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SEC proposal would bar ratings firms from strong-arming issuers

April 9, 2007 Financial Week

In a little-heralded move, the Securities and Exchange Commission has proposed a new credit rating rule that could lower CFOs’ costs of borrowing, but the Big Two credit rating agencies—Moody’s and Standard & Poor’s—are fighting hard against it.

The proposal would eliminate notching, in which a credit rating agency automatically adjusts downward the ratings on structured finance bonds if it didn’t originally rate the underlying assets. Lower-rated bonds cost companies more to issue.

“The practice of notching increases costs to CFOs, so this should matter quite a bit to them,” said Christopher Ricciardi, CEO of Cohen & Co., an alternative fixed-income asset manager with $32 billion in assets under management.

Notching is one of the more objectionable actions allegedly practiced by Moody’s Investors Service, and the Standard and Poor’s unit of McGraw-Hill, the two credit rating giants that were the targets of the Credit Rating Agency Reform Act (CRARA), which Congress passed last year.

In the proposed rule issued in February, the SEC prohibited notching, period. It said that a Nationally Recognized Statistical Rating Organization—be it Moody’s, S&P or anyone else—could not threaten to modify an existing or prospective credit rating based on whether the rated entity, or its affiliates, buys that NRSRO’s credit rating for other products. That prohibition, the SEC said, would prevent an NRSRO from exerting unfair “leverage.”

But as a sop to the Big Two, the agency said that an NRSRO could refuse to rate a structured product if the NRSRO had rated less than 85% of the market value of the assets underlying that structured product. Nearly everyone involved has assailed that 85% standard, which the SEC apparently pulled out of thin air, based on what it called “anecdotal” data. John Heine, an SEC spokesman, declined to elaborate on the language in the Federal Register notice.

Charles Brown, general counsel of Fitch Ratings, the distant No. 3 industry player, said the SEC should cancel the 85% yardstick and force all NRSROs to recognize the ratings of one another.

Moody’s and S&P vehemently oppose the ban on notching and the SEC plan to force them to accept another agency’s rating on even 15% of a collateralized debt obligation’s underlying assets.

Jeanne M. Dering, executive vice president of global regulatory affairs and compliance at Moody’s, said her company “strongly objects to any measure that would compel an NRSRO to use other NRSROs’ ratings interchangeably with its own.” Ms. Dering was echoed by Vickie Tillman, executive vice president at Standard & Poor’s. She said the 85%-15% split “would flatly prohibit NRSROs from incorporating their own analyses into ratings on structured products, and other products as well, where they have not rated all the underlying assets.”

She added that calling the proposal radical would be an understatement. “It would also leave NRSROs no choice but to accept blindly the rating opinions of not only Fitch, but any other rating agency that meets the threshold for designation under the [credit rating agency reform] act,” she said.

Moody’s and S&P are getting support in their campaign from the Financial Services Roundtable. Richard Whiting, executive director and general counsel for the FSR, said the section of the SEC’s proposed rule dealing with notching is “ambiguously drafted and can be interpreted as mandating that NRSROs use the ratings of other NRSROs interchangeably with their own.” He said such a mandate would contradict the Reform Act and undermine rating agency independence to the detriment of the financial markets. He said notching should be prohibited only if it is due “to coercive or anti-competitive intent.”

But other industry players think notching is, per se, anti-competitive. “Notching appears to be designed to restrict competition,” said Sean J. Egan, president of Egan-Jones Ratings. “If a rating firm has proven that it has timely, accurate ratings, there should be no notching.”

For CFOs, “notching can hurt CFOs by potentially raising their borrowing costs,” according to Cohen & Co.’s Mr. Ricciardi.

For example, take a hypothetical case where corporate debt is not rated by either Moody’s or S&P and that debt becomes part of a structured credit product that will be rated by Moody’s. If any of the 15% of the underlying assets are rated by Fitch, then Moody’s could notch or downgrade that corporate debt—if the SEC allows it—from, say, BBB to BB, thus increasing corporate costs of borrowing by up to an extra 1.0% a year.