Industry Wrote Provision That Undercuts Credit-Rating Overhaul

Moments before the Senate overwhelmingly passed a bill to overhaul the credit ratings industry seven years ago, Republican and Democratic sponsors took turns touting its promise for ending an entrenched oligopoly.

The bill, they said, should break the viselike dominance of three agencies — Standard & Poor’s Ratings Services, Moody’s Investors Service and the smaller Fitch Ratings — in an industry that serves as a crucial watchdog over the nation’s financial system.

What’s escaped public scrutiny until now, however, is that the law’s tough criteria defining when a newcomer could join the industry weren’t written by Congress. They were crafted by a yet-to-be-identified official of one of the big three ratings agencies, a former aide to the Senate Banking Committee has told McClatchy.

Experts and the heads of unregistered ratings firms worry that congressional staffers, in seeking help to ensure that fly-by-night companies couldn’t win federal approval, inadvertently let the fox into the coop.

The industry-written criteria, they say, weakened a law meant to spur competition in the estimation of the default risks of bonds and other securities. Those ratings, ranging from AAA to C, often guide investments by pension funds, foundations, insurers and other institutions.

While a handful of new firms have registered with the Securities and Exchange Commission as “nationally recognized” ratings agencies, competition has increased only modestly since the 2006 law was enacted.

The criteria have prevented at least one potential competitor from winning approval and have dissuaded others from even applying, the critics say.

Despite a barrage of criticism over their behavior, the three firms issued 97 percent of all ratings in the 12 months that ended in June 2011, according to the SEC’s most recent publicly available data.

Perhaps most important, little competition has emerged in rating the kinds of complex home-mortgage securities whose implosion led to the 2007 financial crisis. The market for those securities has shrunk, but it’s expected to rebound.

Ann Rutledge and Sylvain Raynes, a husband-and-wife financial team who’ve crusaded for transparency on Wall Street, say they’ve devised a computer program that enables them to take on the big three in rating those complex “structured securities.” However, they said, their application to form a nationally recognized ratings agency has been hamstrung for nearly two years because of the industry-conceived registration requirements.

The criteria make it “exceptionally difficult for a younger player to qualify,” said James Gellert, the CEO of New York-based Rapid Ratings, a 22-year-old company that specializes in assessing firms’ financial health and hasn’t sought registration, also known as certification.

Further, the requirement of three years of experience “absolutely slammed the door on any new competition” in structured products — “the most lucrative part of the ratings business” — just as the financial crisis peaked, Gellert said.

None of the three major credit-ratings agencies, in emails from their spokesmen, acknowledged any role in drafting the Senate criteria.

The disclosure that one of the big three had helped shape a law that appears to partially insulate them from competition comes at a time when the SEC, under new Chairwoman Mary Jo White, has been wrestling with how to address the potential conflicts of interest that occur when a bank pays an agency to rate its securities. On May 14, the agency hosted a daylong round table on the subject with bankers, regulators and other stakeholders.

S&P, Moody’s and to a lesser extent Fitch have been under fire much of the last decade, accused of inflating their ratings on the securities issued by banks that paid them billions of dollars in fees. In the lead-up to the financial crisis, government investigative panels found, the big three compromised their roles as independent checks on Wall Street.

In February, the Justice Department filed a $5 billion damage suit that accused S&P of knowingly overrating junk home-mortgage securities. Sixteen states and the District of Columbia also are suing S&P.

The 2006 overhaul push stemmed largely from the discovery that S&P’s and Moody’s had failed to lower investment-grade ratings on debt issued by the energy trading giant Enron Corp. until four days before its 2001 bankruptcy filing and by telecom colossus WorldCom Inc. until weeks before its 2002 collapse. Investors in those firms lost billions of dollars.

As the Senate drafted its version of the bill, an industry official was “very helpful” in writing standards to guard against unqualified applicants winning registration, said the former Banking Committee aide, who insisted on anonymity in order to avoid harming relationships. The former aide also declined to divulge the identity of the industry official.

The industry-written criteria require an applicant to produce 10 confidential, notarized letters from “qualified institutional buyers” who’ve relied on the company’s ratings for three years, including two such letters for each category in which the firm sought approval.

Committee staffers were unfamiliar with the term qualified institutional buyers, a formal distinction that the SEC gives sophisticated investors that handle more than $100 million for clients, before the industry official proposed the requirement, the former Senate aide said.

Michael Greenberger, a University of Maryland law professor who’s a former senior staffer at the Commodity Futures Trading Commission, said the requirement was exclusionary.

“If it’s true that the existing credit rating agencies wrote the provision, they clearly wrote it in a way that made it very hard for anybody to become properly certified,” he said.

Rutledge and Raynes, former Moody’s employees, said in phone interviews that it would be “nearly impossible” for them to obtain 10 letters that fit the requirements.