Friday, December 11, 2009

Rated 'R' for Resilient

By Eric Jackson Senior Contributor
12/11/2009 11:00 AM EST
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When the history of the financial meltdown of 2008 is written, there will be a special chapter devoted to the large credit-ratings agencies and their culpability in slapping "AAA" on the subprime mortgages and corporate debt that turned out to be toxic assets. Yet we still don't know if that chapter will close with a regulatory overhaul of a now battered industry, or with lost political momentum that leaves us with the status quo.

For years, the Big Three ratings agencies, Moody's (MCO - commentary - Trade Now), Standard & Poor's (a unit of McGraw-Hill (MHP - commentary - Trade Now) and Fitch (a unit of French company Fimalac), had thrived on an "issuer pay" business model. The companies that brought their debt to market paid the agencies to rate the risk to investors of buying and holding those products. This business model proved far more lucrative to the ratings agencies -- Moody's and its cohorts have historically enjoyed operating margins of more than 43% -- than the one they used prior to the 1970s, when it had been the prospective investors who paid for the ratings.

They also enjoyed a regulatory advantage. The Securities and Exchange Commission certifies Moody's and other ratings firms as Nationally Recognized Statistical Ratings Organizations, an accreditation granted under strict scrutiny. Only NRSROs can rate products that certain investors are required by their internal rules to hold, which effectively gives the Big Three a steady stream of customers.

In a financial system built on investor confidence, the ratings agencies were supposed to provide the underpinning for that trust. But in the wake of last year's financial debacles, it is the agencies themselves who are struggling to explain why anyone should trust their judgment.

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