Entry barriers stifle U.S. credit ratings competition

By Rachel Chang - Analysis

NEW YORK (Reuters) - Credit ratings agencies, blamed for exacerbating the credit crisis, seem to be getting off lightly under U.S. plans to overhaul the financial sector.

Critics who want to open up the industry to a new wave of competition say barriers to new entrants stand in the way of shaking up the entrenched system.

The agencies have been slammed for awarding pristine ratings to securities that later proved almost worthless, yet they continue to dominate despite having made few changes to the way they do business.

This, observers say, is because just two of them -- Moody's and Standard & Poor's -- control 80 percent of the market.

"It's easier to raise a militia with armed assault rifles in Michigan than it is to become an NRSRO (Nationally Recognized Statistical Rating Organization)," said Glenn Reynolds, CEO of credit research firm CreditSights, speaking at a Reuters Investment Outlook Summit last week.

Reynolds, who competes with the agencies from a research perspective and has been a vocal critic of their methods, was referring to the waiting period before a credit ratings agency can be considered an NRSRO by the U.S. Securities and Exchange Commission.

The NRSRO label is the SEC's stamp of approval and signifies that a ratings agency is credible and reliable. It is generally acknowledged that without the designation, an agency cannot transcend niche status because most investment firms require an NRSRO ratings on their holdings.

Moody's, S&P and Fitch, which together have over 90 percent of the market, have defended these barriers as ensuring the quality of rating agencies. But critics have charged that their missteps in the recent past have made this argument moot.

An agency has to rate products for at least three years before it can apply. Even then, the vetting process usually takes longer. Egan-Jones, the latest NRSRO, was admitted in 2007, nine years after applying.

FLAWED MODEL

According to the SEC's Fair Disclosure rule, NRSROs cannot use confidential information from bond issuers unless the ratings are disclosed publicly. As a result, Moody's, Fitch and S&P do not profit from the publication of their ratings, but instead make money by charging issuers.

Payments from issuers, however, have been criticized in the aftermath of the financial crisis as a potential conflict of interest.

Unfortunately for smaller, investor-paid credit ratings agencies, the rules effectively bar them from becoming NRSROs, as public disclosure of their ratings would remove their revenue stream.

The new reforms do not touch on the issue of how ratings agencies are paid.

"It's highly damaging because it supports the oligopoly that exists now," says James Gellert, chief executive of RapidRatings, an investor-paid agency. "Being an NRSRO would erode our business model."