The Senate passed the landmark ‘Wall Street reform bill’ which includes important new requirements and oversight of rating agencies.  The most damaging aspect of the reform bill for rating agencies is the liability provision.  Investors could bring private rights of action against rating agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.  Up to now credit rating agencies claim that their ratings are opinions and not investment recommendations or advice.

There are indications that certain European nations will adopt similar measures.  Asian countries could follow suit.  China is already working on a legal framework to regulate credit information in general and rating agencies in particular.  The consequences could be fewer rating agencies rather than more.   The surviving rating agencies will become much more cautious and will be less inclined to provide top ratings.  Information requirements and due diligence will be more stringent, costly for issuers and rating agencies (for unsolicited ratings).   Rating agencies may refuse to rate certain corporate, governments, and structured finance securities altogether.  New emerging industries (bio-tech and new environmental technologies for example) will not be able to get ratings because of the lack of historical data. 

Notwithstanding regulatory restrictions and potential future liabilities, surprisingly a number of firms have stated that the time was right to enter the credit rating business:  Morningstar, Bloomberg, Coface, Kroll, Hearst and not to be left out KPMG and PwC.   As to the potential new entrants, they all believe investors will flock to them because of the current poor reputation of the big three.  What makes them think they would to better? 

Take Morningstar who recently bought Realpoint LLC (one of the ten NRSROs), a relatively small company, but Morningstar thinks it can expand globally, but has not let on how.    Coface, the French credit insurer said its business relied on ratings and got burned.  Perhaps it wants to get even by entering credit rating by using its large experience base of financial statements, positive and negative data on trade credit transactions and its underwriting experience.  Coface has not explained how it would accomplish the transformation from trade credit ratings to capital market ratings.  Bloomberg, certainly has the resources to acquire the expertise to rate companies and debt instruments.  However it would need more than Chinese Walls to keep its rating business sheltered from its news operations.  Issuers will always be suspicious that their proprietary data may end up in Bloomberg’s newsrooms.   Julius Kroll, the corporate sleuth, has announced that he will be entering the credit rating business as early as July.  His expertise is due diligence and he feels that is good enough for starting a rating business.  Due diligence deals with the past and current state of a business, he has not spelled out how he intends to tackle the future assessment of complex risk.  KPMG and PwC are said to be pondering a role in credit rating.  They certainly have expertise, however it would prevent them from rating companies they audit. 

It is most likely that some of these potential new entrants will develop special ratings, benchmarking services or to concentrate on industry verticals, which may be substantially different from the current Nationally Recognized Statistical Rating Organizations (NRSROs). 

Current shareholders of the three largest rating agencies are certainly not very happy and are voting with their feet.  Fimalac, Fitch’s parent, has sold off a further 20%; Hearst now owns 40% and may be picking up an additional10%.  Mr. Buffet is said to be disenchanted with Moody’s and his Berkshire Hathaway company sold repeatedly shares in 2009.  Berkshire’s stake is now down about 34% from the 48 million shares it owned.   Source:  Outsell Inc. and BIIA assessment

BIIA Newsletter June I – 2010 Issue