It sure would be nice if some new firms could challenge the big three, but new entrants face a difficult road ahead
Imagine if there were just three food critics in the U.S. Let's say they proclaimed that a group of restaurants (pick your cuisine: seafood, Vietnamese, Californian, whatever) were creating some delicious, healthful food. So people started eating that food. But after their meals, their stomachs began to ache and they realized that they'd been poisoned. These critics would be quickly out of a job, but in the world of rating agencies such justice isn't so easy. While some new entrants are trying to break in, they're going to have a very tough time.
Here Comes the Competition
Of course, the analogy above describes what happened during the housing bubble. The rating agencies made some serious errors grading mortgage-backed securities, collateralized debt obligations, and some other mortgage-related bonds that became toxic and almost killed the entire financial market. Yet the big three then -- Moody's, S&P, and Fitch -- remain the big now. Shouldn't other firms rise up to replace them?
They're trying. Jeannette Neumann at the Wall Street Journal writes that new challengers are coming. One example is Morningstar Inc. In addition to its mutual-fund research, it has been rating commercial-backed mortgage securities. It now seeks to expand into the residential mortgage-backed securities market. That one, in particular, should be ripe for competition. After all, that's where many of the bonds that almost wrecked the financial system came from.
But Morningstar is only one example that the article names:
Kroll Bond Rating Agency Inc., started by corporate-secrets sleuth Jules Kroll, aims to begin rating municipal securities by year-end. Two startup companies, European Rating Agency and MarketTake Inc., are raising money to launch operations as soon as next year.
Is the rating agency market evolving into a more competitive landscape? We can sure hope so, but a number of high barriers will remain in the way of new entrants.
The first obstacle standing in the way of some of these new entrants is the government. Not just any firm can declare itself a rating agency in the sense that matters. Issuers are required by the government to obtain ratings for certain bonds, but only agencies that are registered with the Securities and Exchange Commission can provide such ratings. Currently, there are 10 registered firms, including Kroll.
But newer firms must prove themselves to regulators before they can attain the designation of being a "Nationally Recognized Statistical Rating Organization." The SEC has some guidelines for what's needed. One requirement is that a firm must provide a list of at least 20 issuers that use its service. Another is that at least 10 investors must supply written certifications on behalf of the new agency. For fledgling new agencies, these requirements can't be a cinch: if you haven't established yourself and aren't registered, why would issuers and investors trust you? And without that trust, registration will be out of reach. This can be a troubling catch-22.
Even though the big three agencies were pretty seriously embarrassed by their poor performance during the housing bubble, the market might not be so quick to dismiss them. Back when I worked with issuers and rating agencies, few issuers had any appetite for considering using one outside the big three on a deal. Sentiment may have changed a little bit, but that isn't particularly likely.
Once an issuer becomes comfortable with a rating agency, hiring a new one doesn't seem like a sensible move. The issuer must then invite the rating agency to pour over its records, which probably includes a site visit or two. It has to understand the agency's rating methodology and how it might differ from the analyses of other agencies. It then has to hope that its investors can stomach a new rating agency, which they probably aren't as familiar with. Finally, the issuer has to hope that the new agency provides the ratings it thinks it deserves, which is no guarantee.
So a new agency has must tell an extremely compelling story of why issuers should switch. It has to get issuers to take on the additional risk and the additional cost of hiring a new firm, which might not work out to their advantage ultimately if the rating isn't what the issuers had hoped. Oh, and it's also very expensive to hire financial experts of a high enough caliber to make your agency succeed. The status quo is hard to change, even if the big three did screw up a few years ago.
This begins to hint at a structural problem within the financial markets. As long as the issuer gets to pick the agencies that rate its deals, it's more likely to go with who it knows. What sort of advantage can a new agency promise an issuer if it switches? Better accuracy probably isn't going to matter if the issuer feels that the ratings it's getting are sufficient.
So what would it take? The only real selling point could be if a new agency claims that the old agencies are judging the issuer too harshly. Of course, the prospect of a new agency going easier on an issuer is precisely what we don't want: lax ratings were the problem back in 2008.
In an ideal world, the structure of the ratings market would be different. Instead of issuers paying the agencies, the investors somehow would. After all, they're the ones that benefit when the agencies provide high quality ratings. Although a provision in the Senate's version of last summer's financial regulation bill hoped to begin to fix this structural defect, it became a mere study during the confirmation process. So even if investors would like to see a better diversity of opinions on bond ratings, they have little power to make that happen.
The financial market certainly would benefit from some more voices in the bond ratings space. If only there had been a legitimate contrarian with a loud voice during the housing bubble, we might have seen a little more restraint on the part of the agencies when it came to handing out AAA ratings on flawed mortgage securities. While better competition is possible, it's a pretty tough outcome to achieve at this time.
Image Credit: REUTERS/Brendan McDermid