Inside Investment: Rating agencies – Sorcerer’s apprentices
The bizarre decision by Moody’s to grant Aaa status to a rag-tag assortment of obscure Nordic credits has put the raters in the spotlight. The relationship between the rating agencies and the big investment banks should also come under scrutiny.
Bigging up companies is not the usual stuff of this column, but Moody’s Inc is a truly impressive business. In 2006 the credit rating agency made top line revenues of $2 billion and operating income of $1.259 billion. A 61% operating margin is financial performance that the most efficient investment banks and asset managers would covet. The growth of the business is even more noteworthy. Net income is up by 375% since 2000.
Moody’s Investor Services and the other rating agencies – the equally esteemed Standard & Poor’s and upstart Fitch Ratings, do an important job. Rating the creditworthiness of companies determines how expensive it is for them to borrow money. They also provide investors with a benchmark of risk. However, the rating business is built on a central conflict of interest: ratings are paid for by issuers not investors.
Investors might wonder how well they are served by the rating agencies. The blow-ups of Enron, Parmalat and WorldCom caught the rating agencies on the hop. They might argue that it is not their job to spot fraud and that they can only rely on information that all investors have access to. But investors used that information to batter Enron stock from $35 to $3 in the autumn of 2001, while the bonds were still rated investment grade.
The rating agencies have several well-rehearsed arguments in their defence. First, they point to those ubiquitous Chinese walls that ensure that analysts are never sullied in the fearful business of extracting cash from clients. Second, they say, when rating thousands of businesses how could there be a conflict when each piece of business makes up so little of the overall revenue?
That second argument is increasingly specious. What has been driving the impressive revenue growth at Moody’s and other credit rating agencies has been structured finance: asset-backed securities, mortgage-backed securities, asset-backed commercial paper and CDOs. Structured finance now constitutes 43% of Moody’s overall revenues and between 1996 and 2004 the compound annual growth rate of this part of its business was 28%.
Structured finance is clearly a great business for the rating agencies and it is easy to see why. Structured finance involves not one asset, but many. Not only does the overall paper need to be rated and analysed but so does the collateral backing it. The structure also needs to be thoroughly stress tested and the tyres of the issuer and manager thoroughly kicked. Potentially, there are layers upon layers of fees.
Structured finance is an area where the careful teasing apart of risk is absolutely vital. The alchemy of modern finance can turn sub-prime (aka high-risk) mortgages into Aaa-rated CDOs. The alchemists are the investment banks. However, by providing opinions that put these products on a par with gilt-edged stock, the credit rating agencies are the sorcerer’s apprentices.
Last year the rating agencies came under scrutiny in the US. House of Representatives legislation pointedly entitled the Credit Rating Duopoly Relief Act was passed into law in September. It gives the SEC the power to regulate credit rating agencies and address possible abusive or anti-competitive practices.
The SEC might like to delve into the world of structured finance. For one thing, the profits the credit rating agencies make in this area blow a hole in their defence that they are not overly dependent on any one source of revenue. The issuers of ABS, MBS, ABCP, CDOs et al, are overwhelmingly the big investment banks. Wall Street is a very important client for the rating agencies.
Euromoney has done a great job reporting on Moody’s recent decision to change the methodology by which it rates banks. The agency has had to perform an embarrassing U-turn. It could scarcely do otherwise. There cannot be a single sane person in the world who believes that lending money to Kaupthing Bank has the same risk profile as lending money to the United States Treasury. Perhaps when you enjoy margins of 61% you can become a little arrogant and complacent.
Moody’s and the other rating agencies have plenty of reasons to love the banks. Structured finance is booming and so are the profits related to it, for both the banks and the credit rating agencies. Even if the Nordic banks have now been denied the prized Aaa-rated status, there’s plenty of it on offer in structured finance. Only a cynic would want to use an ugly word such as reciprocity.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own