Shares of major credit ratings firms gained on Thursday after New York Attorney General Andrew Cuomo unveiled an agreement that will alter the way they collect fees from debt issuers and improve their process for rating mortgage-backed securities.
The agreement comforted shareholders as major credit ratings firms like
( MDO) and
( MHP) Standard & Poor's face a barrage of accusations that they were chief enablers of the credit excesses in the securities markets that led to the current financial crisis. Investors say the industry's key role in the secondary mortgage market could leave them vulnerable to damaging regulatory changes or even litigation.
Cuomo's agreement was partly aimed at addressing the central criticism of the ratings firms -- that they're paid by the debt issuers that they're rating and only when their review is accepted. The arrangement, critics charged, led to overly optimistic ratings on securities backed by sketchy mortgage loans. Under the agreement, ratings firms would get paid for their review even if they didn't end up getting hired to rate the deal.
"In my opinion, when the ratings agencies are only getting paid when their ratings
are accepted by a debt issuer, that creates natural incentives in the market that causes the ratings agency to want to see the deal close," said Cuomo at a press conference. "That gives them a natural incentive
to be accommodative with their ratings."
Cuomo said that the current fee structure for the industry allows debt issuers to shop around their issues to different firms in search of the best rating. In turn, ratings agencies had an incentive to give issuers high ratings. Overly optimistic credit ratings in the secondary mortgage market stimulated demand for lower-quality mortgage loans in the primary market, pumping up the housing bubble.
Cuomo's agreement is viewed as doing little to damage the fundamental business model of the ratings industry. Shares of Moody's were recently up $1.22, or 3.1%, to $40.85. Shares of McGraw Hill were up $1.04, or 2.4%, to $44.92. The third major ratings firm,
, is owned by Fimalac SA.
In reaching the agreement, Cuomo is blazing a similar trail taken by his predecessor, Eliot Spitzer, who recently resigned as governor of New York in disgrace after he was found to be a client of a high-end prostitution ring. As New York attorney general, Spitzer made a name for himself by reforming the sell-side equity research industry, where Wall Street firms like
were accused of giving overly optimistic ratings on equities to boost their investment banking business.
Unlike Spitzer's settlement, Cuomo's agreement with the ratings industry imposes no fines on the ratings firms. Meanwhile, critics say the proposed changes to the industry's fee structure don't go far enough in addressing the fundamental conflict of interest for ratings firms in getting paid by debt issuers.
"He who pays the piper will still be calling the tune," said Sean Egan, president of Egan-Jones Ratings, a credit ratings firm that is paid by investors instead of debt issuers. "Under this agreement, debt issuers still get to choose who they call to rate their products, and it doesn't take a genius to see that if a ratings firm doesn't supply the ratings their customer wants, they won't get called."
Cuomo acknowledged that his agreement wasn't perfect, but he said it was an improvement.
"It is a dramatic overhaul of the system and it's much better," said Cuomo.
All three major ratings firms said the agreement was a step towards restoring "investor confidence" in credit ratings. When asked if the agreement was an acknowledgment that credit ratings had been influenced by fees in the past, Moody's replied "absolutely not," in a statement to
The changes to our fee structure in the U.S. mortgage-backed securities sector are an effort to help prevent 'ratings shopping' by issuers and increase transparency in the industry," the company said.
Ed Sweeney, a spokesman for Standard and Poor's said the firm's credit ratings were not influenced by fees.
"We have rigorous policies in place that support the independence of our ratings," said Sweeney.
Fitch Ratings declined to comment.
While Cuomo's agreement was viewed positively for the ratings industry on Wall Street, ratings firms are still facing scrutiny from regulators and lawmakers. Congress has made inquiries into the industry and the Securities and Exchange Commission said on Wednesday that it would hold an open meeting on June 11 to propose new rules on credit rating agencies.
Investors view Moody's, Standard & Poor's and Fitch as a virtual oligopoly in the ratings industry because they are designated as Nationally Recognized Statistical Rating Organizations by the S.E.C.
Meanwhile, the ratings firms still face the threat of lawsuits. A
report last month alleged that a computer glitch led to Moody's mistakenly giving triple-A ratings to tranches of constant proportion debt obligations, funds that used borrowed money to bet on credit-default swaps. Rather than admit the error and change its ratings, Moody's reportedly altered some assumptions in its ratings model to cover up the incident. The firm has hired a law firm, Sullivan and Cromwell, to investigate the allegations, and it has said it will fire any employees that are found to have engaged in a cover-up.
Amid the firestorm of criticism that was already surrounding Moody's, the
report was explosive, knocking shares down nearly 16%, the largest one-day stock decline for the company since it went public.
"The real heart of the story was that a model error was covered up, and it was covered up by a change in the methodology," said Moody's CEO RayMcDaniel at an investors conference on Thursday. "It goes to the core of our values in terms of integrity and independence and lack of bias in our ratings."
Egan points to Moody's announcement on Wednesday that it may downgrade credit ratings on bond insurance giants
( ABK) of how fee incentives have led to poor ratings practices by the major firms.
"It has been obvious for years to any objective observer that MBIA, Ambac and most other companies in this line of business do not merit the same triple-A rating of the U.S. government," Egan says. "Egan-Jones, which first issued a report in 2002 concluding that MBIA was not a triple-A credit, currently rates MBIA and Ambac well below investment grade."