Credit Rating Agencies - Significant Reforms Needed

For nearly 100 years, credit rating agencies have been providing opinions on the creditworthiness of issuers of debt to assist investors. The Securities and Exchange Commission (SEC), banking regulators, and the Federal Government rely on ratings from rating agencies to make decisions that impact the American public. Recent turmoil in the U.S. credit markets, coupled with a growing distrust of the system itself has set the stage for fundamental reform and AFP has made two suggestions to help achieve that reform.

The model and structure of the ratings agencies is flawed and AFP believes that minor changes to current rules will not adequately address these flaws - significant changes are necessary in order to fix this inherently broken system. There is no doubt that that the credit rating process and investor confidence in those ratings are vital to efficient global capital markets. The ratings produced by Nationally Recognized Statistical Rating Organizations (NRSROs) must be sound and reliable if our markets are to operate in the way they were intended.

Since 2002, AFP has been a vocal advocate for the reform of the credit ratings industry. During that time, we conducted several surveys that found that both issuers of corporate/municipal debt and investors of corporate cash and pension assets believe: 1) the information provided by credit rating agencies is neither timely nor accurate, 2) the rating agencies are primarily serving the interest of their shareholders and other parties rather than investors, and 3) the SEC or some other regulatory body must increase its oversight of rating agencies and takes steps to foster greater competition in the market for credit rating information. We worked closely with key policymakers to successfully pass the Credit Rating Agency Reform Act of 2006 (CRRA) which provided the SEC with the authority to make significant strides toward removing barriers to competition. Regrettably, passage of the CRRA has not led to real competition in the credit ratings market. AFP believes that tinkering with the current rules will not adequately address flaws - we must come up with a new approach.

Limiting Mission of Rating Agencies

On April 15, 2009, AFP unveiled two proposals to fundamentally change the current business models of credit rating agencies and alter the way the ratings business is run. The first proposal suggested a stand-alone model, where the only business of the credit rating agency would be to produce credible and reliable ratings. This model - similar in nature to a utility- would support ratings organizations whose sole business purpose would be to provide credible and reliable ratings.

These new ratings organizations could be financed by a transaction fee levied on investors and issuers alike. As an example, the fee may be based on the amount of debt outstanding of an issuer or assets under management of an investor. The goal is to separate compensation from the actual ratings process. Rating agencies operating under this model would be able to interact with and advise organizations being rated, but could not charge fees for providing advice, as Moody's and S&P do today.

AFP believes this model is a viable way to subsidize rating organizations dedicated to provide credible and reliable ratings as their sole business purpose. Additionally, this type of transaction fee model would have built-in price controls because it is based on a flat fee. With this stand-alone model, most of the conflicts-of-interest that the current CRAs have would be mitigated.

By creating a funding source that is independent of the issuers and investors, the focus of the CRAs will be on producing the most accurate and timely credit analysis rather than satisfying the desires of any vested interest. However, the SEC would still have to exercise vigorous oversight of the CRAs to ensure that they are fulfilling their mission and are held accountable for inaccurate ratings.

Ending Dependence on the "Big Two"

The other proposal that AFP believes is worth exploring would be for the U.S. government to require itself and all federal programs that require credit ratings, as well as any business that has had a capital infusion from the U.S. government, to utilize the alternative NRSROs as additional credit analysis providers. This departure from tradition by such a key market participant would encourage the development of a truly competitive environment and give credibility to alternative rating agencies.

Given the dominant market position that S&P and Moody's currently possess, the barriers to having one of the alternative NRSROs grow to the point of being an equal competitor seems remote. The U.S. government must break its own addiction to S&P and Moody's. These dominant players should not be rewarded for failure. We believe others should have the opportunity to take part in this industry if it is to be truly competitive.

Under this proposal, the government, including the Treasury Department, would immediately begin to use alternative NRSROs rather than relying solely on those provided by S&P and Moody's. We further propose that federal agencies be required to utilize at least one non-issuer/non-subscriber service/new rating agency (as envisioned by our first proposal) for all transactions with underlying assets of $50 million or more.

Although corporate America currently has the ability to utilize alternative NRSROs, until these entities are viewed as being on a level playing field with the major ratings agencies, this is unlikely to occur. Individual companies will be unwilling to spend the time, resources, and money on ratings that aren't view as being "as good as" the majors. If the government were to support alternative NRSROs, they would have the opportunity to grow to be worthy competitors, establish reputations, and provide needed competition in the credit rating agency world.

The rating agencies are an ingrained component of the investment decision process, but they have clearly failed, as a group, to provide accurate and timely information to investors over most of this current decade. Over this timeframe, market participants have been punished severely, while the major rating agency management teams and shareholders have benefited greatly from 'cranking out' ratings without performing the necessary credit review and stress testing that is required by the SEC.

Over the past seven years, the AFP has posited that with increased competition and oversight, the inherent problems of having a government-created duopoly would be corrected. Given the utter failure of the rating agencies over the past several years to identify the credit crisis, AFP believes it is time to try a new approach to provide investors with the information they need to make prudent investment decisions.

AFP fully supports increased disclosure requirements, but we argue for model agnostic disclosure - it must be the same across the board for all NRSROs regardless of how they are compensated. Above all, whether we move to a different rating agency model or not, the SEC must enforce strong anti-conflict of interest rules. Recent history has shown that NRSRO's CANNOT police themselves.

It has been argued that professional investment managers do not require the analysis of rating agencies. Since their core business is making investment decisions, they should have the resources in place to perform their own robust due diligence. However, AFP is concerned about corporate America's ability to make prudent investment decisions in a timely and effective fashion. Given the highly competitive global economy we operate in, most of our membership is unable to allocate resources purely for the purpose of investment credit analysis. In order to participate in the purchase of securities other than the most safe type, i.e. U.S. Treasuries, companies need to be able to rely on third-party credit analysis as a basic credit framework. If investors do not or cannot rely on credit ratings, then ratings agencies serve no purpose in our economic system.