"I'm just a bill, yes, I'm only a bill." For seven days now, I've had the strains of that Schoolhouse Rock tune tumbling around in the depths of my skull. Why? Here's why.
Last week, the Senate Banking Committee unanimously approved submission of a new bill called the "Credit Rating Agency Reform Act" to the full Senate for a vote. This bill, like its July analog in the House, the "Credit Rating Agency Duopoly Relief Act of 2006," has the stated aim of opening up the market for rating the reliability of corporate debt to market competition.
Even if the bill is passed, it's doomed to fail.
And here's why
OK, that is a bit conclusory, so let me explain. The rating of corporate debt is big business in the U.S., and it's lucrative to boot. The following are, in a nutshell, the reasons that Fool co-founder Tom Gardner recommended Moody's
- A mere three companies currently dominate this market. McGraw-Hill
(NYSE:MHP)division Standard & Poor's, France's Fimalac division Fitch, and Dun & Bradstreet (NYSE:DNB)spinoff Moody's together control 94% of the market for rating corporate and government debt around the world.
- Of these three, the "duopoly" that Congress wants to break consists of neck-and-neck competitors Moody's, with a 39% global market share, and S&P, with 40%. France's Fitch comes in a distant third at 15%.
- These companies get to rob Peter and get paid by Paul. In a section of his original "buy" recommendation, Tom Gardner describes how Moody's and its peers make money. To wit: Firms that float debt pay the debt-raters to rate it. At the same time, institutions that buy debt pay to see the ratings. Both sides of the equation are motivated to pay, and aside from counting some beans, the only thing Moody's & Friends have to do is just sit in the middle and cash checks from all comers.
Sounds great! How do I get in?
It's not just investors asking that question. Proving a theory as old as Adam Smith and The Wealth of Nations, lots of companies would love to horn in on the debt-rating biz and steal a piece of this rich-margin business. Moody's, for example, nets $1 in pure profit on every $3 of sales. The problem, as my fellow Fool Alex Dumortier explained last month, is that the debt has been stacked against them. A 1975 SEC regulation requires that debt ratings be established only by "nationally recognized statistical rating organizations" (NRSROs).
But in an example of Washington's sometimes circular logic, before a company can be designated as "nationally recognized" -- a criterion essential to attracting debt-rating clientele -- it must already have such clients certifying its nationally recognized status.
Both the House and Senate bills attempt to do two things: first, improve the quality of ratings; and second, improve the transparency of the ratings process. Both bills also seek to break the "circle" by giving prospective competitors a clear roadmap toward attaining NRSRO status. Under the Senate bill, for example, a candidate for NRSRO status would need to describe:
- its track record in rating companies' debt.
- the procedures it uses to set ratings.
- any conflicts of interest.
It would also need to present certifications affirming the quality of its ratings from institutional investors that have been in the business for three years.
Ooh. Scare me.
For some reason, the Big Three ratings agencies are not exactly quaking in their boots over the proposed legislation. Why not?
Some may argue that it's because the legislation is, as the song goes, "only a bill ... sitting [t]here on Capitol Hill." I beg to differ. The House has already approved its bill. And although the full Senate hasn't yet voted on its variant, the fact that the bill received unanimous approval in committee speaks strongly to its prospects for passage. It may well be "a long, long journey to the capital city" and "a long, long wait ... sitting in committee," but this Fool believes that the bill will "be a law some day."
Yet even so, both S&P and Fitch have gone on record in support of it, with Fitch going so far as to call it a "significant step forward." Why aren't these guys scared of losing their grip on the market?
High quality, low prices
Because permitting a company to call itself a "statistical ratings organization" -- the new term of art proposed in the House bill -- isn't necessarily enough to make that company a true contender. For that, it will need clients -- a critical mass of debt issuers and debt buyers paying money for the ratings. And the way I see it, a "new" ratings company has only two options for attracting a client base and stealing away some of the Big Three's market share.
First, a newcomer might differentiate itself from the competition. One way would be to set tougher-than-ordinary rating standards, in hopes of identifying the "next Enron" before it happens. The problem here is that no one likes a stick in the mud. Debt issuers don't like being told that they're credit risks, and in my experience, debt buyers, although they may say they want to be warned of the risks, really just want to get the deal done. Furthermore, if Joe Debt-Rater, LLC, says a company's bonds are junk, while S&P says they're golden, whom is an institutional investor more likely to believe -- and retain? Whom would you believe?
Another way to steal market share is to undercut the competition on price. That's a more realistic risk to Moody's, in my opinion -- not that the Big Three will lose market share to upstarts, but that they'll sacrifice a few basis points of margin to avoid losing market share, thus slowing their profits growth. I suspect that it's also the reason that, since the Senate's bill passed committee last week, Moody's shares are down 4%, as compared with a less-than-1% decline in the S&P 500.
So you buy the second argument?
Not really, no. I don't buy either one. To paraphrase the Grand Moff Tarkin: I think Mr. Market overestimates the legislation's chances of breaking up the debt-rating duopoly, or even slowing it down significantly. Yes, Congress's action may permit a few more players to enter the debt-rating market. But overall, the effect on the giants will be minimal.
I base this feeling on, of all things, an article published in The Washington Post nearly two years ago -- and I consider it required reading for investors in this sphere -- in which the newspaper did an expose on just how powerful the Big Three are. Suffice it to say that, based on interviews with a whole cast of characters who have interacted with the Big Three over the years -- ranging from German insurers to American municipalities to public companies such as Compuware
It doesn't exactly seem "fair" to me. But it also doesn't sound like a system that's going to be changed by requiring ratings transparency and cutting some red tape for would-be competitors. If the debt-rating industry is to be opened up, the job will require no less than a full-on charge by the trust-busters, with the ghost of Teddy Roosevelt at their head.
Fool contributor Rich Smith does not own shares of any company named above.