The Future of Ratings

Lori Widmer


August 1, 2011

When Henry Varnum Poor published "History of Railroads and Canals in the United States" in 1860, he started something. That publication was the framework for what soon became the credit rating agency model. John Moody and Company jumped on board in 1900 with the first "Moody's Manual of Industrial and Miscellaneous Securities" and in 1909, Moody decided to put a letter-grade rating on railroad bonds so investors could better understand their investment options.

A few years later, John Knowles Fitch started his publishing company, which in 1913 issued "The Fitch Bond Book" and "The Fitch Stock and Bond Manual," two publications loaded with financial statistics to help investors navigate the investment industry. By 1924, Fitch had added a AAA-through-D ratings system.

Fast forward nearly a half century to the 1970s, when the rating agencies made a change that would forever alter their relationship with corporations. What was once a subscription-based model requiring investors to pay for information became a service that charged issuers of credit -- mainly corporations and financial institutions -- for their research and rating services.

The change came after rating agencies realized the significance that their ratings had on issuer market value. No mention was made regarding the impact of bad ratings on those same issuers, which has had an even more substantial impact on how much power rating agencies wield today. Agencies have acquired this influence slowly since 1975 when the Securities and Exchange Commission (SEC) began requiring money market funds to invest in investment-grade securities. Of course, "investment grade" was a determination that could only be made by a government-approved rating agency.

The three main agencies (Moody's, Standard & Poor's and Fitch Ratings) were the first that the SEC designated as nationally recognized statistical rating organizations (NRSROs). The move came on the heels of the SEC's new rules involving ratings in the broker-dealer bond portfolio market.

Using terms like "recognized rating manuals," the SEC became concerned, imagining the language allowed for companies to spring up overnight, promising AAA ratings for a price. In order to avoid that possibility, the SEC created the NRSRO designation, naming the "big three" as its first and nearly only designees, thus granting government endorsement of their business practices.

The SEC's action also created an environment that hindered competition. Because debt had to be rated per the government's standards and those standards mandated credit to be rated by an NRSRO, business was split three ways with nothing left over for any other rating agency.

The market was quick to fall in step behind the regulators in Washington. From 1975 to 2006, a handful of other rating agencies entered the field. However, mergers and acquisitions quickly whittled the list back down, and by 2000, the same three players were holding all the debt-rating cards.

Today, these three innovators of credit rating practices still reign as the industry- and government-appointed kings of credit rating. The simple letter-grade ratings system stuck like glue, becoming the standard that CEOs and shareholders alike hold in highest regard.

The Criticism

In trying to locate commentary for this article, this writer was unable to secure any feedback from corporations. There are some who would suggest it is the influence of the rating agencies on business that keeps their detractors silent; as one source noted, the relationships may be too close for corporations to feel comfortable speaking freely.

That silence could also have something to do with how the rating agencies are perceived in the market, thanks in no small part to government scrutiny and an eventual overhaul of the rating sector. Rating agencies were blamed for failing to properly value debt from Enron and other companies that went bankrupt in the early 2000s. Accusations ranged from failing to identify impending crises to anti-competition practices.

The SEC launched an investigation in 2003, finding allegations of "notching," the practice of lowering ratings on asset-back securities based on another agency's rating without actually rating the debt themselves. Also at issue were claims of agencies billing companies for unsolicited ratings as well as purportedly coupling ratings to the purchase of additional services.

In a now-infamous case, Hanover Re CEO Wilhelm Zeller reportedly received a letter from Moody's Investor Services in the late-1990s, which he said was an offer to rate Hanover's debt for free, noting that the agency looked forward to the day when Zeller's group would pay for such services. Zeller took the note seriously enough to alert his financial department. Apparently, that concern was not unfounded.

According to a Washington Post report, Hanover consistently received weak ratings from Moody's as the agency continued courting the company's business. Hanover had been receiving high marks from its other two rating agencies, to which the company was paying six figures annually. When the Moody's rating came in at junk status, both Hanover's senior management and investors were in shock. The company's market value plummeted $175 million in a matter of hours.

An investigation into the Hanover case led to new legislation, the Credit Rating Agency Reform Act of 2006, that developed an infrastructure and process by which the SEC could inspect the ratings sector and place accountability for their decisions back onto the rating agencies themselves. The act also opened up the sector to allow for more competition. Until that time, only five agencies were granted NRSRO status, two of which were later acquired by one of the "big three," again leaving only Moody's, S&P and Fitch to rate the nation's public sector debt.

Currently, the SEC has listed seven other designated NRSROs (A.M. Best, DBRS Ltd., Egan-Jones, Japan Credit Rating Agency, LACE Financial Corp., Rating and Investment Information Inc. and Realpoint), but none have taken significant market share away from the major players.

Market Influence

In 2008, as the subprime lending market reached its flash point and melted down two years after the housing bubble had burst, the public and political outcry prompted the SEC to dig once more into the practices of the ratings sector. The undervaluation of risks -- specifically mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) -- were at the center of what many were calling the largest financial disaster since the Great Depression.

That undervaluation resulted in a liquidity shortfall that imploded banks, spiked foreclosures and ended with government-backed bailouts. In the SEC's crosshairs were the rating agencies, and the result was a $400 million bill to the big three, which many placed at the epicenter of blame.

For example, the Senate Permanent Subcommittee on Investigations, when delving into the financial crisis, said that both Moody's and S&P changed their assessments on hundreds of MBS bonds in the face of growing pressure from at least six of the nation's top banks. The panel concluded that this action in July 2007 helped trigger the financial crisis.

It is not fair to say the financial crisis was solely the fault of the credit rating agencies, however. In fact, some experts would argue that the rating agencies were slow to lower ratings on bad debt due to pressure from the government. Rather, many fingers that once pointed first to speculation then to financial institution greed and then to credit rating agencies are now pointing to what quickly became a widely-used risk assessment method, the Guassian copula formula, as the weakest link in a damaged chain that brought down America's economy.

The highly complex mathematical formula, created by mathematician David X. Li, determined the correlation and default potential around collateralized debt obligations, linking vastly dissimilar events through a common theme. Created in 2000, it became the new risk modeling tool. The financial world was quick to adopt it, lauding its creator's brilliance. Many were buzzing about what was surely a Nobel-worthy discovery on Li's part. Today, it is yet another victim in the ongoing meltdown blame game.

Formulas and models aside, many in the financial industry are saying that credit rating agencies should have better prepared the market and cushioned the blow by being more diligent and aggressive in pricing risk. Critics say agencies needed to look at the foundations of the formula, which many think did not include the potential of falling housing prices.

Add to that the decision by risk management departments to outsource more of their decisions to the rating agencies. Professor David Reiss, who teaches rating agency regulation at Brooklyn Law School, suggests the monopoly situation, coupled by reliance on the market, created the perfect storm.

"This raises the issue of regulatory privilege," said Reiss. "Why should a select group of rating agencies be effectively given a monopoly over this risk assessment process? And more importantly, their many failures over the years raises the question of whether this system actually works." His short answer on whether or not it functions properly? No.


Little has changed since the 2006 legislation. "I think we're basically back to business as usual," said Peter Hagan, director at Berkeley Research Group in Princeton, New Jersey.

Maybe the reason the ratings sector seems to be operating on a long-running status quo is because, despite the SEC opening up competition in the market, financial institutions are still requiring companies to rate their debt using one of the big three. Given the costs associated with having debt rated, experts agree that companies would be hard pressed to pay twice when one rating will suffice.

Reiss says there has been a rush of rating agencies joining the NRSRO club, but "none have taken away much market share from the big players."

Companies can technically issue debt without a rating, but financial institutions will require a rating, and if the company is seeking funding, that rating is now necessary. "Do [debt issuers] place a lot of faith in those ratings? Not really," said Jeffrey Glenzer, managing director at the Association for Financial Professionals (AFP). "But do they still have to pay for them in order to issue their debt? Yes. So deeply embedded in the banks are the NRSRO-designated rating agencies."

With the passage of the Dodd-Frank reform act, the SEC has been given even more tools with which to regulate NRSROs. Now agencies must file annual reports detailing internal controls and disclosure of performance statistics, in addition to adhering to stricter conflict-of-interest rules around their sales and marketing practices. Fines and penalties have been shored up, and agencies must disclose performance statistics along with data and assumptions underlying their credit ratings.

But all of this does little to address how the rating agencies are actually utilized by debt issuers and company risk management departments.

Who Pays?

Even at their inception, rating agencies faced questions. Chief among them is who should be paying for the ratings. Some rating agencies do offer a subscription model, but within the big three, the issuer of the debt foots the bill.

In the wake of the financial crisis, there was renewed interest in moving back to the subscriber-pays model in an attempt to thwart any potential favoritism or denial of rating. While that relationship calls into question several areas of potential conflict of interest, it has worked quite well within the corporate realm, says Glenzer.

Glenzer is skeptical about a change in models. Having never seen evidence of rating agencies wielding power over senior management or playing favorites, he thinks any push to change things back to a subscriber-pays model is not the answer. "All the subscriber-pays model accomplishes is you're fighting the devil you know and assuming the other model is a panacea," said Glenzer.

According to Glenzer, both models have the potential for abuse. He uses the example of an asset manager whose company has paid to use a subscriber-based rating service. If that asset manager is sitting on a debt position that is material to him, there is a potential for that manager to ask his rating service to hold off releasing a rating on the company whose debt his company holds to "investigate" claims. "That would defer the rating agency's actions long enough for the asset manager to unload the asset position," said Glenzer.

Future Safeguards

Glenzer says AFP entered into the debate early on. The goal then was to manage the conflicts of interest. But realizing the complexity of the situation, his group has now moved toward having ratings paid for through transaction fees. In other words, on trade debt issued in the secondary market, both issuers and investors are paying for those ratings as part of the sale or purchase of the security. "That way you take the economic power of either party out of the equation," said Glenzer.

Another possible solution: due diligence on the part of corporations. Hagan says that rating agencies do a good job in rating debt -- so good, in fact, that complacency can set in. "Credit departments began depending on ratings rather than doing their own analysis," he said.

And that is not only in the corporate environment. On Wall Street trading desks, says Hagan, it was quite common for a trader to be given authority to take a position up to $25 million in a single A-rated credit. No company names -- just authority granted based on the credit rating of that company. For short-term trading purposes this was not a major problem. However, when the same rules were applied to portfolio managers with longer investment horizons, significant issues followed.

Compounding this were banking regulators assigning different capital ratings based on the credit ratings of the assets. Add the CDO market, which brought up to 25,000 more companies into the mix with complex risks and no quarterly statements to rely upon. The sole source of information on the CDO market? The credit rating agencies.

"All the way through this, the rating agencies have done a pretty good job at evaluating corporate borrows," said Hagan. "There is no question that rating agencies have done a consistently good job evaluating U.S. corporations. However, by failing to do their own credit research, many investors failed to understand that other ratings such as those on structured products were not so reliable."

He believes that one of the biggest contributors to the crisis was corporations abdicating their controls to the rating agencies. He advocates a data warehouse of information in which experienced investment institutions cull the information needed to determine an investment's viability and then present it to the corporate marketplace. That access, updated regularly, would, in his estimation, add another layer of due diligence to the market.

Reiss offers another solution. He thinks more companies need to adopt what he calls the Warren Buffet approach. Buffet, he says, does not rely on rating agencies for his information, but instead conducts his own research.

"Warren Buffet has put risk management on notice," said Reiss. "Merely relying on a rating agency when looking at a complex security is insufficient and potentially malpractice...If I were a CEO, I would want my risk management department making more independent assessments in addition to reliance on a rating."
Lori Widmer is a Philadelphia-based freelance writer and editor who specializes in risk management and insurance.

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