By Ted Howard
Moody’s, S&P and Fitch may have taken their licks over their role in causing the financial crisis, but they’ll survive. Nonetheless, smaller firms and newcomers see opportunity.
Fluctuat nec mergitur is a Latin phrase that means, “It is tossed by the waves, but does not sink.” It’s actually the motto of the City of Paris, but these days could very well be claimed as a motto by the Big Three credit-rating agencies. As a result of the financial crisis, they have been buffeted by an unending multitude of waves but despite it all, they do not sink.
This won’t change soon. And in fact Moody’s, Standard & Poor’s and Fitch will likely continue to stay well above water if not sail like a hovercraft into the future. That’s because despite taking a beating after their colossal misfire on rating structured products, their corporate issuance ratings business is very healthy and still trusted (although now often verified by issuers and investors alike).
“If you look at the performance of the big boys of the last few years, historically they’ve done a pretty good job rating the types of entities they’ve traditionally rated,” said Jonathan Katz, a consultant and former secretary of the Securities & Exchange Commission.
These corporations and large governmental entities for instance, Mr. Katz said, are ones that “have an ongoing existence,” where there is a history and independent sources of information like SEC filings, market analyst opinion and known business models. This differs from structured products that do not have that “ongoing existence” feature. “The transaction is a one-off; there is no historical framework, and the only info you have to go by is the info supplied by the originator,” Mr. Katz said. And for rating these products, he said, the Big Three made the mistake of trying to “shoehorn these assets into existing models”—namely models created for traditional issuers
Another reason the Big Three will hang around is that they also have years and years of data that is coveted by investors, banks and analysts. And during the crisis, in response to the no-confidence vote raters were getting in the market and bank regulations that required internal risk
assessments to determine capital needs, they made more of this data available, selling it and other tools for those who “wanted to go DIY,” as one analyst put it. In particular, the Moody’s and S&P “default studies”—which help predict both the probability of default and loss, and the event of default—are the reports that most people use to develop their own models.
“There really is no viable alternative to provide analysis and credit opinions with the depth and breadth that the big rating agencies provide,” said Craig Fitt, Managing Director US Head of Ratings Advisory at UBS Investment Bank.
So while the Big Three appeared to be on their heels, they were in fact just pausing and retooling. The crisis did provide an opening for smaller raters and newcomers (see chart below), but they have their work cut out for them to gain market share.
Regulatory waters
The Dodd-Frank regulatory reform bill made sweeping changes to many aspects of the credit ratings business. As with much of the regulation, most of these changes are still being defined, but what is known for sure is that it won’t be business as usual.
Going forward, rating agencies will now be required to, among other things:
- Disclose their methodologies and any third parties used for due-diligence efforts, as well as their ratings track record.
- Consider independent information in their rating analysis. This can come from sources other than the organization being rated. They are now required to consider this information in their rating decisions.
- Prohibit compliance officers from working on ratings, methodologies or sales activities on behalf of the rating agency.
- Provide a new one-year look-back review when a rating agency employee goes to work for an obligor or underwriter of a security, or money market instrument subject to a rating by the agency.
- Mandatory reporting to the SEC when an employee goes to work for an organization that has been rated by the agency in the previous twelve months.
- Have all rating-agency analysts pass qualifying exams and participate in continuing education.
- Ensure that at least half the members of the board are independent, with no financial stake in the credit-rating agency.
In addition the SEC will create a new Office of Credit Ratings with its own ratings expertise, its own compliance staff and the authority to fine credit rating agencies for violations. It will be required to exam all rating agencies at least once a year and has the authority to deregister an agency.
There are a host of other reform measures, like investors’ ability to file lawsuits for reckless ratings and the elimination of statutory and regulatory requirements to use credit ratings.
New Entrants
With all the new regulations, it was thought that the Big Three would be a bit hamstrung going forward, allowing the smaller firms and newcomers an opening. The crisis has created an opening for these firms, mainly due to the encouragement by regulators for investors to rely less on the big raters and more on their own or other independent analysis.
One newcomer is Kroll Bond Rating Service, begun by Jules Kroll, the former owner and founder of security firm Kroll Inc. The company in August 2010 purchased Lace Financial, subscription-based ratings company, which gave Kroll the SEC’s Nationally Recognized Statistical Organization imprimatur.
In an interview, Mr. Kroll acknowledged that firms like his are “standing on the shoulders” of their larger rivals; nonetheless, his company is finding ways to compete. For instance, he said that they have generated interest from many large corporates—particularly treasurers—who are just looking for the research.
“We’re finding that our value to the treasury function is less about the rating and more about the research and the open sharing of information,” Mr. Kroll said. This includes helping treasury with bank relationships. Kroll’s acquisition of Lace brought with it the ratings and research of about 8,000 banks. Mr. Kroll said that what they discovered was that there are treasury departments that are using this information to determine with whom they’ll do business.
“Our biggest base of subscribers is the treasury function at large corporates,” he said. “They want to know how secure the banks they are dealing with are.” The data is also popular with investors who are interested in the banking sector from an investment point of view. “So we’re finding that very large corporates, like GE and GM, are using our ratings for their credit analysis,” Mr. Kroll said, adding that the growth in this business “was a bit of a sleeper but. . . a pleasant surprise.”
So where regulation has sought to reduce investor reliance on the Big Three, companies like Kroll will likely thrive on an increase in sleeper business.