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Credit rating agencies are back in the spotlight as they downgrade many major companies because of the economic shock sparked by the novel coronavirus pandemic and oil-price rout.

Already companies such as Ford Motor Co., Kraft Heinz Co., and Occidental Petroleum Corp. have become “fallen angels,” a moniker given to companies that lose investment grade ratings when their bonds are downgraded to junk status. Their ranks are expected to swell as forecasts suggest up to US$500-billion of debt could be downgraded to junk by the end of 2020, according to J.P. Morgan Asset Management.

The rising risk of corporate defaults is making the bond market go bonkers, which is why some central banks are spending heavily to buy corporate debt so companies can continue to borrow and finance their operations. The U.S. Federal Reserve and the European Central Bank have said they’re willing to support fallen-angel debt. The Bank of Canada, meanwhile, is sticking to investment-grade bonds for now, but noted “the program’s parameters may be expanded if conditions warrant.”

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Taxpayers are ultimately on the hook for these costly asset purchases, which is why legislators, securities regulators and antitrust authorities have an obligation to investigate whether credit ratings in a slew of industries were too rosy prior to the coronavirus crisis.

There’s also a glaring need to improve oversight. Just like during the financial crisis of 2008-09, there’s concern that credit rating agencies – especially the Big Three of S&P Global Ratings, Moody’s Investors Service, Inc. and Fitch Ratings, Inc. – are only getting a cursory look from regulators even though they play an influential role in liquidity runs.

Steven Maijoor, chair of the European Securities and Markets Authority, is among those warning that hasty credit ratings downgrades could aggravate the current crisis. “The timing of ratings actions needs to be carefully calibrated,” he told Reuters on April 9.

Here’s the rub. Institutional investors, such as pension plans and other asset managers, have investment policies to control risk in their portfolios. Many have stipulations that require the funds to sell debt securities once they lose investment-grade ratings. When large investors start selling en masse, it undermines market confidence. That’s a big problem for businesses these days because what we’re experiencing isn’t a typical economic crisis.

“It’s kind of a weird situation in the sense that you’ve shut down all these businesses, and probably under normal circumstances, they would have probably kept their [investment-grade] credit rating,” said Paul Harris, partner and portfolio manager at Harris Douglas Asset Management Inc. “It’s a worrying thing because people will be forced to sell these securities, and it actually has a very dramatic effect on a company.”

Not only does falling below investment grade increase the cost of borrowing money, the severity of a ratings downgrade can also fuel doubts about a company’s viability.

Tensions are already boiling over. In late March, Japanese telecom giant SoftBank Group accused Moody’s of having "biased and mistaken views,” after its debt rating was lowered by two notches to junk.

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The very fact that SoftBank was surprised by its downgrade should prompt regulators to probe whether credit ratings were broadly inflated prior to the coronavirus crisis. There’s reason to worry. Last year, The Wall Street Journal uncovered evidence of ratings inflation in both the corporate-bond and structured-finance markets.

The problem stems from the way credit rating agencies make money. Under the industry’s “issuer pay” model, companies that plan to issue debt pay for credit ratings. Critics say that creates conflicts of interest – pointing to the bullish ratings on debt linked to shaky subprime mortgages in the previous financial crisis.

In November, a panel of experts pressed the U.S. Securities and Exchange Commission to ban the industry’s “issuer-pay" model and come up with alternatives. Experts also propose creating investor-owned ratings firms.

Industry competition deserves scrutiny especially now that credit rating agencies are moving into new areas such as environmental, social and governance ratings, analytics, stress testing and financial training and certification.

Solutions lie partly at the international level: The IOSCO Code of Conduct Fundamentals for Credit Rating Agencies should be tightened and the Financial Stability Board must redouble efforts to reduce reliance on credit ratings.

Canada must also take action to mitigate risks. Currently, the Canadian Securities Administrators, comprising provincial and territorial securities regulators, oversees S&P, Moody’s, Fitch, DBRS, and Kroll.

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But there’s an easy way for Ottawa to give regulators more control. It could restore measures that would have improved oversight of credit rating agencies in the proposed Capital Markets Stability Act (Canada).

A 2014 draft of that legislation included provisions to designate credit rating organizations as “systemically important," and would’ve created new powers to remedy their public disclosures; strengthen risk management; root out conflicts of interest; and improve governance, compliance and accountability procedures for the determination of credit ratings.

But those provisions were deleted in 2016 after credit rating agencies kicked up a fuss. Perhaps the silver lining here is that Prime Minister Justin Trudeau can still change his mind since the proposed legislation, which is also key to creating a pan-Canadian securities regulator, is drafted but remains at the Department of Finance.

For better or worse, the coronavirus crisis will again test the credibility of credit ratings agencies. Hindsight is always 20/20. But with taxpayers footing the bill for costly bond purchases, Ottawa has a duty to keep the industry in check.

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