Congress giveth and Congress taketh away (Part 1): The SEC and credit rating agency legislation

Two laws recently have been passed by Congress and signed by President Bush that will have a big impact on the regulation of U.S. financial markets. Neither of these laws have received much press, and I suspect that most Congressmen didn't even know what they were voting on when they agreed to them. They don't directly touch on issuers or investors, so, unlike Sarbanes-Oxley, they are pretty much under the radar screen. But they both will have a profound impact on what the Securities and Exchange Commission's Division of Market Regulation does.

The first of these new laws is the Credit Rating Agency Reform Act. (The second will be discussed in a different post.) This is an interesting law with a very convoluted history that some day will make a good study for public choice theorists.

The story basically goes like this: The SEC requires investment banks and broker-dealers and other people who hold your money on your behalf to keep some of that money in reserve to cover losses that the company might experience as a result of operational failures, employee theft and the like. (The risk you face as a result of your bad investment is your own problem, but the idea is that you should be protected from losses that happen if somebody at the company types in the decimal point in the wrong place after you place an order.) Since 1975, the SEC has said that if the investment company keeps some of its money in particularly safe and liquid assets (i.e., investments that most likely aren't going to lose much value tomorrow and can be sold on a moment's notice), then the reserves don't have to be so big. But how do you know if an asset is safe and liquid? Well, one way is to look at the asset's credit rating. If a rating agency says U.S. government bonds are "Triple-A" (in other words, short of a nuclear holocaust, the U.S. government is going to pay you back, particularly since it can print the money to do so), then an investment company holding a lot of those bonds doesn't have to set aside as much cash as would a company investing in "junk" (very risky) bonds or equities.

But which rating agencies are acceptable? Some (such as Moody's, Standard and Poors, Fitch, etc.) are famous and respected. The one I just started in my basement where I assign credit ratings based on the shape of chicken entrails is somewhat less so. So, as part of this 1975 SEC "Net Capital Rule," the SEC said that if the credit rating agency is "nationally recognized," its ratings could be used in determining reserve requirements. So, how do you know if a rating agency is nationally recognized? Up until now, if you were an investment firm, you sent a letter to the SEC asking if they would take an enforcement action against you if you relied on XYZ Ratings, and, after some time (maybe a long time) and after deliberating deep within the SEC's offices, they just might send you a "No Action" letter saying they won't go after you if you do. Or they might not. And, if some rating agencies are to be believed, the SEC rarely tells you why they make the decisions they do, or what they are looking for. As for the SEC, they say they merely poll "the market" to see how widely a given rating agency's ratings are used.

It is an opaque system. Worse, it's arguably anti-competitive. Since 1975, the SEC and a number of other government agencies (and foreign governments) have piggy-backed on this "NRSRO" (Nationally Recognized Statistical Ratings Organization) system for banking, mutual fund and insurance regulation. Even private companies use the SEC's NRSRO status in their own contracts, under the theory that if a rating is good enough for the SEC, it's good enough for them. In the late 1970s, there were 7 NRSROs, but by 2000, mergers had cut this number down to 3. Since then, and under pressure, the SEC has increased this number to 5 (adding the Toronto-based Dominion Bond Rating Service and A.M. Best to Moody's, Fitch and S&P).

This situation has annoyed issuers and smaller rating agencies. Issuers pay NRSROs to rate them, because the NRSROs have figured out that information about their ratings spread so quickly that they face a collective action problem with fees. Nobody (with the exception of Bloomberg and other news services) will pay for their ratings, since they can get it free through the gossip mill. So, instead, the big rating agencies charge issuers for a rating, much like your bank charges you to run your credit score for a car loan. Further, issuers have to pay for more than just one rating, since investors want a second--or third--opinion before parting with their money. Making it worse, they don't want a rating from just anybody. If you don't go with an NRSRO, the investors will just assume you paid me off to rig the chicken entrails in such a way to get you a good rating. (And they'd be right.) So issuers are facing an oligopoly, and new entrants are closed out of the market.

But while issuers have been peeved, in the grand scheme of things NRSRO ratings, while overpriced, are not nearly as overpriced as are underwriting fees. (If you have a $100 million bond offering, you really don't care if S&P sends you a bill for $75,000--particularly since your investment banker's bill will probably be $6-7 million.) At the same time, new entrants to the ratings market tend to be small and politically weak. Consequently, there really wasn't much political momentum for change. That is, until Enron. Enron raised investor hackles because all of the major rating agencies missed the boat and failed to predict the company's collapse until just beforehand. (In their defense, of course, it should be noted that the immediate reason for Enron's collapse actually was a ratings downgrade, since Enron had a number of large loans that came due immediately upon Enron's debt being downgraded to junk status. Nonetheless, Moody's, S&P and the rest seem to have taken at face value whatever Enron was feeding them beforehand.) This event changed the politics of NRSRO recognition and put pressure on the SEC to regulate the industry and open the doors to competition.

In early 2005, after unsuccessfully petitioning the SEC to grant his little operation NRSRO status, Sean Egan, the owner of Egan Jones Ratings Co., asked his congressman, Michael G. Fitzpatrick (R-Penn.) to introduce legislation that would basically take from the SEC the authority to determine which rating agencies could be NRSROs. The resulting legislation, which passed the House this past summer, was called the Credit Rating Agency Duopoly Relief Act ("duopoly" referring to the 70+ percent market share of Moody's and S&P.) House Republicans strongly supported the bill, not so much because they thought that the ratings industry needed more competition, but because certain House staffers instinctively distrust the SEC and Fitzpatrick is a first-term congressman facing a tough reelection battle. Legislation bearing his name might lend him some campaign ammunition (though why his Pennsylvania constituents would care about ratings agency legislation is beyond me). The House bill would have prohibited any rating agency from issuing ratings in the United States unless it was first registered with the SEC, and would have mandated that the SEC would permit registration of any rating agency that had three or more years experience and no obvious conflicts of interest. (How this mechanism would actually promote competition is also beyond me, since you couldn't do business if you weren't registered, and you couldn't register if you hadn't been doing business for at least three years. But, of course, Egan Jones had been doing business for more than three years, so who cares, right?)

This bill passed the House by a wide margin. But a funny thing happened on the way to the Senate. The Senate's version of the bill, which was only drawn up after the House bill had passed, largely paralleled the House version but for a few, very important, changes. In particular, rather than mandating that the SEC permit any rating agency to register as an NRSRO, the Senate version said the SEC should designate any rating agency an NRSRO provided the rating agency submitted certifications from at least 10 financial firms stating that they actually rely on the agency's ratings. The SEC is also given the power to set other rules to determine who qualifies as an NRSRO, and any registered NRSRO is subject to SEC rules and oversight. (Prior to this law, there were questions about whether the SEC had the legislative authority to regulate the NRSROs--see, for example, former SEC Chairman William Donaldson's speech here). This Senate bill passed and the House agreed to the Senate version without hammering out any differences in conference. President Bush signed the bill into law on Sept. 29.

So, what does this all mean? It means that that while the SEC has been forced to clarify how it designates certain rating agencies as "nationally recognized," the SEC also has considerable new powers to regulate them. At the same time, Congressman Fitzpatrick and his constituent, Sean Egan, seem to have lost control over the truck they set in motion. Rather than opening the NRSRO designation to everyone, the Credit Rating Agency Reform Act actually tightens who can qualify as an NRSRO and gives the SEC broad new regulatory powers. Not exactly what Mr. Egan wanted, I suspect.

This new law likely will have two broad results. The first is that it may actually increase the number of NRSROs. Most of these new NRSROs, however, probably will not be small firms like Egan Jones, but foreign companies like JCR or R&I. A second result may be a new raft of "me-too" foreign legislation, particularly in Europe. The entire issue of credit rating agencies is more political in Europe than in the United States, with European issuers often complaining that the big "Anglo-American" ratings agencies don't understand how business is conducted on the Continent, and hence give them too low ratings because of under-funded pensions and the like. A new set of European laws on rating agencies likely will be more protectionist and focus on "issuer rights" rather than actual ratings quality. This could have a detrimental impact on the cost of capital on European markets.