Busting the Rating Agency Oligopoly
Interview with Risk Conference keynote: Jerome Fons.
BY Scot Blythe | July 7, 2011
As a speaker at this summer’s Risk Management Conference in Muskoka (August 23 – 25), Jerome Fons, executive vice-president, Kroll Bond Rating Agency, Inc. in New York, will be sharing his views of structure and history of the rating agencies, and how the role of ratings may be changing in light of the financial crisis. To find out more about Jerry’s presentation and the Risk Management Conference, click here.
The top ratings agencies have been through a crisis, thanks to the financial meltdown of 2008.
The industry has been traditionally dominated, at least in modern times, by an oligopoly of “two-and-half firms” (Moody’s, S&P and Fitch) and there have been calls for increased rating competition.
There was a massive rating failure in certain sectors. It’s actually shaken faith in the industry. So the industry’s main challenge is restoring trust.
Would changing how ratings agencies are paid help restore trust?
What’s crucial is who selects them. And who should pay. Generally speaking, investors aren’t interested in paying for ratings. They are happy getting certain services paid through so-called soft dollars. There’s just a culture of not paying for ratings. Now many investors argue that they do pay for ratings, but they do not get to select the rating agency. That’s still done by the arranger or the banker involved in putting together the deal.
The truth of it is that probably the most effective solution would just be one rating agency, and it would be immune to all conflicts, financial and any other pressures whatsoever and thereby have the luxury of calling them exactly as they see them. Part of the problem is that there are very few champions for the truth. The obvious example is sovereign ratings. People don’t want to know because the truth hurts and can be disruptive.
You say there is a distinction between credit analysis and the rating business. Why the disconnect?
I think because at least with respect to the crisis, the business of ratings corrupted the credit analysis. If someone asked me was the crisis caused by bad models or bad business, my take on it is that maybe it was 20% bad models and 80% bad business practices, that they allowed themselves to be shopped, that they purposely ignored warning signs in order to keep business. Now a number of the proposed rules, regulations and legislation are designed to prevent this ratings shopping and prevent business pressures from corrupting the analysis.
Are there models that would be more accountable?
I think there’s an inherent problem with the whole notion of ratings being simply expressions of opinion and being shielded in the U.S. by a First Amendment protection. Legally, the ratings agencies to date have not been held accountable because they claim they’re equivalent to The New York Times or The Wall Street Journal.
But generally speaking when the Journal expresses an opinion, people don’t lose billions of dollars. Are ratings commercial speech or free speech? This is one of the issues that is being dealt with in the courts and perhaps we will get some guidance down the road, if it goes up the chain to the Supreme Court.
How would you like to see the industry change?
I want to see the credit analysis profession restored and separated from flawed corporate practices. Obviously, we (Kroll Bond Ratings) would like to make a difference. We would like to set a standard that all rating agencies would follow, like being accountable and doing more due diligence. Many rating agencies claim to do original analysis, but they don’t do due diligence. They just accept the information that they get as given and look no further. We’re trying to put ourselves in the shoes of investors. The industry needs to put its focus back on building and maintaining a reputation, a reputation for serving investors because that’s who they should be serving, not their shareholders, not the issuers, but the investors.
Is it feasible for large institutional investors to do their own ratings?
Large institutional investors, possibly; with small institutional investors it becomes more problematic because to achieve the required coverage you need a very large staff and resources. You could outsource a lot of it. You could use models. Yes, the largest investors could certainly do their own credit analysis and they do. They have a fiduciary obligation to do it.. That’s the takeaway here: don’t outsource all your credit analysis to individual companies. Be open to other opinions and do more than look at just the rating, but also consider any supporting research and information. And ask tough questions.
To learn more about the Risk Management Conference, please visit the events section of the website. If you are interested in attending the event, please email Garth Thomas to be considered, as limited space available.