Credit Analysis and Investigations by Sam Spade

It's about time for competitors to the Big Three Credit Rating Agencies to get serious. However, as Wall Streeters know, there are lots of small bond houses that perform credit analysis and exploit the weaknesses and inefficiencies of Standard & Poors, Moodys and Fitch.

Kroll Gets a License to Shoot (Bonds)

Onetime corporate sleuth Jules Kroll is reinventing himself as an investigator of bonds.

The 69-year-old mogul, who founded and later sold security firm Kroll Inc. for $1.9 billion, acquired boutique credit-ratings firm Lace Financial last week in an effort to build staff and get the licenses needed to compete with the three big rating firms, Standard & Poor's, Moody's Corp. and Fitch Ratings.

Jules Kroll made his name in corporate security, not securities.

"There's a need for a credible alternative," said Mr. Kroll, who last year started Kroll Bond Rating Agency Inc. to take on the incumbents. He poured about $5 million of his own money into the venture and hired about a dozen employees, including former executives from Moody's and Fitch, a unit of Fimalac SA of Paris. Then last week he decided with the help of new investors to spend more than $5 million for Lace, a 25-year old company with about a dozen employees that mainly rates banks and other financial-services firms.

One key attraction of Frederick, Md.-based Lace is that it has the regulatory licenses with the Securities and Exchange Commission to be a nationally recognized bond-rating firm. "A lot of investors have no choice but to use" a rating firm recognized by the SEC, said Mr. Kroll from his firm's new office in Midtown Manhattan.

Kroll's Plan

How Kroll's credit-ratings venture will try to stand out:

1. Perform more 'due diligence,' beyond data from bond issuers.
2. Accept much of its pay from investors who subscribe.
3. Provide ratings in some cases when issuers don't want one from Kroll.
4. Provide supporting materials with ratings so investors can see why a rating was given

Mr. Kroll's entry into the business is the latest move by an upstart trying to take advantage of perceived weakness from the three largest credit-rating firms, which have been around for decades and have long dominated their important niche of Wall Street: communicating a bond's risk to investors in a simple alphabetical code.

Regulatory advantages helped maintain the dominance of the big three ratings firms. But in recent years Congress has acted twice to reduce that dominance and open up the market to new entrants. In May, research firm Morningstar Inc. paid $52 million to buy Realpoint LLC, which held a license for its work specializing in rating structured-finance transactions.

"It's very clear that major rating firms have not served the market particularly well in the recent past, so it's wonderful that there's some competition for them," said Sean Egan, managing director at boutique rating firm Egan-Jones Ratings Co. "They obviously need it."

Egan-Jones, Lace and Realpoint were designated as licensed credit-rating firms after the SEC opened up the field to more players following the passage of a 2006 law.

But that move has done little to chip away at the market share of Moody's, Fitch and S&P, which is owned by McGraw-Hill Cos. The three industry leaders issued about 97% of all outstanding ratings across five major debt categories, such as corporate issuers and asset-back securities, in 2008, according to a 2009 report by the SEC.

Not much has changed since then, analysts said. "I don't think Moody's or S&P are losing any sleep on new entrants in this business," said Michael Meltz, an equity analyst at J.P. Morgan Chase & Co.

Kroll is still a minnow in the world of bond ratings. With Lace, which will maintain its name as a unit of Kroll, the firm will have about two dozen employees, compared with 1,300 credit analysts world-wide at S&P and more than 1,200 at Moody's. Lace had only about $1 million of revenue in 2009 compared with $1.2 billion for Moody's Investors Service and $1.7 billion for the rating unit of Standard & Poor's.

Mr. Kroll said he hopes he can change that market share. In 1972, he started an investigative firm that tapped into a growing need to chase down assets in foreign countries and research the financial strength of companies' suppliers, customers and merger partners. In 2004, he sold the company to Marsh & McLennan Cos. for $1.9 billion, and personally took home about $120 million in the deal. He remained chairman of the firm until 2008, when he left to pursue new business ventures.

At the time, the subprime-mortgage market was imploding, dragging down the rest of the credit markets and later the U.S. economy. At the center of the blame game that followed were the major rating firms, which had stamped thousands of mortgage related bonds with top triple-A marks, before changing course and cutting their ratings when many homeowners stopped paying their bloated mortgage bills.

"We were looking for public-policy problems that needed private-sector solutions," said Mr. Kroll, who is planning to rate residential- and commercial-mortgage bonds later this year. His new ratings business shares office space with the consulting firm he founded, and he expects to erect a wall to separate them.

With the deal last week to buy Lace, Kroll Bond Ratings also accepted $20 million in funding from investors including Bessemer Ventures Partners and RRE Ventures.

The investors are pouring money into a business that faces hurdles, from heavier regulation to efforts by users of bond ratings to find other methods to assess the risk in their portfolios. Mr. Kroll said, for instance, that he has met with representatives from insurance companies to discuss their efforts to rely less on bond ratings.

Security Analysis -- Credit Rating -- AAA or Junk?

There are no mysteries about assessing the quality of a bond or other fixed-income security. Credit analysts have been at it for a long time. But if we know what we are doing, why do we sometimes get it wrong, horribly wrong? In a nutshell, through good intentions, the government made a mess of things.

Put the Rating Agencies Out of Their Misery Before It's Too Late

A pillar of the financial crisis was rating agencies slapping triple-A ratings on junk mortgage products only to be mystified when the securities blew up. In the 2007 transaction involving the recent Goldman Sachs (NYSE: GS) CDO fraud saga, almost half of the debt was downgraded from triple-A (perfect) to junk (perfectly worthless) in short order.

Fool me once ...

Now, a sober person would think the rating agencies have learned from these flubs. But that makes too much sense. Truth is, they're as miserably inept as ever.

Last summer, Standard & Poor's invoked the ghost of 2005 when it rated a set of CDO-esque securities triple-A, which implies essentially zero probability of default.

Last week, it downgraded the same securities all the way to junk. That's triple-A to junk in less than a year. Again. Recall Einstein's definition of insanity, and feel free to smash your head against the nearest wall.

"The downgrades reflect our assessment of the significant deterioration in performance of the loans backing the underlying certificates," cried S&P. This is mildly true at best, and more likely a product of the same deceptive shell games rating agencies are now infamous for.

Here's your pig, there's your lipstick. Have at it.

These securities, you see, weren't new products created last summer when S&P initiated the ratings. They're called "re-remics," born from an alchemical process of taking existing bonds struggling for survival, slicing them up anew, and giving the new pieces a fresh set of ratings. The idea is that you can take a low-rated mangled mortgage bond, extract the pieces that still have a heartbeat (even though they share the same characteristics as the rapidly defaulting mortgages), and pronounce the new security triple-A.

So to be sure here, the same material that S&P called triple-A last summer was, at nearly the same time, rated far below that. David Blaine can't even fathom this stuff.

During a flood of re-remics last fall, The Wall Street Journal wrote an article questioning their validity "partly because re-remics rely on ratings firms -- faulted for failing early on to identify problems with mortgage-backed bonds -- to rate the new securities." That was spot-on, as was a comment by Rep. Dennis Kucinich, who warned, "The credit-rating agencies could be setting us up for problems all over again."

That's exactly what's happening, and it's time we do something about it. One of the central flaws in the rating agency world is that large-scale investors such as money market funds are required to hold assets scored by a rating agency registered as a Nationally Recognized Statistical Rating Organization, or NRSRO. Only a handful of raters are blessed with this status, and Moody's (NYSE: MCO), S&P, and Fitch are kings of the court. They're privileged to what amounts to guaranteed business and no threat of new competition.

While it's certainly well-intentioned, there's fairly universal agreement that the NRSRO has created the ability, if not the incentive, for rating agencies to produce wildly flawed work. They have nothing to lose. Investors have to use their services. S&P can recklessly issue wacky ratings (as it just did), and business goes on as usual.

Hedge fund manager David Einhorn summed it up perfectly: "Nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government-created oligopoly and often because they are required to by law." In any normal market, new competition and customers' disgust over shoddy analysis wouldn't let this happen.

Let's do something about this

Fortunately (though long overdue) Congress is waking up. Two amendments in the just-passed Senate financial overhaul bill could euthanize the flawed parts of the rating system.

One amendment would eliminate all mention of the NRSRO from federal regulations. The organization could still exist, but language requiring investors to use products rated by an NRSRO rating agency would vanish. Competition from eager rivals like Morningstar (Nasdaq: MORN) and KPMG could then step in and sanitize the industry.

A separate amendment would create a clearinghouse set up to assign rating agencies with deals. That way, banks that issue credit products couldn't shop around for the morally bankrupt rater that's willing to assign triple-A status to toilet paper just to bag a nice fee. Both amendments aim to end a kink in the financial system that benefits exactly nobody except the rating agencies and the banks that sell glorified debt products.

We'll be patiently watching as the Senate and House reconcile their respective versions of the financial overhaul bill. Stay tuned.

How to Cause a Credit Crisis

When companies issue debt they submit themselves to the Rating Organizations for an examination. However, the impact of the received rating is affected by the reality that the major Rating Organizations have a government seal of approval. The rating is viewed as though it were issued by the government itself. The prevalence of this sensibility led to an unwarranted level of confidence in the ratings. It led to a disaster.

Nationally Recognized Statistical Rating Organization

A Nationally Recognized Statistical Rating Organization (or "NRSRO") is a credit rating agency which issues credit ratings that the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes.

As of September 2008, ten organizations were designated as NRSROs:

Moody's Investor Service
Standard & Poor's
Fitch Ratings
A. M. Best Company
Dominion Bond Rating Service, Ltd
Japan Credit Rating Agency, Ltd
R&I, Inc.
Egan-Jones Rating Company
LACE Financial
Realpoint LLC

Ratings by NRSRO are used for a variety of regulatory purposes in the United States. In addition to net capital requirements (described in more detail below), the SEC permits certain bond issuers to use a shorter prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimick the safety and liquidity of a bank savings deposit, but without FDIC insurance) comprise only securities with a very high rating from an NRSRO. Likewise, insurance regulators use credit ratings from NRSROs to ascertain the strength of the reserves held by insurance companies.

History

The use of the term NRSRO began in 1975 when the SEC promulgated rules regarding bank and broker-dealer net capital requirements. The idea is that banks and other financial institutions should not need to keep in reserve the same amount of capital to protect the institution (against, for example, a run on the bank) if the financial institution is heavily invested in highly liquid and very "safe" securities, such as U.S. government bonds or commercial paper from very stable companies. The safety of these securities, under this approach, is reflected in their credit ratings, as determined by certain highly respected credit rating agencies ("CRA").

In the early 1980s, there were seven NRSROs, but, due to mergers, this number dropped to three during the 1990s. Recently, the SEC, arguably as a result of political pressure and/or concern about concentration in the industry, added to this number, first with Dominion Bond Rating Service (a Canadian CRA) in 2003, and A.M. Best (highly regarded in particular for its ratings of insurance firms) in 2005.

In 2007, the SEC added two Japanese rating agencies, Japan Credit Rating Agency, Ltd. and Ratings and Investment Information, Inc. and a Philadelphia area based firm Egan-Jones Rating Company (EJR).

Originally, NRSRO recognition was granted by the SEC through a "No Action Letter" sent by the SEC staff. Under this approach, if a CRA (or investment bank or broker-dealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determined that this was the case, it would send a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff would not recommend enforcement action against that entity.

These "No Action" letters were made public and could be relied upon by other regulated entities, not just the entity making the original request. The SEC later sought to further define the criteria it uses when making this assessment, and in March 2005 published a a proposed regulation to this effect.

Until recently, the SEC staff used several criteria when determining whether a CRA publishes ratings that the market considers reliable and credible. According to the SEC's Concept Release:

The single most important factor in the Commission staff’s assessment of NRSRO status is whether the rating agency is “nationally recognized” in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings.

The staff also reviews the operational capability and reliability of each rating organization. Included within this assessment are: (1) the organizational structure of the rating organization; (2) the rating organization’s financial resources (to determine, among other things, whether it is able to operate independently of economic pressures or control from the companies it rates); (3) the size and quality of the rating organization’s staff (to determine if the entity is capable of thoroughly and competently evaluating an issuer’s credit); (4) the rating organization’s independence from the companies it rates; (5) the rating organization’s rating procedures (to determine whether it has systematic procedures designed to produce credible and accurate ratings); and (6) whether the rating organization has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed. The staff also recommends that the agency become registered as an investment adviser.

Credit Rating Agency Reform Act of 2006

In 2006, following criticism that the SEC's "No Action letter" approach was simultaneously too opaque and provided the SEC with too little regulatory oversight of NRSROs, the U.S. Congress passed the Credit Rating Agency Reform Act. This law required the SEC to establish clear guidelines for determining which credit rating agencies qualify as NRSROs. It also gives the SEC the power to regulate NRSRO internal processes regarding record-keeping and how they guard against conflicts of interest, and makes the NRSRO determination subject to a Commission vote (rather than an SEC staff determination).

Notably, however, the law specifically prohibits the SEC from regulating an NRSRO's rating methodologies.

In June 2007, the SEC promulgated new rules (Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations) which implemented the provisions of the Credit Rating Agency Reform Act.

Controversies

Many private users (pension funds, banks) of ratings data now demand that ratings be from an NRSRO. Consequently, there is some debate that, by "recognizing" certain CRAs, the SEC has bestowed a competitive advantage on them. This view is supported by the vigor by which many non-NRSRO CRAs seek NRSRO recognition.

On the other hand, historically, many private users of ratings data have "defaulted" to Standard and Poor's and Moody's when specifying which ratings must be used for their own purposes. (S&P and Moody's are the oldest, most widely respected, and by far the largest of the CRAs.)

Accordingly, it is conceivable that the NRSRO designation has actually increased competition in the industry by providing an unintended government "seal of approval" on certain smaller CRAs (such as Fitch, DBRS, A.M. Best, and now, Egan-Jones). If true, this, of course, raises the question of whether this is something the government should do, and whether the NRSRO recognition process is the best mechanism to achieve this goal.

The larger NRSROs have also been criticized for their reliance on an "issuer-pays" business model, in which the bulk of their revenue comes from the issuers of the bonds being rated. While this is recognized by regulators as a potential conflict of interest (since the bond issuer paying for the rating has an incentive to seek out the CRA most likely to give it a high rating, possibly creating a "race-to-the-bottom" in terms of rating quality), the larger NRSROs claim that the issuer-pays model is the only feasible model for them.

This is because, in an age of email and faxes, the ratings of the larger CRAs are so widely and so quickly shared that a subscription-based model would not be profitable. Furthermore, the larger CRAs often receive non-public information from issuers and, under the SEC's Regulation FD, a CRA may only use such information if their ratings are made available to the public for free.

However, some smaller CRAs, including Egan-Jones, rely on a subscription-based business model where the ratings are not made public but are available only to subscribers. These firms argue that such a business model makes them less reliant on the good will of the issuers they rate, thereby eliminating one major potential conflict of interest.