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Borrowers Find System Open to Conflicts, Manipulation

The SEC made one regulatory move that enhanced the credit raters' power. In the mid-1970s, after the raters failed to anticipate a major railroad default, investors grew nervous about the debt markets. The SEC decided to require that brokerage firms maintain a certain amount of cash, bonds and other assets. How much depended in part on the quality of those bonds.

Regulators weren't sure how to assess those bonds. So the SEC created a category of credit raters called Nationally Recognized Statistical Rating Organizations, or NRSROs. The SEC initially recognized Moody's, S&P and Fitch.

About This Series

Unchecked Power: The world's three big credit-rating companies have come to dominate an important sector of global finance without formal oversight. The rating system has proved vulnerable to subjective judgment, manipulation and conflicts of interest, people inside and outside the industry say.
Moody's Close Connections
When Interests Collide
Graphic: The Rating Game

Shaping the Wealth of Nations: As more countries rely on the bond markets to raise capital, they have been forced to accommodate the three top rating firms. The credit raters often have more sway over foreign fiscal policy than the U.S. government.
Transcript: Post Writer Alec Klein
Smoothing Way for Debt Markets
Graphic: Moody's Expansion

Flexing Business Muscle: Lack of oversight has left the rating companies free to set their own rules and practices, which some corporations say has led to abuses. The credit raters have rated companies against their wishes and ratcheted up their fees without negotiation.
New Choices for Consumers
Graphic: Raters' Big Misses

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Investors have come to consider the designation as the U.S. government's stamp of approval, and it is used by institutions, such as mutual funds, as a main criteria for investing only in bonds approved by such rating companies. That has helped the big three secure their monopoly, their critics say.

Last year, the government added to its list a fourth company, Dominion Bond Rating Service Ltd., a small Canadian firm. Competing rating companies have complained about their failure to achieve the designation because there are no laws or regulations explaining how to qualify.

Despite their complaints, the industry has received little public attention largely because its workings are complex and its clients are institutions rather than people. (The creditworthiness of consumers is rated by a different set of companies, which operate under extensive federal and state regulation.) But after the collapse of such companies as WorldCom and Enron Corp., Congress ordered the SEC to consider whether new rules were needed. During a 2002 hearing, Annette L. Nazareth, the SEC's market regulation director, wrestled with that question, saying the industry lacks transparency. The debt markets, she said, are "the dark corner" of the securities industry.

A Private Vote

The big three credit-rating firms wield power through letter grades they hand out. They explain their ratings approach in pamphlets and on their Web sites. But the process itself has remained a mystery of finance.

Committees of rating analysts, headed by one lead analyst, meet privately to weigh the financial strengths and weaknesses of those who want to sell bonds. Then, they emerge to give the bond a rating, announcing it to the world. The companies don't say who voted or how the vote broke down.

Over the decades, the rating companies and their supporters say, the system has proved its value and integrity.

"S&P has, in fact, been very successful in flagging deterioration in credit of companies, and that is why our opinions continue to be highly valued information to investors," said Vickie A. Tillman, executive vice president of the company's credit market services. S&P cited several examples of ratings that anticipated problems, at such companies as US Airways Group Inc., AT&T Corp. and France Telecom SA. Moody's also furnished examples, including its work on Air Canada and Conseco Inc.

The rating companies say they get their ratings right most of the time, pointing to their own studies showing that the higher the rating, the lower the rate of default. Out of 98 defaults in 2003, S&P said, only three were companies that had in the past 12 months held investment-grade ratings, which are considered relatively safe for investors. Still, since only a tiny fraction of all bond issuers ever default, the odds of being right are very high, some critics point out.

Tillman said that because it takes a majority of the committee to approve a rating, no one person can skew the process. Those familiar with the process, however, say the committee usually follows the lead analyst because the others often don't have the time to review the work as closely.

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