Could Ratings Firms Become Irrelevant?

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Published July 08, 2011

| FOXBusiness

Europe wants to do what the Dodd-Frank financial reform bill so far has not  curb the influence of the big three credit rating firms.

After issuing a sharp chorus of criticism of Moodys Investors Service for downgrading Portuguese debt earlier this week, European bankers on Thursday said they would accept Portuguese-backed debt regardless of its rating.

The European Central Banks decision to waive a minimum rating required to accept collateral for credit from Portugal is a clear slap at Moodys, but also at the two other big U.S.-based rating firms, Fitch and Standard & Poors.

In effect, Europe is telling the firms that their services may no longer be required.

Germany, seeking to take things a step further, has called for the creation of a European rating agency.

Its been a long time coming. Criticism of the broad influence wielded by the three firms has grown louder since the financial crisis of 2008. That criticism has now escalated to a full-throated roar in Europe.

They dont want to be held hostage by credit rating agencies decisions, said Brian Dolan, chief currency strategist at Forex.com.

The pushback by European bankers is understandable for a couple of reasons. First, there was a widespread perception in Europe that the timing of Moodys decision to downgrade Portuguese debt only served to exacerbate an already-bad situation.

Furthermore, the decision seemed to confirm suspicions held by many European fiscal decision-makers that the credit firms are harder on European-issued debt than they are on debt issued in the U.S.

It seems strange that there is not a single rating agency coming from Europe. It shows there may be some bias in the markets when it comes to the evaluation of the specific issues of Europe, European Commission President Jose Manuel Barroso told reporters shortly after the Moodys downgrade.

Other European leaders described the big three U.S. credit rating firms as an oligopoly, defined as a market or society ruled by a small powerful group of elites.

European Central Bank President Jean Claude Trichet said a small oligopolistic structure is not what is ... desirable at the level of global finance.

James Gellert, CEO of Rapid Ratings International, explained that the firms have been targeted by critics in both the U.S. and Europe for several years, but the rhetoric in Europe has been a little more emotional, and lately even more so.

Indeed, the criticism in Europe borders on xenophobic, he said.

Gellert said he doubts the big three ratings firms are biased against European issued debt. Rather, Gellert sees a greater speed to act on potential downgrades, which he views as a likely reaction to criticism that the firms were too slow to downgrade ahead of the 2008 crisis.

Gellert sees some irony in calls for a European ratings firm that would ostensibly view European issued debt more favorably than U.S. ratings firms. Such a move would merely replace one form of bias with another, he noted.

The backlash from Europe seems to be bringing to a head an issue that has faded somewhat in the U.S. as the 2008 financial crisis has slipped further into the rearview mirror.

The U.S. credit ratings firms were widely cited as significant and active players in the years leading up to the collapse of the global housing market. Without their approval in the form of AAA ratings, Wall Street could never have packaged and sold trillions of dollars worth of mortgage-back securities chock full of loans that would eventually go sour.

To most bond investors, a AAA rating by Moodys, Fitchs or Standard & Poors is virtually a guarantee that the security is safe.

But they badly misjudged the subprime mortgage market and their critics believe it was no mistake. A lot of evidence suggests the firms knowingly rubber stamped risky securities with their highest ratings because it was profitable to do so.

Dolan said there is legitimate cause to wonder why anybody should listen to them any more given their failure to detect the earlier crisis.

He said skeptics of the firms point to their business model in which the firms are paid by the very companies whose debt they are rating.

They get paid by the issuers of debt, he said. The ECB views that as a conflict of interest.

So do a lot of other people.

A key aspect of the Dodd-Frank bill passed last summer was legislation that called for an overhaul of how debt is rated. Broadly, the bill sought to make the ratings firms more accountable for the accuracy of their ratings, making them potentially liable if they screw up again as badly as they did on the millions of subprime mortgages on which they bestowed their highest ratings. 

One idea floating around recently was to create a model in which the firms were paid by investors rather than issuers. The profits wouldnt be nearly as healthy but it would eliminate obvious conflicts of interest and perhaps help prevent another financial crisis.

A curious aspect of the Dodd-Frank bill, however, is that its a fluid piece of legislation, meaning it set goals whose details still have to be wrangled over by regulators and law makers.

Not only has that dulled momentum in favor of reform but its given the ratings firms time to fight back against significant changes. All three have reportedly hired armies of lobbyists, and the SEC has since backtracked on some of its tougher rhetoric regarding oversite of the firms.

So is the current European backlash a watershed moment in how global debt is issued and rated?

Dolan said theres no question the credibility of the big three U.S. firms was irreparably damaged during the 2008 crisis. But until a viable alternative is established, theyre still the primary voice on credit risk, he said.

In any case, Dolan said the controversy will likely cause competitors to enter the market, which will be beneficial over the long-term but only after those new firms earn their stripes and gain credibility.

In the beginning it could be cacophonous so well need to find out later who the best reviewers are, and thats probably a multi-year process, he said.

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