Mark Gilbert
Bloomberg

Aug. 12 (Bloomberg) -- The easy ride enjoyed by Moody's Investors Service and Standard & Poor's is ending, as the U.S. Securities and Exchange Commission and the European Commission consider ways to regulate the credit-ratings business.

The bankruptcies of Enron Corp., WorldCom Inc. and Parmalat Finanziaria SpA stoked concern among regulators that the ratings companies are failing to identify potential landmines in the credit market even as ratings play a bigger role in determining how much cash financial institutions must set aside to cover investment risk.

The SEC said on June 17 it was a few months away from producing a plan to address whether and how to increase its oversight of the ratings industry. The Committee of European Securities Regulators has asked for comments from ``all interested parties'' by Aug. 27.

Here are five key issues the regulators should consider when scrutinizing the duopoly Moody's and S&P effectively enjoy in the ratings market:

1. The Inside Scoop

Ratings companies won an exemption from the rules on ``full disclosure'' designed to stop companies from selectively telling secrets to analysts. You can't tell, however, whether a rating is based purely on publicly available information, or whether the analyst sat down with the company's chief financial officer for a personal briefing.

Ratings reports should state whether they rely on non-public information. That way, users who disagree with the appraisal get an indication of why there might be a difference of opinion. It would also show whether the ratings companies are using their exemption to gain better insight into the businesses they cover.

2. Quarterly Updates

Fiat SpA, Italy's largest manufacturer, owes bondholders more than 9 billion euros ($11 billion). Moody's hasn't updated those investors on its Ba3 assessment of the company since Aug. 21, 2003. Since then, the company has appointed a new chairman and a new chief executive, sold units worth billions of euros including its Toro Assicurazioni SpA insurance unit, and lost a cumulative 1.8 billion euros in four quarters of earnings.

That's too long to leave between ratings reports. Fiat isn't the same company it was a year ago. Its lenders deserve an up-to- date analysis of the company's creditworthiness from Moody's. Any borrower owing investors more than, say, $1 billion should get regular financial check-ups on its ratings. Stock investors get quarterly insights into the accounts; bondholders are entitled to similar treatment on credit ratings.

3. Secret Covenants

Companies often make financial pledges to their banks, promising that key ratios such as free cash flow to net debt, debt to earnings, or debt to market value, won't violate pre- agreed thresholds. Trouble is, those covenants are often secret, and bond investors only know they exist once a transgression by the borrower gives its banks the right to demand early repayment.

Do the ratings companies insist that the businesses they appraise reveal all of the promises made to bank lenders? They should, because the closer a company is to breaking those covenants, the weaker its future creditworthiness will be. Moreover, that information should be available in the ratings report to bondholders, who typically don't have that same protection against a deterioration in economic health as bank lenders.

4. Who's Minding the Shop?

Suppose you discovered you had a flair for credit analysis, a knack for seeing the patterns underlying a company's accounts. Why on earth would you hang around at Moody's or S&P, rather than hotfooting it out to an investment bank or a hedge fund to earn a gazillion dollars from your financial autopsies?

Regulators should devise a mechanism for measuring the quality of the individual analysts at the ratings companies. Comparing earnings against their peers at financial institutions, charting their longevity at the job, and keeping track of how many get poached might all help provide a barometer of quality.

5. How Sticky Is the Last Rung?

Parmalat was rated BBB- by S&P, the lowest level on the investment-grade scale, until Dec. 9, two weeks before the dairy company filed for Italy's biggest bankruptcy. In November 2001, Moody's was poised to cut Enron's rating by two levels, dropping what was then the world's biggest energy trader out of investment grade. After lobbying by the company's bankers, the rating fell just one level to Baa3. The following month, Enron filed for bankruptcy protection owing $67 billion.

A study by economist Richard Johnson of the Federal Reserve Bank of Kansas City, published in February 2003, showed that companies that got cut from the bottom of the investment grade scale tended to subsequently drop by more levels than from other grades. He drew two conclusions: Maybe Moody's and S&P are more tolerant of companies on the last rung, or maybe companies that drop out of investment grade quickly find that their ability to do business is impaired by the rating reduction.

Are Moody's and S&P too reluctant to drop-kick borrowers out of the investment-grade pool because they know the move will probably choke off the company's access to funds? Is the bottom rung of the ladder too sticky?

As things stand, the ratings industry is essentially unregulated. The SEC held a consultation exercise 10 years ago, which didn't result in any moves toward statutory supervision. U.S. regulators may decide again that the current system works well enough; this time around, though, European regulators are unlikely to allow the status quo to continue.

That, in turn, raises a dilemma that neatly encapsulates the current conflict of interest: Would a U.S.-based ratings company dare to lower Germany's top rating for its flagrant abuse of European Union deficit rules, and risk retaliation in the form of more stringent regulation?

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