August 1, 2004

Pulled Apart

The top rating agencies are torn between investors and their blue-chip clients.


When asset-backed securities were first hitting the scene in the 1980s, Thomas McGuire, the man who headed up Moody's Investors Service's corporate ratings department, said he wanted the risk content of the securities to pass the "wheelchair test." That is, McGuire would track the security for years to come, and if Moody's rating wasn't always the most accurate information out there over the life of the issue, he would come out of his nursing home in a wheelchair and go after the analyst who rated it.

"The wheelchair whipping was a facetious way of getting people focused on the right thing," says a former Moody's official who was there at the time. McGuire's wheelchair imagery was given added credence by the cane he was using at the time, as he had fallen and injured his back. But the message was incontrovertible: "He wanted it correctly forecast, more correctly than anything out there. He didn't want the analysts to have the mentality of an investment banker, whose long-term vision went out as far as their next bonus," the official says.

Getting it correct for the rating agencies continues to be elusive. After all, a company's rating isn't a precise decision; it's a matter of relative risk-a moving target, if you will. Still, since the collapses of Enron Corp. and WorldCom Inc., which garnered investment-grade ratings right up until they defaulted, the major rating agencies, Moody's and Standard & Poor's Corp., along with the smaller Fitch Ratings, have been pulled from all sides. The widely held belief that they are too slow to react, which harms investors, has at times pushed the agencies to overreact. In other cases, the attempt to appear more cautious appears little more than window dressing, given the fear of offending their biggest corporate clients, who after all, still pay their bills. And despite a post-Enron congressional mandate to bring more competition and reform to the business, little progress has been made.

Edward Emmer, executive managing director at S&P, denies that the rating agencies' judgment of its largest clients is tainted by the fact that those companies are the largest contributors to the firm's bottom line. "A recent study by the Federal Reserve Bank concluded there was no correlation between the fact that our fees are paid by the companies we rate and the ratings we determine," Emmer says. Indeed, the study, completed in December 2003, states that the rating agencies are influenced by "reputation-related incentives" rather than revenues when valuing a company's credit quality. In other words, the agencies' credibility is their most important asset.

However, corporate treasurers and investors alike are losing faith, according to the Association for Financial Professionals, a Bethesda, Md.-based organization that represents both. In a recent AFP study, about one-third of respondents said they did not believe the ratings were timely or accurate. "Only 22% of the people who responded thought the ratings favored the interest of investors," says Jeff Glenzer, director of treasury services for the AFP. "A large percentage thought the rating agencies served other stakeholders, such as the issuers of debt."

Shooting first

In what appears to be an effort to dispel such views-and get back their much-desired credibility-the rating agencies are becoming so cautious that their accuracy is being impaired, market observers say. As evidence, some point to S&P's decision last May to put 14 deals backed by auto leases on CreditWatch, with negative implications.

In the asset-backed deals, the rating agency made its decision because of its concerns about the financial condition of the auto companies, whose leases were being turned into asset-backed securities. At the time, underfunded corporate pensions were a big worry in the markets. S&P feared that if a company's pension plan was too underfunded, the Pension Benefit Guaranty Corp. might put a lien on the auto companies' underlying assets, giving the PBGC, not investors, first dibs on those leases. But the move met with a storm of criticism in the market. J.P. Morgan's structured finance group went so far as to release a report that month entitled, "S&P's New Approach to Rating Auto Lease ABS: Shoot First, Ask Questions Later."

Laura Rosenberg, CFA and vp finance at Fiduciary Counselors, worked at the PBGC for 12 years and acknowledged that the agency can indeed slap a lien on assets if it wants to seek payment of pension obligations. But the action is so Draconian that it's rarely done, and when it is, a company has a lot more to worry about than a couple of auto deals, she says. It would set off covenants on most of the company's bond issues, triggering defaults.

"Companies are very aware the PBGC can do this, so they make sure they make their pension contributions, to assure this doesn't happen," she says.

Nisson Motor Acceptance Corp., whose leases backed three of the deals on CreditWatch, had to scramble to undo the damage. Jennifer Kuritz, senior manager in funding at Nissan, gave S&P additional data, and within four days, two of the three deals were taken off of CreditWatch. The third was removed in August.

"My complaint to S&P was that they should have done their homework," Kuritz says. "I think they should be more mindful of people and the impact they have."

Michael Binz, one of the S&P analysts involved in the controversial call, defends the action, saying the firm reacted immediately once it had updated information from the issuers-which wasn't always easy to get.

"We identified an increased risk due to the economic environment," he says. "There are now issuers in the market who have restructured their deals to mitigate this concern."

Mark Adelson, director and head of structured finance research at Nomura Securities International and a former Moody's employee, says people may disagree with S&P's position, but it certainly wasn't crazy. The idea that a bundle of securities is completely separated from any risks associated with the issuer, a concept that undermines the entire asset-backed securities market, has turned out to be a "false bill of goods," he notes. Today, he says, everyone wrestles with the degree to which there is linkage.

To be sure, the agencies have been paying a lot more attention to off-balance sheet liabilities, and liquidity has certainly become an area of focus. "They're trying to get ahead of the curve so that they don't get caught in an Enron-type situation again. Moody's, S&P and Fitch, they've all been quicker to put a negative watch or downgrade on a credit than they were in the past," says one investor.

However, their caution has all but closed down one segment of the structured finance market: the private placement of deals backed by esoteric assets. Market participants blame it on the well-publicized bankruptcy of Conseco Inc., a major issuer of manufactured housing securitizations that filed for Chapter 11 bankruptcy in 2002, as well as several other issuers that seemed to go from triple-A to bankruptcy in a short period of time.

Andrew Jones, senior vp at Dominion Bond Rating Service, says Conseco so dominated the manufactured housing sector that when it came down, the whole industry followed, and that has resulted in the rating agencies shying away from the more complex, esoteric types of assets, such as subprime auto loans. The result is that there is now pent-up demand from sophisticated investors, who know how to price these deals and want to buy them in the private placement market, yet want a rating to corroborate their own internal analysis, says Jones.

"I guess there's the possibility that the pendulum has swung a little too far in one direction," he says. "I've met investors who believe the rating agencies are unwilling to rate some of these transactions, either by not looking at them at all or by offering pricing on them that is so high as to make the transaction uneconomic."

Jones acknowledges the sector was tainted with allegations of fraud. "The fact that you're not dealing with a generic asset means that in some cases, if that originator disappears, there are few or possibly no entities that can step into their shoes and take over the servicing," he notes.

A different standard

But that type of aggressiveness in downgrading ratings or refusing to look at some esoteric assets isn't an across-the-board phenomenon. Indeed, critics point out that the rating agencies still are reluctant to say anything too negative about their best clients. Sean Egan, managing director of Egan-Jones Ratings Co., which is paid by investors instead of issuers, points to studies that seem to indicate the major rating agencies are taking things other than creditworthiness into account when they rate a company.

A recent study by economists at the Kansas Federal Reserve indicates that the agencies are extremely reluctant to downgrade an issuer from investment grade to junk status, which is anything below BBB- for S&P or Baa3 for Moody's. Its study shows that when the three major rating agencies downgrade an issuer's debt from investment grade to junk, its rating tends to slip more grades than if the issuer were simply moving through the notches of investment-grade ratings. Because the rating agencies didn't want to downgrade an issuer to junk, the economists theorized, they would wait until it was inevitable before they did it.

"Kansas was asking why there was a stickiness around the lower rung of the investment-grade level," Egan says. "It's because the larger companies are given a pass. It doesn't happen all the time. Speak to the medium and small issuers. They will say they're not being placated at all. But the large important companies, like Enron, like WorldCom, like Fannie Mae and Freddie Mac, they're given a pass, more than the benefit of the doubt."

Some say S&P's downgrade of Ford Motor Corp. last November, when the company was moved from BBB to BBB- with a "stable" outlook, is evidence of the reluctance of the rating agencies to downgrade their largest clients to junk.

In this case, by the time the call was made, the economy was already improving, the company was poised to benefit from a strong cost-cutting and restructuring, and its earnings power was about to turn around. The market reacted by widening the spreads by an additional 75 to 100 basis points.

Joseph McCusker, vp and analyst at FTN Financial in New York, believes S&P-and probably the other rating agencies-was pressured to keep Ford's rating investment grade because of the company's size and stature, the amount it contributes to each of the agency's earnings, and how a downgrade to junk would have affected the markets. "When Ford was really on the ropes in 2002, the market was in such a tizzy that if the company had been taken down to BBB- with a negative outlook, the markets wouldn't have been able to take it. Ford is such a large component of the corporate bond indices, and the markets had just gone through WorldCom," he explains. He argues that the downgrade was appropriate, but was a little late. As for calling the company's outlook "stable," McCusker calls that absurd, given the enormous pressure of global competition.

"That's a committee decision. An analyst, on his own, is not coming out with a stable' outlook," he says. "Two months earlier, the analyst was saying the sky is falling, and you bring them down a notch and everything is stable?"

S&P isn't the only one alleged to be showing favoritism, according to one market official. Moody's takes a tougher approach with its smaller clients than it does with its larger clients, the former Moody's official says. He cites Nextel Communications Inc., which he says is a stellar company, with strong revenues per subscriber and healthy cash flow. While S&P recently upgraded the company from BB- to BB+-one rating away from investment grade-Moody's gives the firm's debt a Ba3, three notches into junk territory.

Moody's declined to comment for this article except to send a copy of the firm's comments to the SEC, after the commission released a proposal in June 2003 on the ratings industry and what the commission's role in it should be.

S&P's Emmer counters with what others have also pointed out: that more companies are being downgraded than ever before. He says the average large industrial company today is rated BBB, and yet, if you went back 10 years, those same companies carried an average rating of A. Prior to that, many were AA. At the same time, S&P's fees are a lot higher now than they were back then, he notes. Moreover, from late 1997 to early 2004, the number of companies the agency had downgraded exceeded the number it had upgraded, sometimes by as much as 10 to 1, a clear sign that the company is not soft on issuers.

"If that were our mode of doing business, we'd be pretty lousy business people," he argues. Emmer also contests the notion that the rating agencies are being more cautious in the wake of Enron. Not surprisingly, he says they have always been cautious. In the year leading up to Enron, downgrades exceeded upgrades by a margin of seven to one, he says. That said, the company's analysis now puts more emphasis on things like corporate governance and liquidity, and it focuses more deeply on accounting quality. It hired a chief accountant about a year and a half ago, and by the end of this year, it expects to have 10 to 12 accounting specialists on board.

In fact, S&P spokesman Gregg Stein says it doesn't even make sense to say the rating agencies are being too cautious, erring on the side of safety, and yet favoring their largest clients who the pay the bills.

"They both can't be true," Stein says.

Different strokes

One way of understanding the subjectivity of the ratings process is to look at the different approaches S&P and Moody's take to the business. S&P is known for its policy-driven approach, where well-established, well-thought-out guidelines are established and there's a strict adherence to those principles while Moody's is more apt to take individual situations into account, sources say.

"There are strengths and weaknesses to each approach. S&P, by clearly articulating a general set of rules, is able to give a greater degree of comfort to investment bankers and issuers, who are trying to understand and use the rating system. In that sense, they are an easier organization to work with," the former Moody's official says.

"S&P is much more policy-driven," said another former Moody's official. "S&P just basically says this is the way it is. This is our policy. Moody's doesn't have a lot of guidelines. It seems more willing to listen and change based on circumstances."

All that may explain why Moody's and S&P often don't agree on their ratings opinions. When S&P put Goldman Sachs, Merrill Lynch & Co. and Morgan Stanley on negative review in 2001 and again in 2002, Moody's did not follow suit. Nor did Moody's follow when S&P downgraded Ford Motor Co. to BBB- in November 2003. And when Moody's rattled the asset-backed securities market in December of 2002, after the alleged fraud at National Century Financial Enterprises, threatening to downgrade hundreds of existing ABS and mortgage-backed bonds, S&P left the issue alone.

More competition?

While there are some differences between the two biggest agencies, there is still a strong belief that the reason the ratings are not better is that there's not enough competition in the field.

In fact, organizations such as the AFP say they want greater accuracy, free of any conflicts, and they believe competition will lead to more accurate and timely ratings.

"It would force the rating agencies already recognized by the SEC to be aware that they have a need to continuously improve, or they risk losing market share," says the AFP's Glenzer. "If a rating agency can demonstrate that it's doing a better job than the other rating agencies, it will be rewarded with additional business."

Fitch, the smallest of the top three rating agencies, certainly agrees. "It is our belief that the market is the best judge of the value of ratings. If investors lack confidence in an agency's ratings, they will stop using them," says James Jockle, a spokesman for Fitch, whose market share is growing. Fitch rated 70% of the $752.6 billion of corporate bonds issued in the U.S. market last year, an indication that issuers like having more choice, he says.

Competition is precisely where the ratings game may be headed, though it's currently bogged down in political inertia. To date, there's no accreditation process and no criteria establishing how the SEC goes about designating "nationally recognized statistical rating organizations." The main guideline they use, according to a 1997 release, is that a firm must be "nationally recognized." And being designated an NRSRO is no small matter. It's a title held by only four rating agencies and one that gives them a distinct marketing advantage over their competitors (investors need ratings by NRSRO to meet various regulatory and investment guidelines when buying their bonds). Those with NRSRO designations include S&P, Moody's, Fitch and Dominion Bond Rating Service.

In the wake of Enron, the Sarbanes-Oxley Act directed the SEC to examine the role of credit rating agencies in bankruptcies and to fix any problems. Last April, the House capital markets subcommittee held hearings on the issue, and in June, the SEC issued a concept release, which was put out for public comment. Nothing has been released since.

"Here we sit in July of 2004, and there's still nothing being done," says Glenzer. The holdup, sources say, is an internal debate in which the SEC is considering two options. One is to expand its role as designee of NRSROs. The agency would have to decide what the criteria would be and how much oversight it should have over the industry designator to assure that the criteria are maintained. The other option is to exit oversight of the rating agencies altogether.

Annette Nazareth, director, division of market regulation, at the SEC, told reporters in June that the commission hopes to have a proposal out this summer, adding that the SEC is not likely to get out of the ratings business.

The Europeans may force the SEC finally to get its act together. Angry about their own Enron debacle-Parmalat Finanziaria SpA-European securities regulators have jumped on the bandwagon. The International Organization of Securities Commissions published a report on the activities of rating agencies in September 2003, which focused on potential conflicts of interest. And the European parliament voted in February that the credit rating agencies should have to register with an EU watchdog. It called on the European Commission to issue recommendations on how to set up such a body by July 2005.

"The SEC itself said if they don't act soon, they could cede authority on this to European regulators, and the Europeans are very anxious to act on this to avert another Parmalat situation," Glenzer says. "So I don't think the SEC is going to have the ability to punt it this time."

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