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WHO’S WATCHING THE WATCHERS?

Credit rating agencies make a living scrutinizing others, of course. But who is rating them? No one, and that’s a problem, says William H. Donaldson, chairman of the Securities and Exchange Commission.

“Legislation is what is called for in my mind,” he said at an SEC meeting in March. “It is very troubling to see this industry go with no significant oversight at all.”

The SEC has started a push to define what a rating agency is, and industry sources there say they hope to make the agencies more accountable; the current system, they insist, is exposed to conflicts of interest and lacks competition. The agencies, for their part, say they are willing to regulate themselves and are even working with the SEC to draft codes of conduct and self-audit procedures.

But this may not be enough, according to Donaldson. He says the rating agencies’ efforts to self-regulate lack independent oversight and vigorous enforcement. Further, critics say, three agencies — Fitch Ratings, Moody’s Investors Service and Standard & Poor’s — dominate the sector because of the difficulty of the SEC designation process, which discourages competitors.

The SEC does provide a designation — Nationally Recognized Statistical Rating Organization, or NRSRO — for agencies it deems acceptable. Since February 2003, the SEC has recognized two new organizations: A.M. Best Co., of Oldwick, N.J., and Toronto-based Dominion Bond Rating Service, but these and the major three are so far the only ones with the track record and reputation needed for NRSRO status.

One cause of controversy is the fact that agencies earn their revenues from fees paid by the companies whose debt they evaluate — a potential conflict of interest.

Regulators are also disturbed by the increasing amount of consulting work the agencies are doing for companies seeking to raise their credit ratings, another potential conflict of interest. Despite these concerns, the SEC says the rating agencies should develop their own safeguards against conflicts of interest.

The rating agencies bristle at any suspicions of impropriety. “I cannot think of an instance wherein the NRSROs have misused their power,” said Michael Ho, assistant vice president of ratings origination at Dominion Bond Rating Service, which received its NSRSO designation from the SEC in 2003.

As a guard against conflicts of interest, the credit rating analysts do not make rating decisions, Ho says. Instead, they submit their recommendations to a committee. Further, the analysts have nothing to do with setting the fees charged to the companies being rated, the agencies say.

However the SEC and the rating agencies settle their differences, any changes are likely to be incremental. The agencies have set no timetable to produce a voluntary framework of codes for professional conduct and self-audits. And industry sources say that only established NRSROs are invited to the table for those discussions.

Some investors, relying on rating agency opinions for their decisions, like the system as it is. The agencies have instilled discipline in the real estate industry by giving landlords an incentive to manage debt well to get ratings that will make their corporate bonds attractive, says Kin Powell, a portfolio manager at Atlanta-based Enterprise Financial Services, which oversees REIT stocks and unsecured debt investments for institutions.

“If they get out of line, the product that they rate would not perform as expected, and their credibility would be lost,” said Powell. “No, I don’t see that [happening].”