Bring competition to credit rating business

First published in Newsday.

Official Washington was seized again yesterday by its preoccupation with the debt ceiling. But in a nearby hearing room, little noticed, the nation's opportunity to reform a key villain of the world financial meltdown was stealing away.

Credit ratings agencies, which stamped "AAA" on mortgage-backed securities that we now know were riddled with risk, are having their rules of operation discussed and rewritten through a comment period that closes on Aug. 8.

The condensed nature of this industry -- coiled into a small oligopoly of three: Standard & Poor's, Moody's and Fitch -- created the systemic risk that nearly cratered the world economy three years ago. Greater competition among credit raters would broaden the tools investors use to make decisions, and would add security to the financial markets. But it's not clear that's where we're headed.

The financial services reform legislation, Dodd-Frank, celebrated its first anniversary this month. One thing it requires is that the Federal Reserve and the Securities and Exchange Commission remove references to credit ratings agencies from their regulations and replace them with better standards for judging credit risk.

Those efforts were on display yesterday, at a hearing of the oversight subcommittee of the House Financial Services Committee. Executives from Standard & Poor's and Moody's testified. They appear prepared to accept a new operating regime, but that may be because the rules regulators are considering "create a protective barrier around the incumbent ratings agencies and . . . make them even more central to and important for the bond markets of the future."

That was a concern raised by Lawrence J. White, an economics professor from the Stern School of Business at New York University. He recommended to the subcommittee that regulators move away from allowing banks and other institutions to outsource safety judgments to credit ratings agencies. Instead, institutions should be made to justify to regulators that their investments are safe and appropriate.

White is right to shift the burden of accountability -- but I don't care to see it rest so heavily with regulators alone. Think how many times Bernie Madoff was reported to the SEC, without effect.

Fostering competition is a good and necessary tandem approach. It's how we will evolve from the systemic risks of the last decade, to individuals placing investment bets using diverse information and resources. Individuals may guess badly, but their mistakes don't metastasize to an entire industry.

James H. Gellert, chief executive of Manhattan-based Rapid Ratings International, which seeks to knock the crown off the Big Three, compared this technological moment in the credit ratings industry to the change from typewriters to computers or from whale oil to petroleum.

Gellert and the chairman of an emerging ratings firm that bears his name, Jules B. Kroll, testified that Dodd-Frank doesn't do much to promote competition, and depending on how the SEC implements the rules, could actually quash the ability of smaller competitors to offer an alternative.

Kroll stated that the cost of compliance with the new rules is "a disincentive to entering the industry."

While the debt ceiling debate continues to crowd aside other topics, it's worth noting that credit ratings agencies are the very entities that hold the power to downgrade the U.S. Treasury debt -- or tip Greece into the "default" category.

It's important that we find a room on the center stage of our attention for three companies with that much power.