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Over Rated?

The subprime fiasco has put corporate credit-ratings on thin ice.
Alix Stuart, CFO Magazine
September 1, 2008

Having long bestowed upon corporate bonds a measure of credibility, embattled rating agencies are now fighting to retain their own. Cascading credit problems triggered by catastrophic (but highly rated) subprime-mortgage loans have prompted observers to ask whether the agencies furnish reliable benchmarks or perilous illusions of safety.

The Big Three — Moody's, Standard & Poor's, and Fitch — have suffered their share of black eyes over the years. In the 1980s, leveraged buyouts transformed double-A bonds to junk overnight. Later, dubious structured finance vehicles proliferated with few, if any, caveats. And Enron plunged into bankruptcy still sporting an investment-grade rating. But today, the subprime mess, a subsequent Securities and Exchange Commission investigation, and other problems have the agencies on the ropes like never before.

Even some of the agencies' executives concede that their once-commanding voice has lost authority. S&P's president recently advised investors to do "more of their own research," indicating that ratings should be merely a starting point for independent analysis.

Far more telling than the agencies' newfound modesty, however, may be the shift in corporate attitudes toward the very act of being rated. Earlier this year, when declining sales of its powerboat sand other leisure products prompted a significant downgrade (from BBB– to BB+), Brunswick Corp. essentially shrugged off its plunge into junk-bond territory. "We do not believe today's announcement by S&P will have any significant effect on Brunswick," the company reported.

Brunswick expressed a view taking hold more widely. "We're in the twilight zone of credit-rating agencies, where they have a complete lack of credibility in the marketplace, yet investors and issuers still have to use them," says James Kaitz, CEO of the Association for Financial Professionals. As both the SEC and European securities regulators weigh a variety of reforms, some debate not only what kind of future credit ratings have, but whether they have a future at all.

Feeling the Heat
In July the SEC announced the alarming results of an investigation. It faulted the way that S&P, Fitch, and Moody's handle ratings for residential mortgage-backed securities and collateralized debt obligations, two fast-growing structured securities. At the same time, Connecticut Attorney General Richard Blumenthal brought suit against the Big Three, alleging that they use a far more difficult rating scale for public versus corporate bonds in order to boost bond insurers' profits.

In contrast with official policy, the SEC charges, the three principal rating agencies failed to erect sufficiently sturdy Chinese walls between structured finance rating activities and fee negotiations. Conflicts of interest erased crucial boundaries between rating assessments and revenue consequences. In an uncovered E-mail, one analyst wrote, "I am trying to ascertain whether…we will suffer any loss of business because of our decision [to assign separate ratings to a product's principal and interest]." Other E-mails refer to a "paradigm shift in thinking" aimed at competition for market share and closing deals. Under market pressures, some adjustments altered analytic models, a ringing defeat for 2006 regulations that compelled rating agencies to reveal methodologies.

Gaming the system remains common, some critics charge. While investors don't have direct influence over the analysts, their presence as the end user of a rating is felt, leading to perhaps unjustified delays in downgrades or reversals, says Jerome Fons, managing director of credit policy at Moody's until August 2007. "It's ultimately a no-win situation for the agencies, because every time you change a rating, you're going to upset someone," he says.

Moody's, S&P, and Fitch have already agreed with New York State Attorney General Andrew Cuomo to halt a "don't ask, don't tell" policy that winks at the condition of mortgage pools supporting mortgage-backed debt. Agencies will also crack down on abusive "rating shopping" by charging fees to all customers whether or not they accept the ratings, and will adopt proposed SEC rules that improve the transparency of financial information.

European Union regulators are seeking new layers of oversight as well. Undercurrent plans, the Committee of European Securities Regulators would require a formal registration from each agency and would then monitor them for compliance with conflict of interest rules, among other actions.

That's not good enough, say critics, who dismiss the proposed initiatives as temporary, Band-Aid measures. Josh Rosner, managing director at independent investment research firm Graham-Fisher, warns that rating agencies could still use semantics to bend rules about product categories or performance thresholds. The problem is, more may not be better. "It's a fine line," says Fons, "between a regulator saying 'Do it this way' and 'Assign this rating.'" Some proposed legislation has gone so far as to prohibit Triple-A for structured products.

Competition from a cadre of new, nimble rating agencies could challenge the Big Three in certain industries or categories. The SEC has conferred its nationally recognized statistical rating organization (NRSRO) designation on 10 firms, among them Egan-Jones, Realpoint, and Lace Financial. But Moody's alumnus Fons says the answer lies not in competition, but in monopoly. "In the best of all worlds, there would be just one not-for-profit rating agency, and they'd get it right," he says. "Right now, rating agencies tend to compete not on the quality of ratings but on the quality of service to debt issuers."


The perennial question as to whether rating agencies are biased because they are paid by the companies they rate has come up again. Attempts were made in the 1970s to charge investors, the consumers of the ratings information, for that data, but the effort floundered. Fons maintains that such a model is unfeasible because investors can't provide the funding needed to maintain the leagues of analysts and high-touch company interactions that the agencies have developed.

Others maintain it's the wave of the future. "The [investor-paid] model has been working really well for us for the past seven years, and I think it will go a long way toward improving investor confidence in the marketplace," says Robert Dobilas, CEO of Realpoint, the most recently anointed NRSRO. He says Realpoint's subscription revenue covered the firm's ongoing costs by the end of its first year.

Perhaps, some say, those armies of analysts aren't needed at all. One dramatic solution: rely instead on quantitative market forces to determine appropriate bond ratings. It's not science fiction. During his tenure at Moody's, Fons claims he built an automated scoring model that accurately replicated rating-agency decisions. A key component of that approach is the market price of a corporate bond, which reflects the opinions of millions of investors and implies a certain level of creditworthiness.

To anyone aghast at the thought of letting market forces decide credit ratings, Fons points to a parallel example. "We have a functioning equity market without ratings," he says. While acknowledging obvious differences between stocks that rise and fall with company performance versus bonds that require actual repayment, Fons nonetheless maintains that ratings supply a needless crutch. Investors "like a third party that can share the blame if things go wrong," he says.

Blame Game
Things certainly have gone wrong, and blame has certainly been doled out. Regardless of the outcome, "it's hard to believe that rating agencies, and bond ratings, will be held in the same esteem they enjoyed for years before this [subprime] episode," says Richard Larkin, director of research for investment firm Herbert J. Sims and a former managing director at both S&P and Fitch. Adds Kaitz: "There's nothing any regulator can do to make the credit-rating agencies more reliable; the only thing that will restore them is time — if they issue more-reliable ratings."

Despite the criticism, no one expects the agencies to just fade away, least of all the investors who depend on the reality checks they provide. "I absolutely want to know what the rating agencies think of a bond — if it's been upgraded or downgraded in the past, and what the trend is," says Thomas Dalpiaz, a fixed-income portfolio manager at Advisors Asset Management.

"Moody's and S&P have been around for over 100 years, and there have probably been [fewer] than 12 high-profile [corporate bond] disasters, with some of those based on issuer fraud," says Rosner. He expects that track record to hold up, since "they're generally using models that have been in place for a long time, based on a long history of empirical data."

To some degree, the agencies may be less to blame than the rules that govern them. Case in point: an early 2008 downgrade for municipal-bond insurers also beat up the bonds they insure. Despite no material change in the bonds, says Larkin, they slipped below investment grade, and because SEC rules require money-market funds to hold only investment-grade assets, managers with such bonds in their portfolios had no choice but to sell. "There was a massive dislocation because suddenly everyone had to unload this paper, which wasn't really in danger of default, simply because it didn't meet the regulation," says Larkin.

"Our own rules may be contributing to an uncritical reliance on credit ratings as a substitute for independent evaluation," acknowledged SEC chairman Christopher Cox. "That should be neither the purpose nor the effect of any SEC rule."

Some of the SEC proposals address that very issue, but it remains to be seen how much will really change. The status quo persists at least in part because the Big Three have done their job in many or even most respects. But when you're selling credibility, any mistake can be a killer. If other companies follow Brunswick's lead and shrug off a downgrade, reform may become a moot point.

Alix Stuart is a senior writer at CFO.


Lessons in Self-Reliance

Many issuers sidestep credit ratings altogether by tapping the unrated private-placement market, where companies with good credit pay no premium versus rated debt. Aqua America, one of the largest private water utilities in the United States, routinely goes the private route to furnish $1.2 billion in long-term debt. CFO David Smeltzer applauds the cost-effectiveness. Besides avoiding hefty fees to Standard &Poor's and Moody's (as much as 4.25 basis points on a transaction's face value), private placements impose no interest-rate premiums and carry lower closing and legal costs. "Heretofore, there has been very little differential in what we could get as a rated entity and without a rating," according to the company's investment bankers' assessment of the market, says Smeltzer. To play it safe, Aqua America maintains an A+ rating at its largest subsidiary but often issues debt out of the corporate holding company or other subsidiaries.


Large institutional investors already stress self-reliance. A staff of 220 people scrutinizes potential fixed-income investments for the California Public Employees' Retirement System, the country's largest public pension fund. Insurance giant MetLife Inc., with $560 billion in assets under management, employs 100 analysts to assess creditworthiness. "The credit-rating agencies are here to stay, but there still needs to be an independent evaluation of credit," adds MetLife CFO William Wheeler.

Corporate issuers without armies of credit analysts also look beyond rating agencies to evaluate debt owed them. Applied Materials, a $9.7 billion supplier to the semiconductor industry, uses "ratings as a reference point, but we have always looked through to the collateral" in choosing investments for its $3 billion–plus cash portfolio, says CFO George Davis.

As credit-rating agencies lose cachet, corporate finance executives should prepare to step up internal due diligence, say experts, or take cover. Cautious, recession-minded corporate treasurers are moving their cash into money-market funds that do not require credit ratings. A recent Association for Financial Professionals survey found that nearly 40 percent of corporate cash is in money-market mutual funds, up from 31 percent last year. Meanwhile, James Kaitz, the AFP's president and CEO, has noticed more use of outside firms to validate credit quality. It adds another layer of cost to credit decisions, he concedes, but still may furnish the soundest alternative to a flawed system. — A.S.




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