The Credit-Ratings Business May Never Get Fixed

Brian Chappatta

(Bloomberg Opinion) -- Here’s an idea from a bipartisan group of four U.S. senators: The credit-ratings industry needs an overhaul.

Obviously, this is not a novel concept. It seems as if at least once a year, financial journalists publish an investigative piece that highlights how firms including S&P Global Ratings, Moody’s Investors Service and Fitch Ratings are loosening their standards, likely in an effort to win more business. The takeaway is that the industry’s core model — issuers paying for their own grades — is broken, distorts markets and sets the entire financial system up for an even bigger fall when the economic cycle turns. 

Given the role of the credit raters in the 2008 financial crisis, this sort of scrutiny is understandable. For the most part, though, credit investors have learned to live with the system and its faults. Any criticism of the ratings industry amounts to little more than screaming into the void.

As of this week, count Republican senators Roger Wicker of Mississippi, Chuck Grassley of Iowa, John Kennedy of Louisiana and a Democratic colleague, Sheldon Whitehouse of Rhode Island, among those making noise. The Wall Street Journal reported that the group sent a letter to the Securities and Exchange Commission asking why it didn’t reshape the credit-rating industry after it helped fuel a housing bubble by awarding top scores to subprime mortgage investments. It comes as other parts of Washington appear to be mobilizing as well:

The letter, which could be a precursor to legislation, comes as the House of Representatives is making plans for a hearing on the credit-ratings industry and an advisory committee of bond investors weighs making recommendations on how to revamp the industry's conflicted business model.

Maybe I’m overly cynical, but when I read that a letter “could be a precursor to legislation,” that the House is “making plans for a hearing” and that an advisory committee “weighs making recommendations,” I interpret that to mean they’re all going to take their time and raise a bit of a fuss but ultimately do nothing.

Consider what happened when popular anger toward credit-ratings companies was highest. The SEC determined in 2010 that the best solution to the industry’s inherent conflicts was to allow the firms to publish unsolicited ratings on structured-finance deals they weren’t hired to analyze. Of course that was never going to take off. The agencies offering the highest ratings would have been brought on in the first place, leaving those with weaker grades on the sidelines. What company would willingly do extra work for free and burn bridges along the way?

Indeed, Moody’s, S&P, Fitch and Kroll Bond Rating Agency Inc. all told the Journal last year that they hadn’t produced any such unsolicited ratings under the SEC rule. Once in a blue moon, a company will publicly question a rival’s grades, as Kroll did to Morningstar Credit Ratings almost a year ago. But even then, Kroll didn’t put out its own unsolicited rank, opting to just call the investment-grade rating a “head scratcher.”

The senators’ letter cited the futility of the SEC’s measure: “The failure of other mechanisms to curb conflicts of interest, like the issuance of unsolicited ratings, indicates that another path forward should be considered.”

This is usually where the conversation ends. It’s easy to say something has to change; it’s hard to actually figure out a new way of doing things that doesn’t roil global credit markets. As of a year ago, S&P rated close to $20 trillion of corporate debt worldwide. The ripple effects of any abrupt move could spread far and wide.

Wicker, the Journal notes, did get a measure through the Senate a decade ago that would have created an oversight board to assign firms to rate deals. But in yet another sign of credit raters’ entrenched position in the financial system, the plan made it into the Dodd-Frank legislation with enough wiggle room for the SEC to contend that it studied alternative business models, yet ultimately nothing changed.

This is not to say that elected officials, regulators and investors should simply stay quiet and accept the status quo. The persistent attention paid to triple-B rated companies and their “fallen angel” risk keeps both corporate executives and credit analysts on their toes. Public comments like Kroll’s, even without an unsolicited rating, are a welcome and healthy development. I wish they were more frequent.

But the reality is any attempt to drastically revamp the credit-rating industry faces long odds. SEC Chairman Jay Clayton wrote in response to Massachusetts Senator Elizabeth Warren, who is also concerned about the credit-rating industry, that “it is important to consider whether further reforms are necessary or appropriate.” The Journal characterized this as potential openness to additional rules. 

I don’t see it that way. The investment-management industry is consolidating, with the biggest firms with the strongest in-house research analysts surviving. They know the incentive structure of credit-rating firms tilts toward higher grades and adjust accordingly. Ask just about any professional corporate-bond buyer, and they’ll tell you they don’t rely on published ratings because they’re backward-looking relative to the public markets.

It’s never a bad idea to toss around ideas about how to improve a crucial part of the financial system. For the credit-rating industry, though, a true overhaul is unlikely to get past that deliberative stage.

To contact the author of this story: Brian Chappatta at bchappatta1@bloomberg.net

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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