If credit-rating agencies rated themselves today, what would they say? In the tradition of their overly optimistic record of the past few years, Standard and Poor’s, Moody’s Corporation, and Fitch Ratings could very well confer triple-A ratings on themselves and upgrade their outlooks. But after the October 17 Congressional testimony on the agencies’ roles in the current financial crisis, the Big Three might find themselves on negative watch.

Then again, do these ratings even matter? They should be invaluable for investors looking for usable information about their investment decisions. Alas, they have been less than helpful. A triple-A rating was once the equivalent of a golden seal of approval, indicating an almost zero probability of loss. Today, that assessment rings rather hollow. Over the past 18 months, the agencies assigned stellar ratings to mortgage-backed securities, and it has since become clear that they severely underestimated the securities’ risks. Triple-As became double-Bs overnight, as S&P downgraded more than two-thirds of its investment-grade ratings, and Moody’s reduced ratings on more than 5,000 mortgage-backed securities. Nor is this the first time the agencies have been less than forthcoming about bad ratings. They ducked their roles in the 1997 Asian financial crisis, for example; maintained an investment-grade rating on Enron Corp., the Houston-based energy firm, as late as four days before the company declared bankruptcy in 2001; and rated WorldCom as high-grade credit three months before it filed for its $103.9 billion bankruptcy in 2002. These days, few in the money markets have a kind word for the agencies. They have been branded as ineffective gatekeepers of risk, at best, and architects of colossal fraud, at worst.

The roots of the problem? A conflict of interest created by the fact that rating agencies are compensated for their work by the debt issuers not the investors and a paucity of competition in the ratings marketplace. “While the methods used to rate structured securities have rightly come under fire, in my opinion the business model prevented analysts from putting investor interests first,” Jerome S. Fons, who was the managing director for credit policy at Moody’s until 2007, told the House Committee on Oversight and Government Reform on October 22. Robert Reich, Secretary of Labor in the Clinton administration, described the conflict in his blog as comparable to movie studios hiring critics to review their films and paying them only “if their reviews are positive enough to get lots of people to see the movie.” Now the Securities and Exchange Commission has proposed banning credit rating agencies from structuring the same products that they rate. Some firms are trying to get ahead of demands for stricter regulations by improving transparency. S&P, for example, has established an office of ombudsman to “investigate complaints, bring in an outside firm periodically to conduct independent reviews of how the firm manages potential conflicts of interest and review the work of any analyst who leaves the firm for a job with an issuer or investment bank,” according to a Feb. 8 article in The New York Times. The agency is also increasing the amount of information it publishes about the stress tests for ratings.

But many experts think the best solution lies in more competition, not more regulation. Rating agencies have been operating for decades as an oligopoly. Although an estimated 150 credit-rating agencies exist in the world, the SEC has bestowed official status on only seven. They are the Big Three — Moody’s, S&P, and Fitch — plus insurance-industry specialist A.M. Best, the Canadian specialist Dominion Bond Rating Service, and two smaller Japanese bond raters: Japan Credit Rating Agency and Nippon Investors Service. But Moody’s and S&P dominate with a combined market share of 80 percent; add Fitch and market share is over 95 percent. “Competition generally gives us the best indication of what works in the marketplace,” Lawrence White, a professor at NYU’s Stern School of Business, says. “I would like to see more competition rather than some regulatory fiat.” The government can lift the barriers to entry, for example. But he warns that competition wouldn’t work without transparency.

In a sense, the global financial system fueled an over reliance on the agencies. Most investment mandates for insurance, money-market, and pension fund products require that their holdings be certified by the rating agencies. “We need to remove the regulations on financial enterprises that often force them to use the participation of credit rating agencies even if they don’t think these credit ratings are appropriate,” says White. Investors have also placed blind faith in these ratings, without conducting enough checks of their own. They could draw their own conclusions from the markets, “which assess the riskiness of fixed income investments more frequently and accurately than do rating agencies,” writes Frank Partnoy, a professor at the University of San Diego School of Law, in a July 9 editorial in The Financial Times. Partnoy adds that “a three-month rolling average of market prices would be more reliable than ratings.”

But others believe the opinions of the Big Three can’t be considered irrelevant yet. “In a way, this episode has made investors recognize that you can’t rely on credit agencies as the beginning and end when assessing the credit risk of a product,” Acharya says. “But they do serve an important certification role, giving investors simple, easy-to-understand information about products.”

Whether the agencies maintain important roles in establishing the credit worthiness of these products will depend on the kinds of reforms instituted by the SEC and the willingness of rating agencies to comply with them. In the past, the dominant firms have proved adept at ducking the blame. Now, investors and regulators seem in no mood to let that happen. With the agencies’ most recent quarterly profits down and their stocks plummeting as investors shun many of the complex financial products at the center of the credit crisis, they might very well have to slap failing grades on themselves.

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