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.