West Haven, Connecticut, which has closed four school buildings over the past two years and fired 14 teachers to help cut its budget deficit, is about to pay Moody’s Investors Service almost double what it cost six years ago for a credit rating.
Joseph Mancini, finance director for the city of 55,000 near Yale University, says he has no choice other than to meet the demands of Moody’s after the municipality’s bonds were downgraded to Baa1 in January, three levels above junk, from A2.
“The market’s going to punish us for the rating we’re at,” Mancini said in a telephone interview. “If we didn’t get it rated, we would be punished even more.”
Four years after faulty ratings helped trigger the worst financial crisis since the Great Depression, Moody’s and Standard & Poor’s are as dominant as ever, boosting fees at a faster rate than inflation as new competition promised by lawmakers failed to materialize.
New York-based Moody’s raised its rates by 5 percent on average this year, and may impose a similar increase in 2012, Chief Executive Officer Ray McDaniel said at a conference for stock investors on Nov. 8.
Even after provisions of the Dodd-Frank Act cut reliance on ratings and encouraged more companies to enter the industry, the $40 trillion worldwide bond market mostly follows the same rules that have determined since the 1930s who gets access to cash and at what interest rates.
“If I don’t have two ratings on a bond, I cannot sell it,” said Timothy Cox, executive director of debt capital markets at Mizuho Securities USA Inc. in New York, who’s been working in the fixed-income market for 30 years. “No money manager is going to buy it,” he said in a telephone interview.
At least one of the three biggest credit-rating companies was hired for 98 percent of municipal bonds bigger than $50 million this year, up from 94 percent in 2007, according to data compiled by Bloomberg. About 99 percent of U.S. corporate issues have a grade from one of the three, compared with 98 percent four years ago, the data show.
Cities and states are paying higher fees even as Moody’s gives them lower grades relative to companies, according to a study released in August by professors at Indiana University, American University and Rice University. The company favors bonds backed by assets such as mortgages, which cost more to rate, the study showed. Moody’s said the study is flawed.
Thousands of top-rated mortgage bonds plummeted in value in 2008, showing that S&P and Moody’s engaged in a “race to the bottom” to inflate their grades to win business from Wall Street banks, according to a report released in April by a Senate subcommittee. The collapse contributed to the credit-market seizure that brought down Lehman Brothers Holdings Inc. and Countrywide Financial Corp.
Since then, Jules Kroll, the founder of the private-investigation firm that bears his name, and billionaire Joe Mansueto of Morningstar Inc. entered the business. Their firms have gained little market share as bond investors and regulators continue to use S&P, Moody’s and Fitch Ratings to measure risk.
The three companies provide 97 percent of all credit ratings, the U.S. Securities and Exchange Commission said in a September report. S&P leads with a 42 percent share, Moody’s holds 37 percent and Fitch, majority-owned by Paris-based Fimalac SA, is at 18 percent.
“It’s very hard to convince someone to stop using S&P and Moody’s ratings because they’re such a market norm,” James Gellert, chief executive officer of Rapid Ratings, which charges investors rather than issuers for its grades, said in a telephone interview. “If you don’t have one, people will wonder what’s wrong with you.”
Even Namibia decided it needed a second rating, from Moody’s, in September before selling $500 million of bonds to foreign investors for the first time. The southern African nation got a Baa3, the lowest level of investment grade and equivalent to the BBB- it already had from Fitch. “Investors want a second opinion,” Saara Kuugongelwa-Amadhila, the country’s finance minister in Windhoek, said in a telephone interview.
Moody’s standard fees to rate U.S. municipal bonds jumped as much as 21 percent this year, according to lists provided to Port Arthur, Texas. Some fees fell while others rose, said Michael Rowan, managing director of the company’s commercial group, established last year to ensure that analysts are separated from business negotiations. The prices are “fair and reasonable,” he said.
“We don’t look to compete on price,” Rowan said in a telephone interview. “We look to compete based on the quality of our ratings and the value of our ratings.”
Linda Huber, the company’s chief financial officer, said in September that there are limited alternatives. “A Moody’s rating is an important thing,” Huber said at a conference for stock investors organized by Goldman Sachs Group Inc. “If it’s not there, it’s noticed by the market. Cost of capital will go up.”
Moody’s and S&P are able to raise prices because the two are a “natural duopoly,” Warren Buffett, the billionaire chairman of Omaha, Nebraska-based Berkshire Hathaway Inc., told the Financial Crisis Inquiry Commission last year. Berkshire is Moody’s largest shareholder, with a 12.8 percent stake, and bought into the business because of that pricing power, he said.
“There are very few businesses that have the competitive position that Moody’s and Standard & Poor’s have,” Buffett said. Berkshire is an “unwilling customer” of Moody’s when it issues bonds, Buffett said. “We pay for ratings, which I don’t like.”
Moody’s raised its standard fee this year on corporate bond offerings to 5 basis points, or 0.05 percentage point, of the amount being raised with a minimum of $73,000, from 4.65 basis points in 2010, according to Michael Meltz, a JPMorgan Chase & Co. analyst in New York. S&P asks for 4.95 basis points with an $80,000 minimum, up from 4.75 basis points and a $72,500 minimum last year. It would cost $497,500 to have both companies evaluate a $500 million debt sale.
S&P and Moody’s haven’t lost business as a result of their increases, said Peter Appert, an analyst at Piper Jaffray & Co. in San Francisco.
“Pricing has no bearing on whether somebody is going to issue debt or not,” Appert said in a telephone interview. The extra interest a borrower would have to pay on an unrated bond is a “whole lot more” than the cost of a rating, he said.
That’s helped make credit ratings a lucrative business. Moody’s Corp.’s return on capital, a measure of profitability, was 71.6 percent last year, the fourth-highest among companies in the S&P 500 Index, while its operating margin was 38 percent, which ranked 25th, Bloomberg data show.
The company received $1.47 billion in ratings revenue last year, or $1.22 million for each credit analyst and supervisor, according to data compiled by Bloomberg and the SEC report. S&P made $1.7 billion, or $1.26 million per analyst and supervisor, while Fitch’s revenue was $554 million, or $528,160.
Moody’s will use price increases to help achieve its goal of low-double-digit revenue growth, McDaniel said at the conference on Nov. 8. A 5 percent price increase for next year would be on the “high side” if bond issuance stays flat, he said.
The Federal Reserve’s preferred price index, which measures inflation excluding food and fuel, rose 1.6 percent in September from a year earlier.
West Haven’s Fees
Ed Sweeney, a spokesman for S&P, a unit of New York-based McGraw-Hill Cos., said the company’s pricing “reflects the value provided to the market.” Daniel Noonan, a Fitch spokesman, said Fimalac doesn’t disclose pricing information.
West Haven is paying Moody’s $16,400 to grade a planned $45 million bond, which it will use to refinance debt, up from $8,500 to rate a $32 million sale in 2005, Mancini said. The city is also paying $15,300 for a grade from S&P, which said last month it was considering cutting West Haven’s rating from BBB, Mancini said.
“You can choose not to have your bonds rated,” Mancini said. “For a city like West Haven, in the financial situation it’s in, it would be a pretty difficult thing to market.”
The $31,700 of fees would pay a new teacher’s salary in Connecticut for about nine months, according to data from the National Education Association, the Washington-based union.
Cities and towns are “trapped” by the market’s continued reliance on ratings, said Representative Barney Frank of Massachusetts, the ranking Democrat on the House Financial Services Committee.
“They are extorting the cities of this country,” Frank said in a telephone interview. “By the criteria they use for the private sector, every full faith and credit municipal bond should be AAA.”
Bonds from cities and countries are rated “more harshly” than those of banks and corporations, according to the academic study, which was released in August by Jess Cornaggia of Indiana University, Kimberly J. Cornaggia of American University, and John E. Hund from Rice. There’s “virtually no chance” of default on bonds backed by the ability to tax, Frank said.
Last year, after Frank and other politicians complained, Moody’s and Fitch said they would rate U.S. state and local governments on the same scale as companies. S&P says its ratings are comparable and no across the board adjustments are needed.
U.S. Loses AAA
S&P lowered its ratings for thousands of municipal bonds after Aug. 5, when it cut the U.S. from AAA. Downgrades of municipal debt outpaced upgrades in the third quarter by the largest margin since 2008, according to a Moody’s report. The reductions are “preposterous,” Frank said.
The U.S. downgrade triggered a loss of $9.7 trillion in market value from global equities last quarter. Buffett said the U.S. should be “quadruple-A,” while John Bellows, acting assistant Treasury secretary for economic policy, said S&P had made a $2 trillion mistake in its math. A Bloomberg survey of 1,031 subscribers found that 57 percent agreed with S&P’s decision.
In 1936, the Office of the Comptroller of the Currency banned banks from holding bonds that were below investment grade. The SEC began using ratings in its rules in 1975, specifying that the only companies whose grades could be used were S&P, Moody’s and Fitch. Those firms were designated nationally recognized statistical rating organizations, or NRSROs. There are now nine.
“Regulators started telling their financial institutions, starting with the banks, you must pay attention to only these handful of entities,” Larry White, a professor at New York University’s Stern School of Business who’s testified before Congress about credit ratings, said in a telephone interview. “That gives the NRSROs a lock.”
After the Dodd-Frank financial-regulation overhaul instructed regulators to strip ratings from rules, bank supervisors are struggling to find a substitute measure of risk. Making the change is difficult because the international bank capital standards known as Basel III still use ratings, David Wilson, chief national bank examiner at the OCC, told Congress at a hearing in July.
Much of the credit raters’ power comes from mutual funds, pension managers and other investors using their grades as cutoffs or triggers in contracts, Mizuho’s Cox said. “The first thing we ask is what are they rated and the discussion goes from there,” he said.
Moody’s, S&P and Fitch face limited competition in structured finance. Kroll started a rating company that began evaluating commercial-mortgage backed securities this year and plans to expand into municipal bonds and residential mortgages.
Morningstar, the Chicago-based mutual-fund data company that bought a credit-rating business last year, has rated 12 of the 32 commercial-mortgage-backed securities issued this year.
At least nine of those 12 were also rated by Moody’s, S&P or Fitch, Bloomberg data show. Morningstar plans to expand into bonds backed by residential mortgages, Robert Dobilas, president of the ratings business, said in a telephone interview.
Regulators are considering other measures which may encourage competitors to Moody’s, S&P and Fitch. In Europe, regulations were proposed today that would require companies to periodically rotate the firm they use to rate their credit.
“Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes,” Michel Barnier, the European Union’s financial services chief, said in a statement. “I also want to see increased competition in this sector.”
Douglas Peterson, who took over as S&P’s president in September, met with Frank on Nov. 3 to express concern over a draft of the European proposals, according to Frank. He also visited the SEC to discuss a plan by Senator Al Franken, Democrat of Minnesota, to create a board to give out rating assignments in structured finance.
“The agencies are as powerful as ever and will remain so,” Glenn Reynolds, the chief executive officer of New York-based independent debt research firm CreditSights Inc., who has testified to Congress on ratings reform, said in a telephone interview. “It’s economic efficiency to pay the man and go through the turnstile.”