After the fall, credit ratings agencies seek redemption

NEW YORK (Reuters) - A year after the global credit crisis erupted, credit rating agencies still face a long process of restoring reputations and profits that took a century to build.

In 1909, a young entrepreneur named John Moody published a manual of railroad securities and assigned a letter grade to measure the risk of each bond, a major innovation at the time.

The idea was a hit, and Moody and his fledgling company established a name in the market for accurately assessing and measuring risk.

Moody's system became a force in the financial world, challenged later by rivals Poor's Publishing Co in 1919 and Standard Statistics Co in 1922, which devised slightly different grading scales. John Knowles Fitch entered the scene in 1924. The modern ratings business was born -- and boomed.

Today the reputations of Moody's Corp's (MCO.N) Moody's Investors Service, McGraw-Hill Co's (MHP.N) Standard & Poor's and Fimalac's (LBCP.PA) Fitch Ratings are in question because they expanded too fast into rating "structured finance debt," including instruments such as collateralized debt obligations (CDOs).

Those complex debt instruments helped fuel huge profits for banks and investors during the U.S. housing boom between 2001 and 2007, but then saw their value implode over the past year as U.S. home prices dropped, costing banks and investors billions of dollars in losses.

Since August 2007, Moody's Corp's shares have plummeted 32 percent and McGraw-Hill shares lost 27 percent of their value, leading to the departure of top executives, including the head of Moody's structured finance unit last month. Fimalac shares have fallen 26 percent.

And billions of dollars worth of pristine "AAA" letter grades have since fallen to junk bond status of "CCC" or lower, and come to symbolize something else entirely than investment grade.

"The 'Scarlet Letter syndrome' is what we're concerned about, first and foremost," Deborah Cunningham, chief investment officer at Federated Investors, said recently, referring to an American novel about a woman, named Hester Prynne, who was forced to wear a scarlet letter "A," a public badge of shame for committing the sin of adultery.

Rating companies today are the Hester Prynne of finance, the target of regulators and investors alike, scorned for assigning top ratings to CDOs that sparked a massive increase in mortgage-related debt.

Cunningham co-chairs a task force of the Securities Industry and Financial Markets Association, which issued a report last week that questioned the "quality" and "integrity" of the ratings process.

David Weinfurter, a Fitch managing director, said Fitch generally supports SIFMA's most recent report, which he said echoed earlier reports. However, one SIFMA proposal for a global advisory body seemed "unnecessary" since there are already similar groups, he said.

Other executives including Deven Sharma, president of S&P, and Stephen Joynt, president and CEO of Fitch, have said they back the general findings of similar recommendations.

Sharma told Reuters in June that financial firms will likely face earnings pressure over the next year, impacting all rating companies' business.

$1 TRILLION BOMB

By some measures, the risks associated with the three main rating companies may be tantamount to a $1 trillion bomb blowing up global financial institutions' balance sheets.

Investors and world financial markets discovered the breadth of rating firms' power over this past year, in which the mis-aligned ratings contributed to the wiping out of more than $400 billion of value for global financial institutions. Some analysts' estimates, including the International Monetary Fund, top $1 trillion in damage before the crisis is over.

"Yes, the rating agencies made mistakes, but Wall Street bought these bonds and no one stuck a gun to their head," said Andrew Harding, who oversees about $20 billion as chief investment officer at Allegiant Asset Management in Cleveland. "There's plenty of blame to go around."

Harding said rating companies earnings may take at least a year to recover.

"They will recover from this, but they will suffer some revenue consequences," Harding said. "Their credibility is certainly shaken, but they still have reasonable credibility outside of structured finance."

REGULATORS

Regulators like the Securities and Exchange Commission, SIFMA and a separate task force of the Group of Seven industrialized nations have recommended more disclosure of rating methods and fee structures, and a review of structured products ratings to improve the ratings process.

"It's certainly clear to most market participants that the issuer-pay model is fundamentally broken, despite the best efforts of the SEC and rating firms themselves to salvage it," said Sean Egan, co-founder of Egan-Jones Ratings Co, an independent credit-rating firm based in Philadelphia.

Egan, who has testified before Congress on the role of rating firms, said issuer payment to rating companies creates a conflict of interest for rating analysts and leads to inaccurate ratings.

He said the current crisis repeats the mistakes of prior problems stemming from ratings. Enron Corp,(ECSPQ.PK) the Houston-based energy firm, was an investment-grade company four days before going bankrupt in 2001, while WorldCom was rated a high-grade credit three months before filing for its $103.9 billion bankruptcy in 2002, the biggest in U.S. history.

"The rating industry is in a crisis," Egan said. "Until this huge disconnect is addressed, we will lurch from failure to failure."