Why Rating Requirements Don't Make Sense - The market—not government mandates—should decide the value of our work

Why Rating Requirements Don't Make Sense. By DEVEN SHARMA
The market—not government mandates—should decide the value of our work.
WSJ, Jan 19, 2010

Some very eminent voices, including this newspaper, have called for repealing regulations that directly or indirectly require certain investors to hold debt evaluated by rating agencies. They argue this government mandate interferes with the free market and encourages undue investor reliance on credit ratings.

We at Standard & Poor's could not agree more. We support removing investor rating requirements and believe the market—not government mandates—should decide the value of our work.

We have always measured our success by the value we bring investors. We offer our ratings as a view of relative credit risk—not as a buy, hold or sell recommendation. But we recognize that rating mandates may have prompted some investors to use ratings in ways they were never intended.

S&P is one of 10 firms considered by the Securities and Exchange Commission to be "Nationally Recognized Statistical Rating Organizations" (NRSROs). Various federal and state regulations prevent certain banks, public pension funds, money market funds, and other regulated entities from investing in securities unless they have NRSRO ratings.

These regulations may have led some investors to confuse NRSRO ratings with a government seal of approval or to inappropriately use ratings as a short cut for gauging investment suitability, rather than as just one of many tools that investors can use in independently analyzing credit risk.

Now Congress is considering legislation that would subject rating agencies to discriminatory liability standards because of their NRSRO status.

Currently, rating agencies face the same liability standards as accountants and securities analysts. If the proposed legislation becomes law, rating agencies would be subject to discriminatory, more onerous, liability standards than other capital markets participants. The proposed legislation could also make it difficult for new or small rating agencies to enter the market.

Worse, the proposed standards could deter firms from rating new debt, which would restrict the amount of capital available to new enterprises and technologies—capital that is critical to job creation.

Ratings are a valuable benchmark for investors. With respect to the assumptions underlying our ratings of U.S. residential mortgage securities in recent years, yes, we and others, including banks and regulators, failed to anticipate how steep the fall in house prices would be.

We have learned from this harsh lesson and have made significant revisions to our rating approach. Those revisions include modifying our methodologies and criteria to better account for a possible period of severe economic stress. Our ratings should now be more stable, comparable and transparent than before.

For instance, our criteria for rating a security as AAA (our highest designation) include consideration of what could happen to a security if the country faces an economic scenario on par with the Great Depression.

While we believe these and other enhancements will create more forward-looking ratings, it is still true that a credit rating is not intended to be, and must never be used, as the sole determinant of how well an investment meets an investor's needs.

That is why we believe rating mandates should be removed and why other rating firms that have made important changes in response to the financial crisis should also embrace removing rating mandates.

Standard & Poor's traces its origins back 150 years, long before any rating mandate, and would certainly be able to compete in an open market, as it does now overseas. We deploy over 1,300 credit rating analysts to provide investors with ratings that represent a common risk benchmark across industry sectors and geographic regions, as well as over time.

The administration and Congress aim to prevent another financial meltdown by increasing regulatory oversight and transparency for rating agencies, derivatives and mortgage underwriting practices. They also aim to diminish systemic risk. We support these reforms insofar as they create a level playing field that ensures that capital markets return to sustainable growth.

Irrespective of regulatory reforms, our most important audience will remain the marketplace. If our ratings are valuable, people will use them. If not, market participants should not be forced to use them. We should be judged by the quality of our products and the value investors derive from them.

Mr. Sharma is president of Standard & Poor's.