Rating Public Pension Funds?

Last week Tara Perkins of the Globe and Mail reported that rating agencies are at the crossroads:

Just like the investment portfolios of most Canadians, Walter Schroeder is a shrunken version of his former self in the wake of the financial crisis.

The 67-year-old founder of credit rating agency DBRS Ltd. has lost a noticeable amount of weight, something that acquaintances point to when speaking of the stress he and his team have endured over the past couple of years.

More than three decades after conceiving a brazen business plan for a Canadian credit rating agency during a family road trip in his Volkswagen Beetle, Mr. Schroeder succeeded in building DBRS into the country's pre-eminent rating agency.

But a year after Lehman Brothers imploded, DBRS, along with other credit raters, is battling the fallout of having given high ratings to a number of securities that cratered. Now, the agencies are under fire from investors, regulators and politicians who are introducing new rules for the sector.

For Mr. Schroeder, “this is easily the worst” economic cycle in recent history. “I've seen them all, from '72, '82, '92, to 2002,” he said.

In the years leading up to Lehman, credit raters became a backbone of the financial system. Their ratings affect everything from the interest rates companies pay to raise money, to the amount of capital banks must hold, to pension funds' investment decisions.

In the aftermath of Lehman, the rating agencies are fighting some of the proposed reforms and also searching for ways to maintain profits. The recession has bitten into their revenues, and some proposed regulations could leave teeth marks deep enough to cause permanent scars.

The outcome of this evolution will not only change the ratings business, but the way that many investors make choices about where to park their money.

Long before Lehman failed, the credit crisis reared its head in Canada and quickly turned the spotlight on DBRS. Canada's homegrown rating agency was the only one to rate $33-billion worth of third-party asset-backed commercial paper, and assigned high ratings to most of it. The ABCP market froze in August, 2007, when investors suddenly panicked about potential exposure to subprime mortgages. That became the biggest financial headache this country would face as a direct result of the crisis. Other rating agencies say they refused to rate the paper because of possible risks it posed.

The ABCP crisis left thousands of Canadians unable to tap into portions of their savings. In the finger-pointing that ensued, the country's banking regulator questioned why investors would buy a product that only one agency had weighed in on. DBRS, like all of the main players in the third-party ABCP market, was eventually protected from a flurry of lawsuits by way of a special indemnity clause that was written into the plan to restructure the market.

DBRS is a private company and doesn't disclose financial results, but it is one of the biggest players in a sector with estimated sales of more than $5-billion (U.S.) a year. Larger rivals Standard & Poors Corp. and Moody's Investors Service Inc. each saw revenues from their ratings businesses fall by more than 9 per cent in the latest quarter, but their sales still amounted to hundreds of millions of dollars apiece.

Globally, the big three rating agencies – S&P, Moody's and Fitch Ratings – have borne the brunt of the criticism, and their businesses could change dramatically as policy makers figure out ways to serve investors better.

Whether agencies should be legally liable for their ratings is one of dozens of questions regulators are considering as they debate reforms. Until now, U.S. courts have struck down major lawsuits against the agencies on the basis of free speech.

Imposing more liability on agencies could motivate them to give out low ratings, Fitch's chief executive officer Stephen Joynt told the U.S. House of Representatives in May.

“A Fitch rating is our opinion about the future financial capacity of a company or other issuer to pay its debt,” he said. “It is not a statement of fact or a professional judgment. It is not a recommendation to buy a security, it is not investment advice, it is not an advertisement or an offer to buy or sell a security.”

Beyond liability, one of the most talked-about proposals is changing the way agencies earn money.

Since the 1970s, they have been charging companies and other issuers of debt fees for ratings. For instance, S&P, which publishes a general fee schedule, charges corporations, such as banks, a minimum of $70,000 or up to 4.25 basis points per transaction. (A basis point is 1/100th of a percentage point.)

Critics charge that it's a conflict of interest for agencies to be taking fees from companies they rate.

“A good way to do it, and a fair way to do it, would be to have investors who use their services – research and ratings – pay for it,” says Paul Rivett, a spokesman for Fairfax Financial Holdings Ltd. “If [the agency is] not good and the analysis is not sound, no one's going to pay.”

The industry argues that people who use ratings also have a vested interest in them. “Potential conflicts exist regardless of who pays. The key is how well the rating agencies manage the potential conflicts,” Moody's CEO Raymond McDaniel said in hearings at the U.S. House of Representatives.

Ironically, many officials in the ratings business argue the market's reliance on ratings goes beyond what they were intended for. As S&P states in a subscriber contract: “Any user of the information contained in any of the services should not rely on any credit rating or other opinion contained therein in making any investment decision.”

Ratings look at a company's or other borrower's ability to repay debt. While they serve an important purpose, “investors benefit from having multiple perspectives, can't rely on single sources, and must do their own due diligence,” says Don Guloien, chief executive officer of Manulife Financial Corp., whose previous job was running the company's massive investment portfolio.

Charles Dallara, managing director of the Washington-based Institute of International Finance, says “investors perhaps do bear their own share of responsibility for undo reliance on ratings, but that does not absolve the rating agencies from their inadequate management of the rating process on these structured products.”

For his part, Mr. Rivett believes that switching to a user-pay model would spur competition in the ratings business.

The ratings business, dominated by the big three rating agencies, is the most concentrated business in the world, Mr. Schroeder claims.

DBRS is one of 10 agencies the U.S. Securities and Exchange Commission deems to be a Nationally Recognized Statistical Rating Organization (NRSRO). It's a designation that once applied only to the big three, but the SEC has been trying to foster competition. (More than 50 other competitors have not applied for the designation.)

It might have been trying too hard. In August, its auditor-general released a report criticizing it for not doing enough due diligence before approving some agencies.

The report also noted that increased competition could actually reduce the quality of ratings by spurring “forum shopping,” where a company seeks a rating from multiple agencies and hires the one that provides the highest.

Meanwhile, the head of the SEC wants a requirement that all agencies be registered, something that the G20 favours and the Obama administration has proposed. The European Union has already adopted a law requiring registration.

In Canada, the Canadian Securities Administrators (CSA) has recommended that the business be regulated. Securities regulators should have the authority to review, and require changes to, the practices and procedures of rating agencies, it suggests. The CSA made the recommendation last fall and is still looking at the issue while watching to see what other jurisdictions do so that it can develop regulations that are consistent.

More regulations are likely to increase costs, if not reduce revenue, for agencies that have already laid off staff as a result of the crisis.

For DBRS, the timing of the crisis was particularly bad. It finally had its name emblazoned in lights on top of a tower in Toronto's financial district. It was making inroads in the United States, and had opened offices in Europe.

It closed its three European offices last year, laying off 43 people in London, Paris and Frankfurt, and some staff in North America. Its worldwide headcount is down to about 175, from 280 before the crisis.

“We felt that European rating assignments could be handled by our New York and Toronto-based analytical teams, and decided that three local offices were not necessary, given the credit crunch,” says Huston Loke, co-president of DBRS's Canadian business. One of the changes that European regulators are now looking for is ensuring that agencies have an on-the-ground presence. With markets stabilizing, DBRS is considering opening a European office in the future, Mr. Loke says.

Meanwhile, Mr. Schroeder moved from president to chairman in December, initiating a series of management changes that left his son David, 38, CEO.

Mr. Loke and Peter Bethlenfalvy were promoted to co-heads of the Canadian business. They acknowledge that they have had a lot of tough conversations with debt issuers and users of their ratings, and say that they're learning from those.

“We've evolved,” Mr. Bethlenfalvy says. DBRS wants to move beyond ratings to become more of a credit information provider, by issuing newsletters, research and “thought pieces.”

It has new products. One is something it calls an impact assessment, where DBRS tells an issuer what the rating impact will be following a major strategic deal. For example, when an oil patch company considered splitting into separate oil and natural gas companies, DBRS told it with certainty what the ratings would be on each business following the split.

It sounds eerily similar to the so-called reverse engineering of ratings that agencies have come under fire for – helping issuers put together structured products in such a way that they receive top ratings – but Mr. Bethlenfalvy said impact assessments are different because “we only rate capital structures and businesses as presented, and do not structure or give any advice.”

Another is called transparency rating meetings, where DBRS hosts a session for clients who want to better understand how the agency's methodologies work, and the drivers that affect the client's rating.

“Over the long term, we want to do much more – provide information, transparency, and help with understanding,” Mr. Loke says.

Mr. Schroeder still says foreign markets are key. “I think Canada is probably a very stable market,” he says. “I think the growth is going to be outside of Canada for us.”

The company's reorganization saw Dan Curry recruited to head the U.S. business. He has dedicated much of his time to the agency's relationship with regulators.

“We were complaining to the Fed and anyone else who would listen that they seemed to have a bias towards relying on the three large U.S.-based rating agencies,” says Mr. Curry, who was previously a managing director at Moody's.

Ironically, he saw it as a big breakthrough when DBRS began receiving calls to testify at hearings about the problems in the industry. “We captured some mind share, so when they think about industry issues they're interested in our input as well.”

A major coup was the Fed's decision in May to include DBRS on the list of agencies whose ratings will be recognized on commercial mortgage-backed securities (CMBS) that are eligible under the U.S. government's program designed to boost credit and the economy by trying to revive part of the securitization market.

Originally the Fed was going to limit participation to the big three agencies, and DBRS worked to convince them to include a fourth, Mr. Curry says. The Fed said in May that CMBS had to have at least two triple-A ratings to be eligible for the program, and it would recognize those from the big three as well as DBRS and another agency called Realpoint.

Warren Buffett's decision to sell some of Berkshire Hathway Inc.'s shares in Moody's Corp. this summer was read as a negative sign for future profits in the industry.

But “it's still a reasonably good business,” Mr. Schroeder says. He suspects that new oversight will scare away some entrepreneurs who might otherwise have started an agency.

“With regulation and everything happening on control and transparency, it's going to get tougher and tougher for more competition to develop in this market, simply because it's going to get much more complex,” he says. The technology and software required for modeling, accounting, auditing and surveillance is increasing significantly.

“When we started out, our biggest capital expenditure was just a shade over $1,000.”

Yesterday, the Investment Executive reported that according to DBRS, Canadian public pension funds hard hit by downturn are still solid:

Public pension plans and asset managers have been rocked by poor returns, but their credit ratings remain strong, DBRS Ltd. said Monday.

Pension plans rated by DBRS include the Caisse de dépôt et placement du Québec, Canada Pension Plan Investment Board, Ontario Teachers’ Pension Plan Board, OMERS Administration Corp. and Public Sector Pension Investment Board.

According to new research from the credit rating agency, while the public pension funds and asset managers it rates “have been adversely affected by the challenging economic environment that prevailed in 2008 and into 2009”, they remain solid credits. DBRS points to several factors that support their high credit ratings, including low leverage, superior liquidity positions and strong sponsorship, along with large asset bases.

DBRS notes that the funds and mangers it rates were certainly hurt by the financial market turmoil, reporting returns of -15% to -25% in the last fiscal year. “The poor investment performance had the effect of significantly shrinking their asset base and eroding their funding position, suggesting that the risk level in certain portfolios may have been higher than originally measured. This situation also generated considerable attention among investors trying to assess the potential impact of the losses on the credit profiles of these organizations,” it says.

Moreover, the rating agency allows that the downturn has reduced the financial flexibility of these operations, and that it will likely take several years to make up for the poor performance. However, it maintains that they retain “considerable resilience” and that these factors keep them highly rated. “DBRS believes that these credits have the necessary flexibility to weather the downturn, provided leverage is kept under control and no attempt is made to recover the recent losses through increased risk-taking,” says Eric Beauchemin, managing director at DBRS.

Let's set aside the potential conflicts of interest of having DBRS rate Canadian public pension funds who bought ABCP paper based on their ratings (Caisse, PSP Investments, and Ontario Teachers).

I agree with DBRS, it will take several years for these funds to make up for the poor performance, but I question the assumption of "low leverage and superior liquidity positions". There is plenty of leverage and low liquidity in private equity, real estate and infrastructure holdings and to a lesser extent, hedge fund holdings.

More importantly, how can DBRS or any rating agency rate these public pension funds without conducting thorough independent performance and operational audits? To do that, they need full transparency on the benchmarks governing internal and external investments. That information is not readily available, especially for private markets.

Finally, I am not sure that leverage will remain "under control" or that no attempts will be made to "recover recent losses through increased risk-taking". There too, I agree with DBRS, but I fear that the pension parrots will crank it up once again, especially if they're underperforming their peers.

It's not just rating agencies that are at the crossroads, but pension funds are at the crossroads too. We need a governance overhaul that introduces more transparency and a compensation system that rewards risk-adjusted returns. The status quo at rating agencies and pension funds is totally unacceptable.

***UPDATE: Moody's accused of issuing inflated ratings***

Based on news from the WSJ, Reuters reports that Moody's accused of issuing inflated ratings:

A former analyst with Moody's Corp has accused the credit ratings agency of issuing inflated ratings, and has taken his concerns to U.S. congressional investigators, the Wall Street Journal reported on Wednesday.

In a letter dated July, obtained by the paper, Eric Kolchinsky accused Moody's Investor Service of issuing a high rating to a complicated debt security in January, in spite of it being aware it was planning to downgrade assets backing the securities.

"Moody's issued an opinion which was known to be wrong," Kolchinsky wrote, along with detailing other instances of inflated ratings issuance, according to the paper.

The paper said a Moody's spokesman declined to comment on the January rating under scrutiny, but had said Kolchinsky refused to cooperate with an investigation into the issues he raised, and was suspended with pay.

Kolchinsky is scheduled to testify on ratings firm reform before the House Committee on Oversight and Government Reform on Thursday, the paper said.

Moody's was not available to comment.

Inflated ratings only serve to distort the true financial health of a company or pension fund. The model governing rating agencies and pension funds needs to be revisited.