating agencies realise that they are valuing the manager as much as the assets. Although such work is taxing, it is also lucrative, so the agencies are not complaining. Not so in the case of a proposal, under new banking regulations to be introduced in 2006, that the agencies’ ratings be used to determine how much capital banks should set aside for each loan they make. When the idea was first mooted by the Basel committee on banking regulation, the agencies threw up their hands in dismay. Ratings embodied in regulation, they protested, would leave the agencies open to accusations that they are influenced by bank supervisors.

S&P, Moody’s and their smaller rival, Fitch, owe their special status to the SEC’s decision in 1934 to introduce a net capital rule for broker dealers operating in the capital markets. This determined that the dealers must have a “haircut” (reduce the value of securities they can trade) if their capital were depleted by a fall in the value of bonds held on their books. The SEC decided that the haircuts could be less severe if the securities were rated by nationally recognised and respected agencies. Since then, the agencies have taken on other quasi-regulatory roles. For example, the SEC insists that the bulk of the billions of dollars held in money-market funds—savings products not guaranteed by the government—carry top or near-top ratings from at least one approved agency.

Twice in recent years the SEC has pondered rating-agency reforms—mainly to define the agencies’ role more clearly and to set out a system for overseeing them—but on both occasions it has hesitated for fear of over-regulating the market. This time, in the wake of the Enron and WorldCom scandals and the increasing complexity of the agencies’ work, the SEC may be forced to act.

When things go wrong, the agencies get it in the neck from both sides. Investors caught holding Enron’s investment-grade bonds as their price sank to below that of junk say that the agencies are just too slow to spot companies’ declining health. A better guide, say some, are the spreads (above Treasury bonds of a similar maturity) at which the bonds trade. Others argue that the agencies are now acting too quickly to downgrade companies’ ratings in order to avoid further accusations that they failed to spot problems. And that, say the critics, is a classic case of slamming the stable door shut after the horse has bolted. This week, the bosses of several large French companies lashed out at the rating agencies, accusing them of unjustified downgrades that have precipitated several debt crises. Alcatel’s chief executive, Serge Tchuruk, likened the agencies to “pyromaniac firemen”, while Vivendi Universal’s boss, Jean-Rene Fourtou, called them “the executioner”.

Steven Schwarcz, a professor at Duke University and one of the experts taking part in the SEC hearings, says rating agencies are more likely to be conservative in their judgments because to do otherwise would jeopardise their reputations. Yet, did the risk of losing its reputation prevent Andersen’s failings at Enron? Indeed, rating agencies are increasingly offering themselves as consultants to companies whose debt they rate, and thus run the risk of facing the same conflicts of interest as auditors do when they also offer consulting services to their clients. Fund managers worry that the agencies will lose their objectivity, and thus their willingness to shout if they spot a problem, if they are also advisers to the companies they rate.

If nothing else, fund managers would like to see more nationally recognised agencies and more competition between them. Some also think tougher supervision is needed. “The rating agencies do need greater oversight to make them more accountable to the markets they serve,” Cynthia Strauss, a director of Fidelity Investments, told the first of the SEC’s hearings. How tight a grip the SEC will want to take remains to be seen. Earlier hearings by the Senate suggest that legislators favour closer control. There is little doubt in the present climate of re-regulation in financial markets that the rating agencies will lose some of their freedom.