From the April 2011 issue of Treasury & Risk magazine

New Raters Enter the Fray

Two new competitors, Kroll Bond Rating Agency and Meredith Whitney Advisory Group, are out to make their mark on the world of credit ratings. The timing couldn't be better for new players. The rating agencies' reputations took a beating during the credit crisis when they had to slash their ratings on huge numbers of mortgage-backed securities. There are opportunities for new players that can do things better.

"Competition is necessary, and the market has laid groundwork for more agencies to enter," says Jeff Glenzer, managing director at the Association for Financial Professionals.

Lawrence White, a professor of economics at New York University's Stern School of Business, says that as an investor, he wants as many opinions out there as possible. Additional rating agencies will mean more ideas, new technologies, new models and new ways of assessing risk, White says.

Sanjiv Khattri, CFO and executive vice president at $1.6 billion Covanta Energy, is also bullish. "Does the industry really need new players? Yes. Recently, there's been significant relief, from a regulation point of view, to allow more competition where previously, regulation prevented it."

The Big Three--Moody's, Standard & Poor's and Fitch--issue almost 90% of ratings for corporate bonds and asset-backed securities and 99% of those for government, municipal and sovereign debt. Their market lock reflects both regulatory endorsement and the opaque Nationally Recognized Statistical Ratings Organization (NRSRO) designation criteria.

The three agencies were grandfathered in when the Securities and Exchange Commission created the NRSRO system in 1975, which effectively set them up as the main credit rating arbiters. Over time, ratings became tightly wrapped up within various securities, banking and insurance regulations, forcing investors to seek out only NRSRO-rated securities. While additional agencies later joined the NRSRO-designated ranks, mergers ate away at the expanded ranks, leaving Moody's, S&P and Fitch with their giant share of the market.

Until recently, the black hole surrounding NRSRO licensing helped the Big Three retain their market hold. The SEC offered no regulatory process or even a statement of NRSRO licensing qualifications. Applicants could wait years to receive the "no action" letter that served as their license designation.

This opacity began clearing in 2006 when the Credit Rating Agency Reform Act required the SEC to lower NRSRO licensing entry barriers, make the process more transparent and allow all qualified applicants to obtain the NRSRO designation. And last year, Dodd-Frank pushed for additional clarity by demanding methodology transparency, conflict of interest limitations and ratings agency liability.

The SEC now lists 10 companies as NRSROs. One of those companies, LACE Financial, was bought by Kroll, which gives the merged company NRSRO status, while Whitney Advisory awaits the SEC's green light on its application.

"General market acceptance for the new agencies will take longer where certain securities are concerned, specifically where the Big Three hold a virtual monopoly," Khattri says. "In order to succeed, new credit rating agencies must find a niche, build on it and then expand. This will take time. Basically, it's a long-term effect based on a great deal of short-term work."

Larger rating agencies can spread the costs of analytical software and administrative, legal, compliance, marketing and support staff across a wider range of ratings, while new rating agencies must pay to assemble those resources from scratch. Additionally, companies with a long history of producing quality products develop a reputation that allows them to command higher prices.

Yet even Fitch was once an unknown quantity. John M. Peterson, an independent risk consultant, recalls working with Fitch when he was senior vice president of corporate finance at MBNA and later as assistant treasurer at Cendant. Fitch "succeeded by focusing strictly on certain asset classes," he says. "They didn't try to be all things to all people."

Peterson says Fitch also gave issuers more information on the ratings process. "Not that it meant ratings were easier to achieve, but that they were more likely to contact you to clear up miscommunications," he says.

Today's financial executives want even more ratings clarity. Roy Weinberger, a principal at Credit Research, Advisory, Consulting and formerly managing director for corporate ratings at S&P, says in the last decade, rating agencies came to rely more on mathematical models than fundamental analysis, a shift that left market participants complaining about a lack of transparency.

"We don't feel there's been transparency and accurate ratings," agrees Marie Hollein, president and CEO of Financial Executives International. "It's always been very vague. Companies need to see the methodology, know up front how agencies are rating them and what's expected from them."

Kroll, the brainchild of Jules Kroll, founder of the eponymous corporate security firm, appears to be listening. Kroll says it will do its own due diligence on the organizations it rates, pay greater attention to ratings transparency and develop a post-rating follow-up plan. The company is also starting slowly. It will initially offer only structured finance ratings then segue into municipal ratings. By 2012, it plans to rate corporate bonds.

Meredith Whitney made her name as an analyst with her presciently gloomy prognosis on bank stocks a few years ago. Her firm, Whitney Advisory, until now has specialized in investment analysis of financial firms. The specifics of its rating methodology are still under wraps, and the company refuses to comment. A presentation Meredith Whitney made to SEC officials in support of gaining NRSRO status indicates the firm plans to build its research staff from 27 currently to 100 in its first year as a rating agency.

Some experts caution that improving rating methodologies does not necessarily mean a one-size-fits-all solution.

"Credit rating methodologies cover a broad spectrum of topics," says Jerome Fons, executive vice president at Kroll. "Some are concerned with the way the rating agency analyzes issuers and obligations within an industry sector or region.

"There are differences even within a rating agency as to how to analyze credit risk across sectors," Fons notes. "It would be very difficult to document how methodologies vary across all sectors."

At the heart of the rating agencies' credibility is the issue of which party pays for the ratings. The fact that Moody's, S&P and Fitch are paid by the organizations whose debt they rate--the issuer-pay model--creates a potential conflict of interest, critics say, raising the possibility that issuers could shop for the most favorable ratings, or agencies could pressure companies for more business by threatening downgrades.

Rating agencies argue that in the modern world of e-mail and text messages, the subscription model, in which investors pay for information, simply isn't feasible, since ratings could be quickly disseminated to non-subscribers. The SEC currently lists three NRSROs--LACE (purchased by Kroll), RealPoint and Egan-Jones Ratings Co.--that operate under the subscriber-paid model.

Subscriber-pay appeals to "a significant portion of the investor base that would like timely, accurate credit ratings, and we serve this need for our 400 institutional investors," says Sean Egan, managing director of Egan-Jones.

"Most sophisticated finance people have realized there is a good portion of securities rated at the high levels that experienced dramatic decline in credit quality," Egan says. "If they are doing their jobs, they should seek out firms that have provided accurate ratings."

Weinberger says Egan-Jones grew its subscriber base by offering a quicker review process and faster response and turnaround times. Egan-Jones conducted quarterly or semi-annual reviews of issuers on schedule, identified any problems and quickly alerted customers, he says.

Kroll is taking a mixed approach, supplementing LACE's subscription-based program with an issuer-pay model. However, Kroll's version of issuer-pay has a twist: Clients pay some of the costs prior to rating in order to deter shopping around.

Whitney Advisory is initially providing rating services on a subscription basis, but Whitney has said in interviews that she believes only the issuer-pay model allows an agency to gain market share. "Issuer-pay allows for scale, for paying quality analysts and is a model that has worked for decades," she told the Financial Times in November.

The issuer-pay model has been the standard in both developed and developing capital markets ever since ratings demand soared in the 1970s, generating the opportunity for additional fee income. Rating agencies justified these fees by claiming the increased demands required much higher staff and compensation levels than could be borne through sales of subscriptions alone.

"The pressures to take advantage of these incentives ultimately changed the nature of the game," Weinberger says.

NYU's White says that despite the inherent conflict of interest, the issuer-pay model worked until the early 2000s. "When it did unravel, [it] succumbed only in the structured finance area, not the corporate or municipal or sovereign areas," he says.

AFP's Glenzer would like to see the issuer-pay model disappear. "If you believe rating agencies provide value, why aren't all parties paying for it, thus managing the conflict of interest and eliminating the wallet control issue altogether?" he asks.

Weinberger suggests that both investors and issuers pay for ratings through a small fee attached to new fixed-income issues and bond trades in the secondary market. This would eliminate conflicts of interest while allowing ratings to be distributed throughout the market and in a more transparent way, he says.

Yet the debate about conflict-free payment models is irrelevant if the new rating agencies don't have any clients.

"CFOs and corporate treasurers have the luxury of saying to the newcomers, 'What can you do for me?'" says Peterson. "The onus is on them to demonstrate they are relevant to investors."

Glenzer suggests Kroll and Whitney Advisory could solve this Catch-22 by convincing large institutional investors that they're putting out better ratings. "Once investors acknowledge this value with orders, corporate treasurers will soon follow," he says.

"We would certainly work with new players in this area, if we would feel that a credit rating from these new agencies would help us to reach a broader investor base, if and when we would have further bond offerings," says Erik Smolders, corporate treasurer and vice president at Ingram Micro, a $34.6 billion technology distributor.

"However, any new rating agency that enters the market has to prove to investors that the rating they provide will help the investor make better investment decisions," Smolders says. "Once the investor community is convinced of the value, corporate and bond issuers will start to engage the new agencies. Right now, we feel a rating from the three traditional rating agencies is sufficient for us to be able to successfully tap the bond market."

"A corporate treasurer of a Fortune 1000 company has little reason to go out to a smaller rating agency," Glenzer says. "You want people to buy your debt. If people won't buy it because they won't recognize the rating agency, then you've lost your return."

Yet corporate treasurers now face their own set of investment pressures, and Peterson says those pressures could provide opportunities for new agencies.

Although companies came to grief during the financial crisis with investments in auction-rate securities, board members are asking whether it's possible to get higher returns on the company's cash, he says. Peterson suggests new agencies take advantage of this impasse by explaining how their better ratings systems can bridge this divide.

Fons says Kroll is working on the challenge of breaking into the market, although the fact that it is 40% owned by pension funds and foundations means it's off to a good start with at least some investors.

"We're completing an outreach program, meeting with the large institutional investors, explaining what we do and suggesting that they alter their investment guidelines to include a rating by Kroll," Fons says. "If specific NRSROs are named in the guidelines, we ask the investors to consider loosening that configuration."

Attempting to clarify the opaque system of credit ratings could give Kroll and Whitney Advisory an advantage. However, successfully conquering widespread industry skepticism will be an uphill battle. As they enter the market, the SEC is starting to remove requirements for ratings from credit agencies in many of its regulations.

"The goal is to ensure transparent and unbiased ratings affecting corporate liquidity issues," Hollein says. "Remove the subjective and move toward the objective," she advises.

"It's not how many [rating agencies]," Glenzer says, "but having the right agencies who can reliably rate across all assets."

For a discussion of Dodd-Frank's impact on credit ratings, see Downgrading Rating Agencies.

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