Undue credit

DAVID EINHORN, a hedge-fund manager, saw the financial crisis coming and made a fortune from it. But not all his predictions have been as prescient. Asked in 2012 about rating agencies, which, unlike him, had failed to discern the impending disaster, Mr Einhorn said, “It’s a matter of time before they all disappear.”

After all, the three big rating agencies, Fitch, Moody’s and Standard and Poor’s (S&P), had all judged Lehman Brothers a safe bet until the morning of the day it defaulted; they also gave high ratings to securities based on subprime mortgages that turned out to be toxic. “Deeply disappointing,” was how Ray McDaniel, the boss of Moody’s, described its performance.

In response, politicians vowed to change the industry beyond recognition. They handed the job of regulating them to new outfits: a special unit of the Securities and Exchange Commission (SEC) in America and the European Securities and Markets Authority in the European Union. A provision of America’s Dodd-Frank financial-reform law, enacted in 2010, states that any requirements in regulation for a security to be rated should be expunged. For good measure, America’s Department of Justice began investigating S&P for fraud, claiming it deliberately distorted its ratings to win more business.

The result? Rating agencies are thriving. Demand has been so strong, according to Bill Bird of FBR Capital Markets, a broker, that they have been able to raise their prices by about 4% a year since 2010. Revenues are at record levels. The shares of Moody’s, the sole stand-alone agency, are up more than sixfold since 2009. Its board was not, apparently, so disappointed by its poor performance during the crisis: it kept Mr McDaniel in the job and paid him $14m last year. S&P settled with the Department of Justice in February, paying $1.4 billion but not admitting any wrongdoing.

The main boost to the business has come from ultra-low interest rates, which have prompted a surge in bond issuance. Trying to sell a bond without a rating remains really hard, says Mr Bird; reselling one is even tougher. That is because investors cannot hope to assess the creditworthiness of the hundreds of thousands of bonds in circulation: at the end of 2013 S&P had ratings on 1.1m issues, Moody’s on 900,000. Many big investors, such as CalPERS, an enormous public pension fund, do not allow those managing its money to invest in any unrated securities.

Scrapping legal mandates to have securities rated has also proved difficult. The SEC, for one, still stipulates what ratings the assets held by money-market funds should have, despite Dodd-Frank’s injunction to the contrary. It has proposed changing this rule to make the use of ratings voluntary, but in a way that implies that the funds it regulates will continue to rely on them. By the same token, the Basel Committee, an international club of regulators which sets global rules for banks, still uses ratings to judge the quality of their assets.

The big three agencies, despite their dire record in the crisis, have maintained a near-lock on the market (see chart). A few smaller firms provide competition in certain niches, such as A.M. Best, for ratings of insurance firms, and Kroll, for ratings of commercial mortgage-backed securities. But in corporate bonds, the big three have a market share of over 90%.

The heavy regulation of rating agencies appears to be part of the problem. Far from damaging the incumbents’ prospects, the rules seem to shield them from competition. To issue new ratings, a firm must qualify as a “nationally recognised statistical rating organisation” (NRSRO)—a process several potential new rivals to the big three have struggled with. Since 2011, for instance, the SEC has been reviewing the application of R & R Consulting, a firm established by two former employees of big agencies. Rather than try to change ratings as infrequently as possible, the conventional approach, R&R constantly adjusts them in response to new economic data, changes in interest rates and the performance of the underlying assets. This innovation has been popular with clients, and drawn interest as far afield as China. But it seems to have flummoxed the SEC, says Ann Rutledge, a founding partner.

Another problem is the cost of becoming an NRSRO, which involves exhaustively documenting the methodology behind each rating and ensuring that commercial staff have not influenced the work of analysts. The activity of certain employees must be monitored even after they have left the company. Such cumbersome procedures favour incumbents, which can divide the cost of compliance among a bigger pool of customers.

According to James Gellert, the boss of RapidRatings, another new agency with barely 50 employees, becoming an NRSRO would double its operating costs. RapidRatings has nonetheless won business from investment firms and companies looking into the solvency of counterparties thanks to its innovative techniques. It crunches 73 ratios for every security it covers, adjusting for 24 industry models, to compute a rating. Updates are generated automatically as new financial information is disclosed.

Many of RapidRatings’ clients use it precisely because it is not an NRSRO, says Mr Gellert, and so is not bound by the ossified systems that entails. It is not even bothering to apply for the title, which means its ratings cannot be used by money-market funds or banks, and do not pass muster with the likes of CalPERS. That cannot be the outcome that policymakers were hoping for when they dreamed of changing the industry beyond recognition.