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Regulators Continue Scrutiny of Ratings Agencies, As Kroll Plans to Challenge Big Three

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The credit ratings agencies have had another hard couple of weeks of it, with the US government hurling criticism at these firms for their perceived contribution to the economic downturn. This attitude however, does not appear to have dissuaded risk consultant Jules Kroll from planning to establish his own ratings agency to rival the big three.

Kroll has been talking up his plans this month to launch a new credit ratings agency in the first quarter of next year in order to challenge the dominance of Standard & Poor’s, Moody’s and Fitch. He is ambitiously planning to achieve US$100 million in annual turnover by the end of its third year and says the agency will specialise in providing second opinion ratings on complex securitised products, an area that has come under intense regulatory scrutiny since the financial crisis.

According to reports, Kroll is partially funding the endeavour himself but is also looking to receive backing from institutional investors over the next few months. Kroll will also bring his past risk consultancy experience to the mix by using his investigative skills to dig deeper when determining ratings for complex products, or so the theory goes.

Founded in New York in 1972, Kroll Associates pioneered professional detection work for big corporate clients by providing forensic accounting and corporate advisory services. Kroll sold the firm to Marsh & McLennan Companies in 2004 and is using some of this money to launch his new venture.

Speaking at a Council of Institutional Investors conference at the start of October, Kroll explained that his efforts are aimed at providing a different sort of service to the market and dealing with the issue of conflicts of interest within these ratings firms. “The way to reform the credit rating agencies is for there to be a series of entities, not just the one I am going to start, that should be to a substantial degree investor owned enterprises,” he said.

He contends that by having an investor owned operation, this will be less of an issue with regards to conflicts of interest. “I think the primary initiative should come from the private sector, the people who have the most at stake, the various institutional investors, the pension funds, the endowments, the corporate pension funds,” he explained. “I would like to see the private sector take the lead, those with the most money at risk.”

The venture is currently un-named but it will be a unit of Kroll’s risk consulting firm, K2 Global Partners. It will also likely initially employ a staff of about 25 professionals from a variety of backgrounds in accounting and analytics, according to Kroll. It will begin life rating only residential mortgage backed securities (RMBS) and then later will add commercial mortgage backed securities (CMBS) and other asset backed securities (ABS) and, by the end of 2010, municipal securities.

All of these plans are set against a backdrop of serious criticism of the ratings sector, with US Congress currently embroiled in debates around the reform of the sector. During a 30 September hearing on these agencies and their role in the crisis, Edolphus Towns, chairman of the House Committee on Oversight and Government Reform, said they had played a “starring role” in the financial crisis.

Moreover, Paul Kanjorski, chairman of the House subcommittee on capital markets, is currently proposing a bill that would go one step further than the Obama administration’s proposed reforms for the sector by making these agencies collectively liable for inaccuracies. The US Securities and Exchange Commission (SEC) has also mooted the idea of requiring these agencies to be liable under securities law for inaccuracies in their ratings. This would mean that these agencies would be regulated as “experts” under securities law, in the same way as auditors, who can currently be more easily sued over their findings.

The sector has already faced a greater level of regulatory attention with the passing of new regulations by the SEC in September. This action meant that legislation that mandates the use of ratings for areas such as risk management has been repealed by the SEC in order to reduce reliance on these measures within the financial markets overall. These agencies are also now required to reveal more data about their past ratings in order to permit investors to compare relative performance.

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