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Industry Wrote Provision That Undercuts Credit-Rating Overhaul

Industry-written criteria weakened a law meant to spur competition in the estimation of the default risks of bonds and other securities.

Washington – Moments before the Senate overwhelmingly passed a bill to overhaul the credit ratings industry seven years ago, Republican and Democratic sponsors took turns touting its promise for ending an entrenched oligopoly.

The bill, they said, should break the viselike dominance of three agencies – Standard & Poor’s Ratings Services, Moody’s Investors Service and the smaller Fitch Ratings – in an industry that serves as a crucial watchdog over the nation’s financial system.

What’s escaped public scrutiny until now, however, is that the law’s tough criteria defining when a newcomer could join the industry weren’t written by Congress. They were crafted by a yet-to-be-identified official of one of the big three ratings agencies, a former aide to the Senate Banking Committee has told McClatchy.

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Experts and the heads of unregistered ratings firms worry that congressional staffers, in seeking help to ensure that fly-by-night companies couldn’t win federal approval, inadvertently let the fox into the coop.

The industry-written criteria, they say, weakened a law meant to spur competition in the estimation of the default risks of bonds and other securities. Those ratings, ranging from AAA to C, often guide investments by pension funds, foundations, insurers and other institutions.

While a handful of new firms have registered with the Securities and Exchange Commission as “nationally recognized” ratings agencies, competition has increased only modestly since the 2006 law was enacted.

The criteria have prevented at least one potential competitor from winning approval and have dissuaded others from even applying, the critics say.

Despite a barrage of criticism over their behavior, the three firms issued 97 percent of all ratings in the 12 months that ended in June 2011, according to the SEC’s most recent publicly available data.

Perhaps most importantly, little competition has emerged in rating the kinds of complex home-mortgage securities whose implosion led to the 2007 financial crisis. The market for those securities has shrunk, but it’s expected to rebound.

Ann Rutledge and Sylvain Raynes, a husband-and-wife financial team who’ve crusaded for transparency on Wall Street, say they’ve devised a computer program that enables them to take on the big three in rating those complex “structured securities.” However, they said, their application to form a nationally recognized ratings agency has been hamstrung for nearly two years because of the industry-conceived registration requirements.

Gene Phillips, a director at New York-based PF2 Securities Evaluations Inc., said his company had decided against seeking registration because “there didn’t seem to be a clear path to achieving the criteria required, even if we did our job very well in the niche area of our expertise.”

The law set “odd barriers that are very favorable to the incumbents,” he said.

The criteria make it “exceptionally difficult for a younger player to qualify,” said James Gellert, the CEO of New York-based Rapid Ratings, a 22-year-old company that specializes in assessing firms’ financial health and hasn’t sought registration, also known as certification.

Further, the requirement of three years of experience “absolutely slammed the door on any new competition” in structured products – “the most lucrative part of the ratings business” – just as the financial crisis peaked, Gellert said.

None of the three major credit-ratings agencies, in emails from their spokesmen, acknowledged any role in drafting the Senate criteria.

The disclosure that one of the big three had helped shape a law that appears to partially insulate them from competition comes at a time when the SEC, under new Chairwoman Mary Jo White, has been wrestling with how to address the potential conflicts of interest that occur when a bank pays an agency to rate its securities. On May 14, the agency hosted a daylong round table on the subject with bankers, regulators and other stakeholders.

S&P, Moody’s and to a lesser extent Fitch have been under fire much of the last decade, accused of inflating their ratings on the securities issued by banks that paid them billions of dollars in fees. In the lead-up to the financial crisis, government investigative panels found, the big three compromised their roles as independent checks on Wall Street.

In February, the Justice Department filed a $5 billion damage suit that accused S&P of knowingly overrating junk home-mortgage securities. Sixteen states and the District of Columbia also are suing S&P.

The 2006 overhaul push stemmed largely from the discovery that S&P’s and Moody’s had failed to lower investment-grade ratings on debt issued by the energy trading giant Enron Corp. until four days before its 2001 bankruptcy filing and by telecom colossus WorldCom Inc. until weeks before its 2002 collapse. Investors in those firms lost billions of dollars.

As the Senate drafted its version of the bill, an industry official was “very helpful” in writing standards to guard against unqualified applicants winning registration, said the former Banking Committee aide, who insisted on anonymity in order to avoid harming relationships. The former aide also declined to divulge the identity of the industry official.

The industry-written criteria require an applicant to produce 10 confidential, notarized letters from “qualified institutional buyers” who’ve relied on the company’s ratings for three years, including two such letters for each category in which the firm sought approval.

Committee staffers were unfamiliar with the term qualified institutional buyers, a formal distinction that the SEC gives sophisticated investors that handle more than $100 million for clients, before the industry official proposed the requirement, the former Senate aide said.

Michael Greenberger, a University of Maryland law professor who’s a former senior staffer at the Commodity Futures Trading Commission, said the requirement was exclusionary.

“If it’s true that the existing credit rating agencies wrote the provision, they clearly wrote it in a way that made it very hard for anybody to become properly certified,” he said.

Rutledge and Raynes, former Moody’s employees, said in phone interviews that it would be “nearly impossible” for them to obtain 10 letters that fit the requirements.

Their clients, one of whom took a year to deliver a letter, fear that word of their support will leak out and lead to reprisals, Raynes said.

Greenberger said institutional clients “don’t want to anger the other prominent credit-rating agencies.”

Rutledge and Raynes’ New York firm, R&R Consulting, built a sophisticated computer program that can accurately assess the resale value of structured securities such as the home mortgage securities that contributed to the financial crisis, they said. If they’d been able to rate securities issued before the U.S. housing bubble burst, Rutledge said, “the markets would have frozen in a week.”

The resulting panic would have subsided quickly as investors saw a way to trace securities’ true values, Raynes said, unlike after the 2007 meltdown, when fear and uncertainty gripped a wildly gyrating market for months.

But their application was hurt because R&R provides “valuations” of securities, not letter-grade ratings as the major ratings agencies dispense, Rutledge and Raynes said, even though their valuations could easily be used to derive ratings. The SEC rejected all but one of the seven or eight investor letters they submitted because they referred to valuations rather than ratings, they said.

Greenberger said that “there are other ways to demonstrate competency” besides demanding client reference letters.

Moody’s spokesman, Michael Adler, said his firm “did not draft the act,” but he declined to say whether it had proposed the registration criteria.

S&P spokesman David Wargin declined to comment.

Fitch spokesman Dan Noonan said the firm had provided written comments about registration criteria for an earlier House of Representatives version of the bill “and suggested that the criteria ought to be objective and based on investor use of ratings.”

He said Fitch executives thought that “the law must promote rather than impede competition.”

SEC spokesman John Nester said the agency’s staff had reviewed a draft of the legislation but had had no role in writing the criteria.

Since the Credit Rating Agency Reform Act of 2006 took effect, the SEC has registered six new firms, bringing the total to 11. But three of the newly registered companies were small U.S. agencies that had operated for years. No U.S. firm has registered as a nationally recognized statistical rating organization over the last five years, and one Japanese firm relinquished its certification.

Two new U.S. players have emerged, Kroll Bond Ratings and Morningstar Inc., but only because they bought two of the three newly licensed U.S. agencies.

The 2006 bill seemed to have been dead as the congressional session neared its end, when Alabama Republican Sen. Richard Shelby, who was then the chairman of the Senate Banking Committee, suddenly introduced it on Sept. 6. It flew through both chambers and was signed into law, all within 23 days.

Shelby “didn’t support the provision” laying out rigid registration criteria, but he agreed to it in a compromise with other panel members, said his spokesman, Jonathan Graffeo. He apparently referred to Democrats led by then-Sen. Paul Sarbanes of Maryland.

Shelby’s political action committee received at least $28,750 from lobbyists for S&P, Moody’s and Fitch and their wives in 2005 and 2006, including a $5,000 donation from Lea Berman, the wife of Fitch lobbyist Wayne Berman, on the day that Shelby introduced the bill, Federal Election Commission records show. Fitch’s lobbyists also hosted or co-hosted a fundraiser for Shelby in the spring of 2005, the data indicate.

Graffeo said there was “absolutely zero” connection between the legislation and the donations. Fitch spokesman Noonan said the firm had “no knowledge of or influence over” campaign donations by its lobbyists.

Sarbanes, who retired from the Senate three months after the bill was enacted, didn’t receive any donations from the agencies or their lobbyists, according to election commission records.

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