The European Union is retreating from a vow to defangcredit-rating companies as reforms prompted by the 2008 crisiscollide with the needs of bond investors.

“More than taking a sledgehammer to crack a nut, Europe is usingTNT,” said Jonathan Pitkanen, who helps oversee about $43 billionof fixed-income as head of credit research at Threadneedle AssetManagement Ltd. in London. “Then the law of unintended consequenceskicks in and they have to back off.”

Finance ministers agreed last week to revisit plans to obligeborrowers to rotate credit assessors every three years, or six if abusiness hires more than one firm. The backtrack comes as investorsdescribe the changes as unworkable, citing the risk of relying ongrades from firms with insufficient expertise or forgoing formalassessments.

The European Union has been seeking to rein in the raters foralmost four years, blaming Standard & Poor's, Moody's InvestorsService, Fitch Ratings and smaller peers for ignoring conflicts ofinterest that helped fuel the 2008 financial crisis. While theauthorities have set up a regulatory agency, outlawed some abuses,forced companies to register and to reassign analysts regularly,attempts to crack down further are foundering on concern theindustry may be rendered unviable.

Yields on French 10-year bonds rose 11 basis points to 3.24percent on Dec. 6, the day after S&P said it might downgradethe nation. They dropped four basis points to 3.03 percent on Jan.16, the first business day after S&P stripped the nation of itsAAA grade.

Stock prices suggest investors are relaxed about increasedregulation crimping profits. Shares of New York-based Moody's havegained more than 23 percent since Nov. 15, when the EuropeanCommission's Financial Services Commissioner Michel Barnierproposed a suite of rules. Those of McGraw-Hill Inc., S&P'sparent, are up 11.5 percent in that period. Fitch is a unit ofFimalac SA in Paris, whose shares have lost 2 percent.

Investors demand a yield premium of 246 basis points more thanbenchmark Treasuries to hold Moody's $500 million of BBB+ rated 5.5percent bonds due 2020. That compares with an average spread of 243basis points shown by Bank of America Merrill Lynch's index ofsimilarly rated bonds. The spread on McGraw-Hill's $400 million of5.9 percent notes maturing in 2017 is 156 basis points, in linewith the 168 basis-point average on Merrill's U.S. Corporates, ARated Index.

Functioning Markets

Moody's “remains hopeful” that a revised regulatory framework“will not include features that would undermine the functioning ofEuropean credit markets and access to credit,” said Daniel Piels, aspokesman for Moody's in London.

Regulatory efforts since the financial crisis have come in threewaves, starting in November 2008. The first set out rules ofconduct and governance to create a formal framework for raters'activities.

The second set of proposals came from the EC in June 2010 asGreece suffered a series of downgrades. It dumped self-regulationand placed the European Securities and Markets Authority in chargeof supervising the industry across the 27-nation region. The thirdstage was presented in November.

The aim of the changes is to reduce “over-reliance,” boostcompetition and bolster the independence of ratings firms from thecompanies they assess, according to Barnier.

His focus on rotation may make life harder for bondholders. Aseven-year bond, for example, would start out rated by two firms,one of which would have to drop out after three years. For anissuer with grades split between A- and BBB+, say, the firm thatgets its mandate renewed after the first three years may not be theone that assigns the BBB+ grade, said Pitkanen at Threadneedle.

“This would be vindictive, aimed at undermining the agencies'business model,” said Roger Doig, an analyst at Schroders Plc inLondon, which manages about $58 billion in fixed-income assets. “Itwould raise questions about their ability to staff themselves,about their ability to cover issuers and about maintainingcoverage.”

The proposals are “impractical and remove the continuity ofexperience,” the European Association of Corporate Treasurers saidin a statement. Chantal Hughes, a spokeswoman for Barnier, declinedto comment.

Temporary Ban

Ratings are “deeply embedded” in financial markets and in theregulations that govern those markets, said Doig. Definitions ofcreditworthiness help define what money managers can and can't dowith their clients' funds, delineate the boundary betweeninvestment-grade and high-yield debt, and guide the cost ofrepurchase agreements banks use to borrow from central banks, hesaid.

Barnier was defeated on his proposal that ESMA, which hasregulated the industry since July, should have the power totemporarily ban sovereign grades for countries negotiatinginternational bailouts. He also failed win backing from his ECcolleagues for a temporary ban on mergers and acquisitions by thelargest ratings firms.

Ideas that did make it into the draft law include givinginvestors the right to sue if they lose money because of grossnegligence or misconduct, putting the burden of proof on theassessor.

Raters would become more conservative, less willing to assaysmaller companies, and quicker to react when an issuer'scircumstances change, according to a February discussion paper fromBlackRock Inc., the world's largest money manager. It would alsocause “irreparable harm to the European securitization markets,”hurting European banks and constricting the flow of credit,according to the paper.

There would be restrictions on the time of day assessments ofgovernment creditworthiness could be published, and more detailswould have to be provided on the rationale behind a sovereigndowngrade. Supplying full details of methodologies would allowcopying by imitators.

One aspect of Barnier's proposals that does have support fromthe industry is his plan to remove references to credit grades frombanking and market regulations.

S&P said in January that it backed an end to “mechanisticreliance on ratings” and supported “requiring investors to conducttheir own analysis of credit risk rather than relying solely onratings.” Mark Tierney, a spokesman for S&P in London, declinedto comment.

Fitch “is fully committed to compliance” and understands “theneed for continuous improvement,” Mark Morley, a spokesman inLondon, said in an e-mail.

“It's a costly venture to set up a rating agency in any case,”said Gary Jenkins, director of Swordfish Research Ltd. “They'retrying to encourage new entrants at the same time they'reincreasing costs with regulation, opening the business topotentially crippling litigation and maybe having their modelsstolen. The lesson coming out of Brussels is that they want topunish someone.”

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