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Presently, proposals by Congress to create a government-appointed committee [probably within the SEC] to assign credit rating agencies, or CRAs, for structured finance deals are being reconciled by both the House and Senate as financial overhaul draws near. The Senate version of the overhaul bill approved the process of a government-appointed board, but the House version contains no such proposal. However, Senator Al Franklin (D., Minn.), who proposed the plan, stated, “I’m very confident that when it’s put together with the House version, it [the Senate version] will remain.”

First, perhaps a government-appointed board is not the best business model. Structured finance deals are immensely complex and there is no guarantee that the regulators will understand the ratings and their underlying securities any better than the CRAs. Not to mention, the proposal could invoke a strong incentive shift for the CRAs. It would be a stretch, but still a possibility, that CRAs may tempt to bridge the government-appointed boards to win over future deals. When asked about the possibility of the government assigning CRAs, Warren Buffett, CEO of Berkshire Hathaway (NYSE:BRK.A), who tested before the FCIC commission Wednesday, answered, “The wisdom of somebody picking out raters…I don’t know.”

Second, another alternative for the CRA business model is for users to pay for the ratings. When asked if this model was feasible, Mr. Buffett replied, “It’s very difficult to think of an alternative where the user pays. I’m not going to pay.” Accordingly, the current system of issuer pays seems very extensive and successful. Mr. Buffett goes on the state in his testimony that whenever Berkshire needs a rating, they are required by their insurance regulators to get a rating from Moody’s (NYSE:MCO), Standard & Poor’s, and Fitch. Mr. Buffett claims that he has no influence in the process and believes that overall the CRA business model is the best there is when you consider the alternatives.

Although, these Congressional proposals—if approved— may have an effect on the CRA business model, the durable competitive advantage of CRAs may remain intact. Structured finance deals will only get more complex and who else has the intelligent capacity and manpower to rate them besides the major CRAs. Moody’s, Standard & Poor’s, and Fitch are the big players in this industry, and a world with increased competition for CRAs would be hard to imagine.

Disclosure: The author is a shareowner of Berkshire Hathaway.

Source: The Future for Credit Rating Agencies