We've been here before. Over the years, and especially after the spectacular collapse of top-rated companies like Enron and WorldCom in 2002, and then the more recent (and perhaps ongoing) collapse of the structured finance market in late 2007 and early 2008, critics have increasingly charged that the issuer-pay model is seriously flawed, creating the possibility of a conflict of interest that could make rating agencies reluctant or slow to downgrade a rating of a customer. It's a notion S&P, Moody's and Fitch dismiss, claiming that their need to protect their reputations is reason enough for them to avoid such conflicts.

But others have their doubts. "If reputation is their most valuable asset," says Jeff Glenzer, managing director at the 1,600-member Association for Financial Professionals (AFP), "then it's been depreciated considerably over the last few months."

Glenzer has heard enough from AFP's membership in recent months to know the mood of the finance community. Certainly there is plenty of blame to go around, but the role of the main rating agencies is increasingly at the top of the list and some are taking action. "There is a serious crisis of confidence in the big rating agencies–so serious that many of our treasury members are starting to outsource their investment management to institutional money managers and having them do independent credit analysis. They're paying them for relatively plain-vanilla portfolios because they can't trust the ratings–and the shareholders are supporting them in this extra expense."

At a hearing of the House Financial Services Subcommittee last September, committee chair Rep. Paul Kanjorski (D-Pa.) suggested that fixing the problem with rating agencies may require a long list of reforms. Those include more disclosure, as with auditors, institutionalizing of analyst rotation as now required of auditors; altering methods of compensation; and improving the transparency of modeling debt products. Sean Mathis, managing director at the investment firm Miller Mathis, who testified at that subcommittee hearing, went further, saying, "The rating agencies have been paid enormous sums of money by their structured finance clients, which has caused outsiders to question the impartiality and objectivity of their ratings." He added, "There is no accountability for mistakes or failures."

He's right about that. The agencies have successfully argued in court that they cannot be sued on the basis of their ratings, on the grounds that they are in fact publishing enterprises (S&P is a division of McGraw-Hill), and that their ratings are protected by the First Amendment guarantee of free speech. And beyond the granting of Nationally Recognized Statistical Rating Organization (NRSRO) status, the Securities and Exchange Commission (SEC) has been largely hands off regarding industry regulation.

In defense of their funding model, Michael B. Kanef, group manager for the Asset Backed Finance Rating Group at Moody's Investors Service, denied that there was any problem with conflict of interest, saying that ratings were determined by committees, not by individual analysts. He added that analyst compensation is tied to analyst and company performance, "not to fees from issuers" or to analyst's ratings.

That said, Paul Coughlin, head of corporate and government ratings at Standard & Poor's, concedes that the Big Three agencies have a problem. "Obviously, things did not turn out the way we expected" in the structured finance market, says Coughlin, "We're conscious that we have to re-establish confidence in form and substance in our ratings." Toward that end, Coughlin says S&P is implementing a "27-step-program" of reform in its operations, which will include bringing in an outside auditor to check regularly on the company's ratings and rating procedures, and an ombudsperson, to respond to complaints from clients and investors. Also on the company's reform list is a plan to rotate analysts "so we don't have psychological dependence develop" between analyst and client.

Asked whether S&P's 27-point reform plan might lead people to conclude that there has been a real conflict of interest, not just the potential for one, Coughlin says, "There's always a risk that if you make these reforms, people will see it as admitting a mistake, and I think that's why there's been some reluctance to do it, but it's a question that's been applicable to the whole industry–it was true with investment banks, with banks, and with accounting firms, too."

Nonetheless, Coughlin says, S&P is "committed to these things." Adding that the other two large agencies have to decide whether to follow suit, he says, "I think the markets would benefit if they do the same thing." (Efforts to obtain comment from Moody's and Fitch were unsuccessful.)

AFP's Glenzer is skeptical that reforms such as those being put in place by S&P will solve the problem of potential conflicts. He wants to see more SEC regulation of the $5-billion rating industry. "The SEC was given tremendous power by Congress in 2002 and then in 2006 to regulate the rating industry," he says, "and they have done almost nothing. It's past time for action."

Glenzer says that by expanding the number of NRSROs to nine and adding several investor-pay agencies, the SEC has increased competition, but he says it will take some time for the new, smaller agencies to become competitive with Moody's, S&P and Fitch, whose role is institutionalized at most banks and pension funds. "I don't think we can wait for competition to correct the problem we have," he says.

As an example of the problem, Glenzer explains, "From an issuer standpoint, you may opt to use one of the smaller, newer rating agencies, but when you go to the bank, they will still have an institutional requirement for a rating from one, or often two, of the Big Three firms." He adds: "There are times that our members have been told by bankers that they are using internal models because they don't trust the Big Three ratings, but they still require them."

"It would be great if some large top-rated corporation would just say to the Big Three, 'We don't need your ratings,' and just go ahead and issue some paper," says Ed Ketz, a professor of accounting at Pennsylvania State University. "I've tried simulating what the rating agencies do using just publicly available information, and get a reasonably good approximation of what the agencies come up with, which suggests that the additional information they provide is marginal at best. You really have to wonder what else most investors would really need than their 10K's and 10Qs."

Meanwhile, Ketz says, despite the fact that the Federal Reserve and other observers say that the U.S. financial markets came close to a meltdown earlier this year in large part because of those flawed CDO ratings and the investments that were made based upon them, the SEC is simply sitting on the sidelines. "The agency opened up the door to competition by granting NRSRO status to some smaller investor-pay rating agencies, and that's good," he says, "but in terms of fixing the problem with the Big Three, while they've talked about more study, and offered some vague ideas about fixing things, nothing has been done."

At this moment, there appear to be no plans at the SEC for a step-up in regulation of the rating agencies. The only significant regulatory change relating to the conflict of interest issue has been an SEC requirement, imposed last June, that rating agencies must publicly declare any potential conflicts of interest, and explain how they plan to manage those conflicts. The new rules also require rating firms to give employment backgrounds of their analysts and to disclose their compensation.

These are no doubt improvements (though they didn't prevent the CDO disaster), but whether they will calm the storm of criticism, or assuage the concerns of investors and of issuers about the state of the rating industry, remains to be seen. If the credit storm passes by, and clear skies return, it may be enough, but if another investment bank goes the way of Bear Stearns, or if there is another kind of blow-up that catches the rating agencies flat-footed, the cry for more serious reform and regulation will no doubt grow louder.

"Our members are severely frustrated," says the AFP's Glenzer. "They are getting hurt in multiple ways because they need ratings for their debt, their treasury departments need reliable ratings so they can make good investment decisions, and many of them are also managers of employee pensions. Right now, they have no faith in the credit ratings."