From the July-August 2010 issue of Treasury & Risk magazine

Downgrading Rating Agencies

As the federal government crafts landmark financial reform, the debt rating agencies--especially Moody's Investors Service, Standard & Poor's and Fitch--have targets pinned to their chests. For corporate treasurers, what happens to the agencies they rely on to rate their public debt and provide recognized standards for investment policies is a big deal. For better or worse, both market pressures and legislative mandates are forcing reform. So how do forward-looking treasury staffs react?

They decrease their reliance on agency ratings for investment policies. For too long, treasury staffs have neglected credit analysis for their cash investments and relied almost exclusively on agency ratings, says David Stowe, a director and practice leader for financial risk management at Strategic Treasurer in Atlanta.

"A rating is no longer sufficient," Stowe says. "We know that the agencies can get it wrong, that their ratings are sometimes out of date, and that they are not always given the proper incentives to get it right."

Credit ratings gave short-term investors cover to take risks that the ratings masked. Corporate cash investors with investment policies pegged to agency ratings loaded up on auction-rate securities in 2007 because they carried high ratings and attractive yields, but these securities tanked, points out Jeff Wallace, managing partner of Greenwich Treasury Advisors in Boulder, Colo.

Equating investment prudence with agency ratings now "borders on malpractice," Wallace warns.

When guided by agency ratings, many professional investors will routinely pick the highest-yielding security that meets their rating standard. Since collateralized debt obligations were paying more than corporate issues with comparable ratings in 2008, investors loaded up on CDOs and generally shunned better understood but less rewarding corporate debt, explains Peter Hagan, a managing director at global advisory firm LECG and a former senior banker at Merrill Lynch.

Treasury investment staffs need to look more closely at the systemic risk in asset classes, something rating agencies are not good at, Hagan says. The great fallacy of 2008 was that if you had great diversity within an asset class, you were reasonably safe. The lesson learned, he explains, was that an asset class itself can fail.

Now, with the fallibility of the rating agencies fully exposed, corporate treasuries that invest will need to hire their own credit analysts and do their own credit assessments, or default to investments like Treasuries or insured bank deposits where credit assessment is not an issue, Hagan says. "The cost of getting it wrong can easily justify the expense of adding two or three credit analysts to your staff."

Stowe says that aside from cash-rich investors like Microsoft and Google, most treasuries don't have the resources to do in-depth credit analysis on securities they might buy. Some will outsource their investing to outside managers that have greater resources, he suggests. "The big winners will be the outside money managers who have the resources to do independent credit analysis."

It doesn't have to be that complicated, insists Tom Deas, treasurer and vice president at $3 billion FMC, a Philadelphia-based chemical company, and president of the National Association of Corporate Treasurers (NACT). FMC uses ratings for its investment policies on both its short-term cash and its defined-benefit pension plan, but "only as a starting point," he says.

"We read the prospectuses to see what money funds are buying. If there is a concentration of Greek banks, we back off," Deas jokes. What's required is not so much credit analysis expertise as common sense, he claims.

Agency ratings will matter less to short-term investors in the future because we are entering an era of plain-vanilla offerings, predicts Lee Epstein, CEO of Money Market One, a San Francisco corporate cash investment firm. "You won't see the investment banks putting talent and development dollars behind cash management products, like you saw with auction-rate securities," Epstein says, arguing that a 25-year run in yield-enhanced short-term paper has come to an end.

On the issuing side, treasury staffs should prepare for tougher scrutiny and possibly lower ratings when they plan new debt offerings. The agencies will get tough, Stowe predicts. "They have reputations to regain and will do what it takes, so this will make it harder for issuers to get the ratings they expect. There's a lot of soul-searching going on at the rating agencies. They are revising how they look at paper."

Pat Milano, executive vice president of operations at Standard & Poor's, seems to agree. "The criteria we are adopting will yield different results," Milano says. "It may be more difficult for certain issuers to get the rating levels they want and expect."

"Expect more questions about the assets and risk in defined-benefit pension fund portfolios," LECG's Hagan says. But he expects that the change won't be that radical for commercial and industrial companies, because that is where rating agencies did a relatively good job.

Rick Moss, treasurer at $3.9 billion Hanesbrands in Winston-Salem, N.C., doesn't worry about lower ratings. "The market now expects tighter ratings and has calibrated for it," he notes. "Besides, the large investment firms and banks have built their own analytical staffs, so there are more voices out there. The market is sophisticated and can accommodate a more conservative tack by the rating agencies."

Beyond operational adjustments, treasury staffs can enter the debate and advocate policies they consider treasury-friendly, whether that means pushing change or resisting it. The Association for Financial Professionals wants change. The rating agencies need more reform than the financial reform bill will provide, says Brian Kalish, finance practice lead at AFP. "We're disappointed in that bill. It's not bold enough."

The bill's main attempt at rating agency reform is to mandate a two-year study by the Securities and Exchange Commission. "This would not be the first study the SEC has undertaken, and they have yet to move the ball downfield," Kalish notes.

In addition to the study, the legislation would set up an Office of Credit Ratings within the SEC, but what it would do, how it would be staffed and how it would be funded are up to the SEC. The bill would make it marginally easier to sue the rating agencies, but liability would still require errors to have been made "knowingly" and "recklessly," high standards of proof for litigants, Kalish says. The bill would also empower the SEC to deregister an agency if its rating performance was really bad over an extended period, he adds.

Some treasurers are skeptical about reforming the corporate debt rating part of the agencies' business. "For a company making underwear for 100 years and avoiding the bleeding edge of financial engineering, the rating agencies have called it right pretty consistently," Hanesbrands' Moss says. And he insists that Enron didn't discredit them. "Enron was fraud," Moss says. "They didn't misjudge the business fundamentals. They were fooled, along with a lot of banks, by dishonest people. You can never regulate fraud out of existence."

NACT's Deas says the credit raters' problems came in structured finance. "There are four categories of issuers: corporates, municipalities, sovereigns and structured finance. For three of them, the current rating process has worked pretty well," he says. "The fourth needs attention, but the SEC is implementing more rules around structured finance ratings.

"The problem is getting appropriate attention under existing law," he adds, suggesting that NACT is somewhat at odds with AFP on this issue.

The rating agencies, of course, agree that the breakdown was selective, not across-the-board. "We're disappointed in our performance in rating mortgage-backed securities and collateralized debt obligations," Milano admits. "There were certain conditions in the housing market that we didn't call right. But in other areas, we performed quite well."

Moreover, the agencies have already taken steps to improve their ratings process. "We've introduced new scenario analysis and stress tests," Milano says. "We've made a number of criteria changes. We intend to be more transparent and let investors see the assumptions we make so they can agree or disagree." Going forward, S&P will recognize "the big differences in how you rate a structured security supported by collateral versus how you rate a traditional corporate offering," he promises.

You have to be practical, Deas insists, and ratings can be a practical tool. FMC and its underwriters had to price a $300 million, 10-year bond issue last fall. The company hadn't done a new issue in years and had paid down most of its public debt, so trading in its debt was too light to provide reliable price data, he explains. "We were able to look at a peer group of BBB-rated chemical companies and determine what the price should be. The offering was eight times oversubscribed." The key was identifying that BBB-rated peer group, Deas says.

The sentiment among treasury pros, summarizes Ann Svoboda, former Americas treasurer at Cadbury and author of Actual Cash Flow, is that the current system is about as good as it's going to get. "They see reasons to tweak the credit rating system but not to throw it out."

And tighter regulation carries its own risks, argues Lawrence White, professor of economics at New York University Stern School of Business. What the government shouldn't do is saddle the agencies with costly new regulation, he argues. "We need new ideas, new technology, new business models," White insists. "If you raise the cost, only the large incumbents can afford it. You'll discourage start-ups, which is counterproductive. We need less regulation, not more."

But serious voices insist that the flaws exposed in how credit ratings are determined are fundamental and need to be fixed, not excused. "The whole world believed that rating agencies were infallible. Now we're disillusioned," Hagan says. "They didn't do the quality of work we all deserved."

"There's no question that they messed up badly in rating securities backed with subprime residential mortgages," White concedes. "They could make a lot of money by being overly optimistic. There was an obvious conflict of interest."

There are many issuers of plain-vanilla securities, so no one issuer can intimidate the rating agencies, White explains. There were just a handful of issuers of mortgage-backed securities, so they had too much clout in negotiations with the agencies. To compound the problem, the profit margin in rating mortgage-backed securities was higher than it was for rating conventional issues.

"If a corporate issuer were to complain about a rating, Moody's would tell them to buzz off," White says. "No one issuer was important enough for them to put their reputation at risk. With residential mortgage-backed securities, a few issuers accounted for most of the revenue in a very lucrative business."

Furthermore, the relevant data around conventional securities were generally clear and well understood, while the data around mortgage-backed securities were opaque, White points out. "You had a perfect storm--a few dominant issuers, fat profit margins and opaque data. It was a potent threat, and the top three rating agencies all succumbed."

People at Moody's have said that the culture changed when the company went public in 2000, and that the company began to place more importance on keeping customers happy, White adds. New entrants into the ratings business should be encouraged, and mandates that drive business to the Big 3 should be relaxed, he urges.

Greed was definitely a factor. Before they got caught up in the go-go 1990s, rating agencies were staunch public servants respected and relied upon for their acumen in rating corporate debt, LECG's Hagan explains. Then they found gold in rating structured finance bond issues. Moody's saw its stock price soar from $12 into the $70s, and McGraw-Hill discovered that three-quarters of its profits were coming from its Standard & Poor's unit, Hagan notes. "Rating structured finance offerings was more lucrative than rating anything else, so they went for it in a big way."

The agencies took a rating protocol built for corporate debt issues, stretched it to cover municipal and sovereign debt, and then stretched it even further to cover structured finance offerings based on assets like home mortgages. This fostered the illusion that an AA-rated collateralized debt obligation was somehow equivalent to an AA-rated corporate bond, when it wasn't, Hagan says.

For an update on the rating agencies, see Raters Strike Before Ink Is Dry.