globeandmail.com

THE PAIN IN SPAIN IS PLAINLY IN THEIR VEIN

Friday, October 26, 2012

Its against-the-herd ratings are putting Canada's Dominion Bond Rating Service on the map in Europe alongside giants like Moody's. (Now to make sure there are no more mistakes like that little asset-backed commercial paper thing)

GRANT ROBERTSON

On the morning of Aug. 8, bankers and politicians in Madrid awoke to a sense of dread about their tattered financial system. It was an easy feeling to have in a country where one in four people is unemployed, the government is nearly insolvent, and many of the banks were on daily bailout watch.

But on this particular day, there was yet another reason to feel queasy in Spain. In recent months, Moody's, Standard & Poor's and Fitch - the three biggest names in the credit rating business - had all dramatically downgraded Spain's sovereign debt. They had ratcheted down their assessment of the reliability of Spain's bonds not just one notch, but had inflicted a humbling degradation of as many as three rungs in a single decision. Spanish bullfighters have a word for this kind of thing - cornada. That's when the matador is gored.

Sovereign credit ratings measure the confidence that a country can pay back its debt on time, and in full. Triple-A is the gold standard, but Spain was now plumbing the depths of investment-grade status. It wasn't quite junk-bond territory, but it was a perilous step in the wrong direction. If you lent a dollar to Spain, the chances were that you might not get it all back, according to the raters.

Under normal circumstances, a trio of significant downgrades from the Big Three firms that dominate the ratings industry would have dealt a serious blow to the country, sending borrowing costs sharply higher. But in recent years, a fourth ratings agency has emerged on the scene in Europe, and this player now held a significant chunk of the Spanish banking system's fate in its hands.

If it followed suit and slashed Spain's credit rating to below A-status, the impact would be swift, and serve to compound the country's problems. Without a minimum single-A rating, government bonds would be instantly less valuable to the banks that use them as insurance on loans from the European Central Bank: The banks would immediately have to post 5% more collateral. With more than €375 billion in loans outstanding, that extra 5% equalled as much as €18.75 billion - money that the debt-ridden country and its teetering banks would be hard-pressed to produce.

Thus the new kid on the ratings block, Dominion Bond Rating Service of Toronto, suddenly has a pivotal role in the euro crisis, with billions of dollars at stake.

DBRS has a tendency in Europe to issue its ratings after the Big Three have already weighed in, which can give its decisions extra clout, tilting the balance one way or the other. "One could argue," a report by JPMorgan said last spring, "that rating changes by DBRS are the most important for sovereign bonds held as collateral at the ECB."

With the eyes of Europe now fixed on DBRS, what would the upstart from Canada do?

Credit ratings are now ubiquitous in the machinery of the world's financial system. But Walter Schroeder remembers a time when his biggest job was telling companies why they needed a rating at all. "I used to have to explain to people, this is what a rating is, here's how we do it, and this is why it's important," says the founder and chairman of DBRS. "I call it speech one."

It was a speech Schroeder, who is now 71, delivered often in the early 1970s, when he was a hungry young credit analyst at Wood Gundy Ltd. on Bay Street. When corporate clients came looking to raise money in the bond market, Schroeder's job was to help them secure ratings from the Big Three credit agencies.

But on countless trips to New York brokering meetings with the raters, one thought kept running through his mind: These companies were making a lot of money issuing ratings. But if you had the skills - a mix of accounting, finance and market knowledge - and the right contacts, it wasn't that tough to figure out. When it came to issuing ratings for Canada, he could do this job better himself, Schroeder believed. "Everybody around the world seemed to rely on Moody's and S&P," he recalls. "Those two were supreme."

In 1976, while driving to Montreal on a family vacation, Schroeder started sketching out a business plan in his head. By the time his Volkswagen Beetle had reached its destination, his mind was made up. He would build a bond ratings agency from scratch. "It was a volatile market - interest rates were 18% back then - and there was a need for credit research of some sort, but there was none available in Canada. It was an extremely lucrative market potentially."

It didn't take much to start a firm back then. Schroeder spent $400 on an IBM typewriter, purchased two calculators (for $200 each), a few desks, a couple of chairs and some filing cabinets. The total bill came to less than $1,000.

Respect, however, was much harder to come by. The day DBRS opened its doors, in a tiny 1,500-square-foot office on Toronto's University Avenue, a crowd gathered outside Schroeder's door. He soon saw what the commotion was about: Posted on the wall was a makeshift placard - a jab from his old colleagues at Wood Gundy - proclaiming the office as the new home of Sexy Susie's Body Rub Parlour Inc. Schroeder says, "The people were outside laughing."

But then, the beginnings of the entire industry, a century earlier, were also modest. During the railway boom, Henry Varnum Poor published detailed financial information about the sector in his Manual of the Railroads. By 1909, journalist John Moody was putting out his own manual, which used letter grades to rate railroad (and, later, corporate and government) securities. The letter-grade concept was popular with investors, so competitors soon followed suit - Poor's in 1916, Standard Statistics in 1922 and Fitch in 1924. Standard and Poor's would merge in 1941 to create S&P; in tandem with Moody's, it would come to dominate the industry.

Just as stock analysts exist to figure out which equities are worth buying, bond ratings agencies evolved to inform investors which bonds were likely to be paid back, and which were the more risky bets and should be priced accordingly.

However, it was regulation - not entrepreneurial spirit - that ultimately solidified ratings agencies as a lucrative and heavily influential business. Soon after the 1929 stock market crash, the U.S. government began requiring banks to book the value of their bond portfolios according to ratings, in the hope of creating an early warning system for financial failures. At the same time, large investors began implementing internal policies stipulating that they would only carry bonds with an acceptable rating. By the 1970s, institutional investors such as pension funds universally required top ratings on all bonds they purchased, which essentially made the ratings agencies indispensable, for better or worse.

It also turned the market on its head. Investors were no longer the primary customer; that role belonged to the corporations issuing the bonds.

This was the industry's game-changing moment. Suddenly each ratings agency became exponentially more profitable, given the number of corporations that needed ratings. This in spite of the obvious conflict of interest: The parties that the agencies were rating were also their customers. In the face of criticism, the Big Three insisted those conflicts were manageable, since no rater would willingly risk its good reputation by allowing itself to be influenced. A specific rating could not be bought, the industry argued.

The final piece of the puzzle came in the mid-1970s, when the Securities and Exchange Commission, concerned about fly-by-night agencies rushing into the market to make a quick buck with shoddy ratings, gave the agencies the only thing they didn't already have - a licence, in effect.

The new designation, Nationally Recognized Statistical Rating Organizations, or NRSROs, effectively enshrined the ratings agencies in law, and cemented the Big Three's hold. Yet there was no real reason to believe that only three firms had a monopoly on the skills involved. "I don't think there is something particularly powerful in the ratings agencies in their ability to process information," says Lynnette Purda, an associate professor of finance at Queen's University. "But we've built them into legislation and regulations so that we only invest in particular products that have a particular rating from a particular firm."

Despite the influence that bond raters now wield, the process of how ratings are derived is poorly understood. In the popular imagination, the agencies are painted as judges deliberating a verdict, disappearing behind closed doors only to emerge days or weeks later with an alphabet soup of letters and symbols - AAA, A (low), BB+, CCC - upon which the fate of a company or a government's financial situation can turn.

In fact, behind each agency there is no star chamber, but rather a ratings formula and a team of bond analysts. Analysts at DBRS work in pairs, each assigned to cover up to 15 to 20 companies or 10 countries. Much like equity analysts would, the analysts meet regularly with corporate management or government officials to discuss the financial state of affairs. These conversations, held in strict confidence, help form the rating, along with ongoing analysis of public and private financial data.

The rating is voted on by a committee and, whenever a material event occurs - say, a company makes a major acquisition, a government produces a new budget, or debt covenants are breached - the committee votes to maintain or change its rating.

When ratings agencies are right, the results are uneventful. Like a plane that lands safely, a correct rating never makes the news. But when ratings are wrong, the results can be catastrophic, and there have been a few of those in the last decade or so. The collapses of Enron and WorldCom in 2001-'02 cast ratings agencies in a new and unfavourable light. Enron and WorldCom were both businesses built on false numbers and financial sleight of hand. But by the time S&P and Moody's got around to marking them down below investment grade, the firms had already combusted. In the case of Enron, the company suffered a downgrade just four days before its demise. The early warning system had failed, miserably.

Investors didn't have to look very far for a culprit. At congressional hearings probing the debacle, a ratings analyst for S&P admitted he hadn't read all of Enron's key financial filings. He had, however, taken Enron management at their word.

The Enron and WorldCom disasters prompted a shakeup of the rating industry. U.S. regulators feared the financial system was relying on too few ratings agencies. Adding new players would increase competition, which, it was hoped, would boost accuracy as well as reducing the dependency on one or two powerful firms.

The shakeup was a break for DBRS. It had been trying since 1990 to expand into the U.S. market, but had been turned away by regulators loath to give it the coveted NRSRO designation. Thanks to Enron et al., the Canadian agency was finally admitted to the club in 2003.

Though DBRS ran a distant fourth to the Big Three in size - it is about a quarter the size of Moody's - Schroeder was now at the helm of a pre-eminent North American ratings agency. (Privately held, DBRS does not disclose financial data. Its head count stands at 280, dispersed in Toronto, New York, Chicago and London.)

But more competition in the ratings world would lead to a different set of problems only a few years later. By the mid-2000s, a new monster was lurking in the financial world: structured finance.

In order to make the riskier sort of loan - such as subprime mortgages - palatable for conservative investors hungry for higher yields, lenders started packaging those debt products together with lower-risk investments, and marketed the bundles as safe. These bundles needed ratings, and with competition now on the upswing, ratings agencies were anxious to fight for a slice of this rapidly growing market. Many of these complex investments were given top ratings from the agencies, suggesting they were safe - a mistake now seen as irresponsible, if not reckless. When the subprime housing market crumbled in the U.S., it took the structured finance market down with it. And these supposedly safe investments were suddenly worth pennies on the dollar.

In Canada, the fallout had its own particular ugliness, and DBRS was in the middle of it. Canada's structured finance market was driven by asset-backed commercial paper (ABCP). The investment houses selling these bundled products needed two things: an investment-grade rating from an agency, and a liquidity backstop for the paper they were peddling, in case the market froze. Banks and other financial institutions agreed to provide the backstop for a fee. But there was a problem: Under Canadian-style liquidity arrangements, the banks would only have to pay out on this liquidity commitment in the event of a "general market disruption."

The conditions that had to be met for such a fix set the bar extremely high - so long as there was any paper trading, there was no market disruption. Moody's and S&P looked warily at the "general market disruption" clause and determined the paper was too risky to rate. DBRS disagreed and figured the assets were safe, because the chances the market would implode were remote. After all, ABCP carried only small amounts of subprime mortgages at worst, and the asset mix was healthy. Breaking from the pack, DBRS stamped one of its highest ratings on ABCP, and the products were snapped up by institutional and mom-and-pop investors alike.

But when fears over subprime mortgages began to emerge in the U.S., much of the ABCP market in Canada - about $35-billion worth of paper - froze. Nobody was buying, so no one could sell, which cast the entire asset class into doubt. However, several banks disagreed that the market had suffered a "general disruption" that would require them to kick in funding, since some segments of the market were still functioning.

Investors were stuck with no access to their money. Amid the chaos, it took more than a year for the banks, lawyers and a bankruptcy judge to unravel the mess. The frozen paper was restructured: The ABCP notes were exchanged for long-term paper. That meant even though investors would get much of their money back, it would take many years. Those who bailed out and sold took a hit. Fingers were pointed squarely at DBRS.

They were stressful times. Schroeder dropped 50 pounds from his large frame. "I was working 14-hour days," he says. "It was tough. It turned into a total liquidity crisis, like a run on a bank. ...Bang - the thing froze."

Today, Schroeder and his son David, who is CEO and heir apparent at DBRS, argue the firm rated the assets correctly, but misjudged the liquidity of the market in a crisis. That the market would fall apart was an eventuality no one had worked into their models. Regrets, DBRS has a few. "I don't think you'll get us arguing about what was our worst call," says David Schroeder.

To Purda at Queen's University, the freeze-up demonstrated the danger of relying heavily on ratings, especially a single rating. "Everyone was very complacent and kind of going along with it. There should have been red flags out there." Following the ABCP imbroglio, Canadian regulators now require two ratings.

Indeed, governments around the world began to look even more skeptically at ratings agencies in the aftermath of the credit crisis. The events raised a difficult question over their role in the markets: Should ratings agencies be relied on so heavily, or merely taken as one of a variety of opinions that go into making an investment decision?

In the U.S., hearings were called to determine whether the agencies needed to be reined in, held accountable, punished, or all three. And in Europe, politicians called for a European solution - a government-owned ratings agency that would limit the EU's dependence on private-sector American ratings agencies.

But in a fractious euro zone, reaching consensus on such a plan has proven to be impossible. So Europe reached for the next-best option: Just as U.S. regulators had done in the wake of Enron and WorldCom, European leaders decided to bring in more competition. Naturally, they looked to the only significant non-American ratings agency there was, and one that had been trying to break into Europe. Thus began DBRS's rise to prominence on the other side of the Atlantic.

In 2008, as the credit markets in North America were imploding, DBRS was solidifying its position in Europe, where lawmakers had quietly enshrined it as rater number four. DBRS was officially on the same plane as S&P, Moody's and Fitch. And the scenario that played out in Spain on Aug. 8 is precisely why Europe wanted a fourth player.

Mistrust ran high in Madrid this past summer. Spain's credit rating was being gutted by the Big Three, and billions of dollars were at stake. But what if Moody's, S&P and Fitch had it wrong? What if the ratings agencies were merely running in a pack, feeding off one another's dire predictions? Across Europe, politicians and public officials - led by Mario Draghi, head of the European Central Bank - grumbled about the ratings agencies. While running Italy's central bank in 2010, Draghi complained loudly about the accuracy of the ratings agencies during the credit crisis. How could they be so powerful now? How could they be trusted?

Adding more competition doesn't necessarily solve the problem. With agencies vying for business, debt issuers who need a high rating can theoretically shop around until they find one they like. This has been a long-held fear among critics of agencies. "What is the right level of competition? I don't know," says Purda. "We definitely don't want a monopoly on these things. But at the same time, we don't want them to be so competitive that they're scrambling at all costs to get their ratings out there."

Though sovereign debt is less susceptible to so-called rate shopping, since governments don't have to pay to have their bonds rated like corporations do, the potential for political interference exists. Indeed, there is often blowback when governments don't agree with a controversial rating. "You don't get that from corporations," says Dan Curry, the president of DBRS. When a government is unhappy with its rating, it shows up in the press, often as a veiled attack on the agencies' credibility. "That's what they do. It's all about managing perceptions," he says. "These are the real pros."

In the most blatant example, S&P's credibility was lambasted in the U.S. in August, 2011, when it downgraded the country's credit rating one notch, from AAA to AA+. And in Europe, whenever there are controversial decisions by raters, talk of creating a European-based rater to do the job is suddenly revived. "That's the big difference," Curry says. "The corporations don't start changing regulations on you."

The way Curry sees it, politics is just one of the hazards of the job. It doesn't mean ratings agencies bend to pressure. Not everyone agrees that complete independence is possible, however. John Coffee, a law professor at Columbia University who testified at 2009 hearings in Washington probing the independence of ratings agencies, remains convinced the firms are susceptible to outside influence, particularly when it comes to rating corporate debt.

"It's hard to be the umpire when you're being paid by either the batter or the pitcher," Coffee says. He believes an agency will think twice about a harsh downgrade of sovereign debt if there is a risk of regulatory reaction. "A lower rating may mean billions of dollars of additional interest paid," Coffee says. He argues agencies inherently "know where their self-interest is - and it's not on the side of total integrity and independence."

One school of thought has it that the financial world should simply rely on market data to rate debt. Investors such as hedge funds, who want to gauge risk on bonds, will often track the price of credit default swaps, which are essentially insurance policies purchased against the default of a lender. Some academics argue that the prices in the credit default swap market can be used in place of grades from ratings agencies. "Think about it like car insurance," says Chayawat Ornthanalai, an assistant professor of finance at the University of Toronto's Rotman School of Management, who has studied the swaps and their relation to bonds. "If I ask you what your car insurance premium is, and you say you're paying $300 a month, I can kind of guess you might be a more dangerous driver than someone paying $100." He concludes, "The market already has a better benchmark to judge risk."

Curry, unsurprisingly, doesn't agree. Ratings agencies are about legwork, he says, in particular, questioning management or governments on a regular basis. "What ratings agencies bring to the table is, to some degree, consultation with management: Here's what we're seeing. Are we missing anything? Have we misinterpreted something?" Curry says. "If we look at the European sovereigns with that background in mind...we don't just react to the numbers."

Curry points to Ireland. When DBRS rated that country's bonds this year, it decided Ireland had a better handle on its debt situation than it was getting credit for, so DBRS did not slash the rating to B status, as the Big Three did, but lowered it just one notch. It was a decision that raised a few eyebrows. "Was Ireland good? No, Ireland was a mess," Curry says. "We felt that it was a bad situation that they had pretty effectively stabilized."

A byproduct of the Irish decision is that DBRS is now seen as contrarian. It is the friendlier rater in Europe - that one judge at the Olympics who seems to score a little easier when the gymnast doesn't quite stick the landing. And because of that, DBRS is being watched more closely, and more skeptically, by the market. While multilevel downgrades have been common from Moody's, S&P and Fitch, such a move from DBRS would be unusual and newsworthy, sending a chilling signal to the market. Soon after the three biggest agencies issue their ratings, the question becomes: What will DBRS do?

In the early evening on Aug. 8, DBRS issued the crucial decision. Spain was in financial trouble, yes, dire trouble, and in need of a downgrade. But not to the extent that the other bond raters believed.

Just as it had done with other countries in the embattled euro zone, DBRS lowered Spain's credit rating, but with restraint, dropping the country's bonds from A (high) to A (low).

Crucially, Spain wasn't relegated to less than A status. There would be no triggering of billions of dollars worth of payments. Spanish banks had a reprieve. As the headlines would suggest in Europe the next day, Spain had dodged a bullet.

"We've got a different philosophy than the other agencies," Walter Schroeder says. He makes no apologies for his outlier stance on European sovereign debt. But Europe is on the brink of financial ruin - so much so that the ECB in September dropped the requirement that all bonds used as collateral by countries like Spain carry a minimum rating, to make emergency funding more accessible. It was a reminder of the power that governments ultimately hold, and of how the European landscape is deteriorating. So is DBRS irresponsible in not slashing ratings?

"Just watch," Schroeder says bluntly. "Let's see how good we are three years from now. Let's see what the ratings are then. And let's see who's right."

He has, in other words, just issued a challenge to every other ratings agency - and the market. They have it wrong. "Most of the countries in Europe are basically strong, there's no reason they can't get out of their problem," Schroeder says, citing the case of Italy. "We don't think that warrants cutting the thing four rating categories. Why all of a sudden are you cutting it that many grades?"

Wild swings only imply that your original analysis was wrong, he maintains. "When we do it, we mean it." That is why DBRS is now a critical cog in Europe. Schroeder has built a business on trying to predict the future by analyzing the present. And given the ratings that DBRS has issued this year, the reality of the present is plain and simple: There are governments across Europe hoping the upstart credit rater from Canada is not wrong.

*****

HOW'S MY DEBT?

What those letter grades mean, according to Dominion Bond Rating Service

AAA This is the safest bet, the highest credit quality. The capacity for payment of financial obligations is exceptionally high and unlikely to be adversely affected by future events.

Who it applies to

DENMARK

Not everybody in Europe is hurting. On Sept. 20, DBRS rated Denmark AAA, a reflection of the country's "wealthy and diversified economy, strong political institutions and sound macroeconomic policy management." A deficit that is only 1.9% of GDP, among the lowest rates in the European Union, doesn't hurt either.

**

AA The credit quality of borrowers is deemed "superior" and the capacity to meet obligations is considered high.

Who it applies to

CANADA'S BIG FIVE BANKS

DBRS confirmed that each of the Big Five maintained a AA rating this year. The rating noted that the banks are well-funded and firmly ensconced in the relatively low-risk business of Canadian retail banking. However, exposure to unpredictable revenue streams, such as investment banking and trading, keeps them from earning an AAA.

**

A "Good" credit quality: Countries and companies with this grade have "substantial" capacity for payment of their financial obligations, but may be vulnerable to future events. Negative factors are considered manageable, however.

Who it applies to

SPAIN, ITALY

Two of Europe's most embattled financial systems have fallen to the bottom rungs of A status, and could slip further if their financial picture doesn't improve. Spain was rated A (low) on Aug. 8, while Italy was rated A.

Neither is considered to be at a high risk of defaulting, given the likelihood of a bailout from the European Union. (DBRS sometimes attaches "high" or "low" to a grade, signifying a slight difference from the standard rating.)

**

BBB Credit quality is "adequate" and the capacity for payments is "acceptable," although the bond issuer may be vulnerable to future events.

Who it applies to

ROGERS COMMUNICATIONS

On July 26, DBRS rated Rogers a triple-B. Baked into that rating is a positive: Rogers's market presence in wireless and cable. But Rogers's debt levels and "the intensifying competitive landscape in both industry segments" make it hard to grow subscriber numbers. Given that Ted Rogers built the company by taking on loads of debt and issuing junk bonds in the 1980s and '90s, a BBB rating for the firm is a big improvement.

**

BB Credit quality is "speculative" and "non-investment grade." DBRS is uncertain of the subject's capacity to make its payments.

Who it applies to

FIAT

The struggling Italian automaker was rated BB (high) on Sept. 11, given weak performance from its European operations and the "difficult conditions expected to persist for at least the next two years."

**

B This is "highly speculative" credit quality. There is a "high level of uncertainty" about meeting financial obligations.

Who it applies to

E*TRADE FINANCIAL CORP.

Last April 23, DBRS rated E*Trade a B (high). The U.S. investment website racked up deep losses between 2007 and 2010, and has only recently shown profits.

**

CCC/CC/C These grades are "very highly speculative" in terms of credit quality and "in danger of defaulting on financial obligations."

Who it applies to

YELLOW MEDIA INC.

Yellow Media's fall from grace culminated July 23 when its rating was dropped to C (high), one of the lowest grades possible short of a default. The downgrade followed the company's announced debt restructuring, which is expected to result in a default.

**

D In this world, a D is actually an F. It means the issuer has not met one or more of its financial obligations, or it is clear that such payments will not be made in the near future.

Who it applied to

CANWEST MEDIA INC.

In September, 2009, Canwest fell to a D rating, marking its long descent into bankruptcy protection. The company owed $954 million and "indicated that it does not have sufficient liquidity to satisfy any such demands for payment," DBRS said. The company's print and TV assets were sold in a court-ordered restructuring.

gam