Hearing on the Credit Rating Agencies
Securities and Exchange Commission
November 15, 2002
Rating Agencies in the Capital Markets
We recognize the vital role the rating agencies play in the capital markets. The fact is that they are now more important than ever given the more complex array of structured credit products, cross-border issuance, and new borrowers in the capital markets all set against the backdrop of a post-bubble recession characterized by declining asset valuations and heightened price volatility. The explosion of new issuance of securities in the past 2 years has created very lucrative ratings opportunities for the rating agencies and the underwriters in the credit markets and broadened the array of funding alternatives for many classes of borrowers. That rapid expansion of the market has created some indigestion, however, and we are seeing how limited resources and some questionable standards of due diligence have roiled the markets and eroded confidence in the past year.
In gaining market color on the impact of the rating agencies' performance over the past several years and what that might mean for the evolution of the regulatory framework, we would recommend that institutional investors be surveyed on a confidential basis for some additional insights. The rating agencies wield considerable market power with respect to the ratings of many entities that issue in the market and candor may be enhanced by confidentiality. The array of ratings for commercial paper, bonds, bank debt, structured products, claims paying ability, mutual funds, and sovereigns gives the major agencies considerable heft in the financial markets. We would say that market power by itself might temper the information flows in the rating agency review process. Underwriters and banks need to maintain very sound relationships, and the fact that many brokerage firms have in-house "rating agency advisory" groups staffed by ex-agency professionals speaks to their importance in the underwriting process.
Our comments are from the vantage point of an independent fixed income and credit research firm that does not seek to be an NRSRO and does not "rate bonds" per se. We are staffed by a mix of backgrounds including institutional investors, the brokerage and banking industries, rating agencies, the Fed, equity research, and quantitative research. One of our jobs, and one which many of us have spent the bulk or our careers doing, is to anticipate the behavior patterns of the rating agencies since their decisions can be a major market variable, especially when it cuts across structural boundaries (ratings triggers, minimum ratings requirements, etc.). We believe the process has never been quite so unpredictable as it has been in the aftermath of Enron even as the market also wrestles with a mix of structural factors and fundamental pressures.
Our main areas of concern with respect to the rating agencies have been the transparency of the ratings process and how information flows are extracted from higher risk issuers and subsequently delivered to the market. One major area of confusion has been in the use of confidential information and to what extent the decisions are tied to public information. We also address below some of the considerable barriers to entry that have been created by the long process of allowing new NRSROs to enter the market. This has served to protect the market position and the revenue stream of the current peer group of rating agencies. The fact that the agencies have a business model that allows them to get paid regardless of the quality of product they deliver to the market, all the while insulated from securities litigation and competitive inroads by new market entrants, makes for a great equity story but not necessarily a very good market watchdog. We also believe there are some conflicts of interest worth considering in light of broader trends going on in the market. We discuss these issues below.
Reg FD Exemption vs. Public Information
One of the more confusing and disturbing aspects of the ratings process is the level of due diligence that the agencies perform in their rating reviews and to what extent they gain access or even request confidential information. After lobbying for exemption from the requirements of Reg FD, the hope would be that the agencies would be very demanding in their informational requirements for more volatile issuers. It is no small matter since credit stress and volatility have been all too prevalent in the market. The exemption from Reg FD is a very important strategic advantage that the agencies possess that can be used to benefit the marketplace and support the confidence levels of institutional investors and intermediaries in the ratings system. We would hope that the active pursuit of this exemption did not just reflect the desire to gain a margin of safety advocated by rating agencies' counsel to keep the agencies and their issuing clients away from any risk of a "violation."
The Reg FD exemption is an opportunity for the agencies to take a very activist approach when major credits start to unravel in the market as we have witnessed with disturbing frequency this past year. It is not a surprise that the most spectacular market freefall of the past year provides a perfect example. Enron presents a situation where the Reg FD exemption could have played a crucial part of a more transparent rating review process for the market and more efficient decision-making. We fully agree that the agencies cannot protect themselves from a management team that lies, cheats, and stonewalls. We do not agree that more cannot be done, and especially with respect to educating the market on the nature of the review process, and where the Reg FD exemption does play a role. The agencies too frequently claim that they need to depend on public information only. They should, at a minimum, make it clear when that is the case. Otherwise, the market could assume more is being done. While many may tire of revisiting Enron, it does present an example of confusion over "insider" versus "outsider" information and what is being used to drive the analysis
In the specific case of Enron, the world changed after the October 16, 2001 press release, and there were clearly many unanswered questions. The ensuing conference calls raised many risks in areas that Enron would not address, most notably around the performance of its structured partnership units, the asset shortfall in those units, and the activity in the Enron trading ledger. That is where the agencies could have dramatically improved their performance even if the rating agency company line remains "they lied to us." We would agree Enron lied to everyone, but the agencies had an insider's advantage that would have allowed them to play a more significant role in the protection of the market. We have addressed those shortcomings in an earlier testimony in the Senate hearings (see Enron hearings at www.senate.gov). From their Reg-FD-exempt pulpit, the agencies could have taken some steps in that situation to clarify the risks, and it is an example of other areas where the agencies could either raise the quality of information flows into the market, or at least be source of information for the SEC in their filing review process.
In the case of Enron, the knowledge in the market that certain areas were even addressed would have revealed much, or if certain information was not obtained might have revealed even more. Specifically, the knowledge that the agencies had specifically addressed (or not) the areas of ratings triggers, reviewed (or not) the counterparty book and collateral flows, reviewed all existing bank lines (Enron had not filed them as exhibits at the time), or gained update information on the Osprey and Marlin asset valuations and reviewed the status of deals-in-process with investment banks.
The risk of the Reg FD exemption and the manner in which the rating agencies communicate the rating review details sends confusing signals to the market. For the agencies, client confidentiality reigns supreme so even the nature of the specific questions is often a client-agency matter. The outside world often does not even know whether the critical questions have been addressed. In the case of Enron, follow-up conference calls by the rating agencies after October 16 thus generated a number of vague but false positive signals in the market in terms of rating trigger risk, asset sale progress, and the state of counterparty credit availability. The delays in the clarifications were wreaking havoc in the market as investment banks and commercial banks, often from their insiders vantage points, started to close out swaps (or try), require collateral to be posted, and drain liquidity. There are certainly some issues to address with respect to this exemption for the agencies. If they are not going to use it effectively and to the benefit of the market or the oversight process, they should lose the exemption. At least then the market will not get mixed signals.
Barriers To Entry
Market Entrants and Consolidation Trends
The concept of the NRSRO may have started out as a market safeguard, but over the years it has become a major industry that now dominates the investment parameters of investors in fixed income and equity-linked instruments. The largest rating agency, Moody's, boasts $6.8 billion in market capitalization and has often tipped the scale at 50% operating margins. In turn, Moody's stock (ticker MCO) has dramatically outperformed the market and has generated total returns of +122% over a trailing three year period (versus a negative 35% for the S&P 500), 79% over two years (versus negative 31% for the S&P 500), and +23% over the past year (versus negative 21% for the S&P). One would expect that these types of returns would attract more market entrants into a business that clearly has a valuable role to play in the capital markets. To date that has not been the case, so it is appropriate that the barriers to entry issue to be readdressed even if we need to be realistic about the prospects for success on this scale for new NRSROs.
While the market is justifiably concerned about the inability of new market entrants to gain the designation of NRSRO given the inability of new organizations to clear the SEC in the past, the market reality is also that there has been a significant reduction in the number of NRSRO's even with the regulatory barriers that have been in place. The question might be asked why the companies that had operated as NRSRO's had not been able to expand and flourish as stand-alone entities. The economic reality was that the industry had been shaping up as a de facto duopoly of Moody's and S&P in the 1980's and early 1990's, and the second tier players were having trouble making headway. The natural result of this competitive imbalance was just what we have seen in many industries-i.e. a steady period of consolidation. Credit ratings and credit research firms such as Fitch, Duff & Phelps, IBCA, and Keefe BankWatch have essentially been rolled up into one under the umbrella of Fitch, a subsidiary of French conglomerate Fimilac. The past is not a confidence builder in terms of new competition making inroads that will sustain independence, and tells potential market entrants that they better have a clear strategy they can execute to counter this history.
The past failure to mount effective competition to Moody's and S&P aside from Fitch does not change the fact that some will try and some may succeed, but the current structure of the regulatory framework still discourages anyone from trying. We could see well-capitalized companies in the financial media sector get more attracted to the superior profit margin of the ratings industry and look to roll up smaller specialized research firms into a larger competitor to the existing agencies. We could also see the changing nature of debt research at the investment banking houses provide the opportunity for start-up entrepreneurs to establish strong investor-focused research products that could attract capital and personnel to try again what has failed in the past, namely mounting an effective alternative to what is now shaping up as a group of three. The past year has certainly highlighted that the current system is not working well and it might inspire more competition over time in the NRSRO sector. That will not happen, however, if the fear exists that there is no hope of gaining the designation or that the first few in line will lock NRSRO status down and the books will be closed.
Potential market entrants
One approach to develop a client base as a rating agency (if not an NRSRO) has been to take no fees from issuers and make the credit research an investor-targeted product that sells on quality of the output rather than just the issuance of a rating. That business model is not based on relationships with underwriters and issuers. It is based on relationships with investors. That approach has some merit, but it typically comes from smaller firms that are likely to be informative and instructive for investors, but will lack the market clout to move the market with their ratings action. The reality is that a surprise change of view by the agencies will have an impact on the market. That will not be the case with a smaller competitor. Furthermore, the established agencies have become deeply imbedded in the investment parameters of many investing institutions by name, as in Moody's and S&P as opposed to by the broad designation NRSRO.
Another approach is to offer specific industry specializations (e.g. telecom, banks, utilities) to compete with the large agencies based on a superior product and personnel in a more narrowly defined universe of industry groups or issuers. The limited number of competitors that have taken this approach have generally been folded into the larger agencies in mergers (e.g., IBCA and Keefe BankWatch in banks, Duff &Phelps had comparative strengths in utilities even though not narrowly specialized). Generating a following among institutional investors could also create leverage with issuers that could translate into a shift of strategy and charging issuers fees to fuel more growth but this strategy requires success with investors first before the issuers will pay fees above and beyond the two or three major agencies. Issuers naturally feel compelled to pay at least Moody's and S&P just on the basis of market penetration. The fact that Moody's and S&P are so deeply imbedded in the investing landscape creates economic risks to any issuer that chooses to not pay them for a rating. It could render a security ineligible for many portfolios, and thereby depress demand or at least reduce negotiating leverage in the pricing process. The issuer could also run the risk of a hostile rating that, in the views of some cynics, might not give the issuer the benefit of the doubt on some key variables. While no agency would ever admit to such behavior, the fear of such behavior could also have a dampening effect on demand at the margin for a new issue that lacks one or two ratings from one of the "Big Two." This again would translate into basis points and higher cash costs to the issuer in terms of funding.
If the main product offering of any of these start-up efforts is simply a rating as opposed to more market-based research or strategy that adds value to the decision-making process, such efforts will face an uphill battle to even survive longer term. The risk of agencies just coming in and issuing ratings rather than raising the level of information in the marketplace is a good reason to have high standard of performance and quality. Examining that performance in the context of investor needs certainly applies to the existing agencies as well as any entrants. Scale and multi-market reach are important but should not be the main criteria. Regional operators and industry specialists can add considerable value in the marketplace.
Conflicts of Interest
The nagging accusation of conflicts of interest for the rating agencies can be overstated but in some areas they are quite real. The main areas of conflicts are rooted in the fact that they are paid by issuers and generate the great majority of their revenues from ratings fees. They also are now facing a conflict of interest in business lines as they move into more risk consulting services with the expansion of default risk model products. The rating business caters to a very different need in the marketplace than the recent aggressive move into risk products. The purchase of KMV by Moody's this year and the expected purchase of RiskMetrics by S&P, which we view as a competitive response, presents a business mix dilemma that is very similar to what the accounting firms face in audit versus consulting.
For the agencies, offering high margin risk advisory products present some potentially disturbing issues. They will be offering these services to companies that take a high level of credit risk exposure such as banks, brokerage houses, insurance companies, and finance companies among others. These unfortunately are also companies where the agencies issue ratings and where the customer is very funding sensitive. That makes for at least the appearance of a conflict if a credit agency is marketing high margin non-rating services to an issuer that is also being periodically reviewed for a ratings update and/or reassessment. KMV and RiskMetrics are two of the benchmark products in risk management. With these products falling under the umbrella of the rating of entrenched NRSROs, who in turn have regulatory leverage that competitors do not, presents anti-competitive aspects as well as conflict of interest issues. Risk management services are a rapidly growing and high margin end of the marketplace that have relatively low barriers to entry, an unusual feature in the NRSRO discussions.
Issuer fees versus investor needs
In terms of the issuer-fee conflict, we have heard a number of points made in the past by investors. Since the fee does not get generated without a deal, being generous at new issue and revisiting the credit trend after the deal is in the market creates an apparent tension in the decision making process. Any rating action/assessments that prevents an issuer from accessing the market such as an unduly harsh opinion or demand (and transparent) set of metrics and forward expectations could jeopardize the deal. That means no fee. That action presents additional risks since the agencies can always revisit later after the deal is in the market. At that point, the ability to be more aggressive in ratings actions and express disappointment in financial trends can lead to rapid and precipitous downgrades. We certainly saw such post-new-issue-boom revision in the aftermath of the record 2001 issuance wave.
When such post-issuance revisions occur, the problem is that the rating agency has booked its fee, the underwriter has booked its fee, and banks have refinanced their exposure and laid off their risk, and the only loser is the investor who gets blindsided after an accelerated review. The holders of the debt securities are often pension funds, insurance companies, and mutual funds, so the impact goes down to the individual level of retiree, policy holder and life savings. We have seen too frequently major deals get printed and a reassessment of the credit in a matter of weeks and often a few months. While the agencies often describe this as "calling them as they see them," the fact is greater transparency in the information flows and more detailed criteria for future ratings moves should be available when the new deal is printed. At least, such an approach will give investors a better idea of what is expected, and they can better gauge what the agencies are expecting and make investment judgments appropriately. Then they will not be so shocked when the agencies "call them as they see them" later. Uncertainty over this process only heightens market volatility and for many institutions promotes risk aversion. This aversion can impair market access and the irony that follows is that the agencies can then downgrade a company again for lack of capital markets alternatives. It is a vicious cycle.
The rating agencies are obviously in a tough position here. If they move slowly, they get criticized. If they move too fast, they get criticized. One solution might be for them to be much more transparent about their criteria and expectations that are built into ratings so investors can better assess what the risks are when they rely on the ratings. For example, clear statements of time horizons for achievement of specific metrics, downside target ratios that would prompt a downgrade, expected growth rates for an industry, or any other tangible and quantitative yardstick that would improve the ability of the investor to make a more informed assessment. Then there would be less accusations that the agencies take the fee now and change the rules later.
We would encourage the SEC to take more extensive surveys of institutional investors on the topic of quality of output from the rating agencies from the vantage point of the investor. At this point, the agencies drive their revenues on issuer fees. The investor basically does not have a choice but to accept the explanation provided. That bar needs to be raised for the agencies.