Markets operate on trust. More than 150 years ago, as the American frontier pushed westward, merchants found themselves doing business with far-flung firms with whom they did not have direct relationships. Credit rating agencies were born in response to this need. They provided impartial, independent assessments of reliability; those who extended credit to highly rated firms could be assured their loans would be repaid. As the industry evolved, it came to be dominated by giants such as Moody’s, Standard & Poor’s and Fitch. Over the decades, though rating services became global and highly complex, the basic idea remained the same: A Triple-A rating meant your money was safe. That is how credit ratings safeguarded trust that sustained markets.
This core belief was severely challenged a decade ago. During the subprime mortgage crisis of 2008 and the Great Recession that followed, it turned out that leading credit rating agencies had provided top-grade ratings to mortgage-backed securities worth billions of dollars that ultimately turned out to be worthless. As credit agencies scrambled to downgrade their ratings to junk, according to one estimate “the writedown and losses came to more than half a trillion dollars.” Lawrence White, a professor of economics at New York University’s Stern School of Business, writes: “When the histories are written of the U.S. subprime residential mortgage debacle … and the world financial crisis that followed, the three large U.S.-based credit rating agencies – Moody’s, Standard & Poor’s (S&P), and Fitch – will surely be seen as central parties to the debacle; and rightly so.”
During the past decade, many have demanded that credit rating agencies re-think their business models and operations. How, though, should that be done? The co-authors of this opinion piece believe the time has come to re-imagine the way credit rating agencies work. Jules Kroll is chairman of Kroll Bond Rating Agency (KBRA), a global, full-service firm established in 2010. Jim Nadler is KBRA’s president and CEO, and Kate Kennedy is the firm’s senior managing director.
When Jules Kroll set out in the wake of the financial crisis to launch a credit rating agency, he knew there would be demand for one. The failures of the status quo at that time have been well chronicled, and we see no point in dredging up the past. Rather, we think it is more advantageous to lay out how we think about building a better rating agency — one that learns from the past and never loses sight of the needs of investors and issuers.
Building such an agency requires adopting a different perspective — one that challenges the conventional way of thinking associated with the pre-crisis rating agencies. It starts with analysts, who need not be career rating agency people. They can be market participants from the buy-side and the sell-side, investors and bankers, as well as researchers who know what they would like to see from a rating agency because they have been consumers of rating agency research for years. They know there is a better way.
The blueprint of a re-imagined rating agency should map two ways forward. First, it should adopt a professional code of standards that values the needs of its clients. Second, it should make a commitment to get the precise rating, one that is forward looking and free of unsubstantiated bias. Combining this into one cohesive, cross-asset-class culture that defies the powerful gravitational pull of our industry’s worst practices is the challenge. It is a challenge that all rating agencies will have to accept if they want to rebuild trust not just with their stakeholders, but also with the world at large.
“Agency professionals need to actively engage clients.”
Let’s elaborate on these two points, starting with the code of professional standards.
Credit rating agencies should be responsive, not standoffish. Agency professionals need to actively engage clients. They should know that their clients’ time is valuable, and their work is sensitive to markets. That means agencies need to be accessible and approachable, even in matters as simple as returning phone calls on a timely basis.
Credit rating agencies need to be transparent. They need to understand that operating in a black box in an ivory tower is not helpful. Too often it leads to unwelcome surprises to a banker or issuer late in the ratings process or to an investor trying to manage a portfolio. Being transparent about how ratings agencies think and operate helps clients do their job better.
Credit rating agencies should fight to break down internal silos. Rating assignments sometimes require collaboration between asset classes. Close coordination between asset classes ensures that transactions can be processed in the most efficient and thoughtful way possible. That produces the best outcome.
Credit rating agencies should pledge to bring a different perspective to credit analysis, challenging conventional rating agency thinking in several important ways. This can ultimately result in more accurate ratings. For instance, legacy analysis relies too much on the backward look. Investors truly value something that is much more difficult to assess — a sense of what is going to happen in the future. No one needs to pretend to have a crystal ball. Still, they could lay out and consider key credit drivers and likely scenarios as part of the rating determination.
Credit rating agencies should believe in evolution. They should be informed by the past, but not held hostage by it. The credit strengths and risks reflected in ratings — for companies, governments and assets — evolve. It is important to factor in not only these attributes, but also how these will change in the future.
A clear case in point is how financial institutions have evolved since the financial crisis. Even the most casual observer has taken note of firm-specific changes, such as the material strengthening of balance sheets, as well as influential external factors, including regulatory changes and improved market discipline. And yet, ratings in the sector have barely moved off post-crisis lows. We understand potentially why — if a crisis happened once, it can happen again — but that view is simplistic, ignoring evolution, and we don’t think that serves investors well.
“Some rating agencies have a clear size bias, meaning smaller enterprises are penalized simply for being small.”
A re-imagined credit rating agency should challenge what it considers to be rigid and unsubstantiated biases. Over time, certain biases have become calcified into the thinking of mainstream rating agencies. We highlight a few below:
Size. Some rating agencies have a clear size bias, meaning smaller enterprises are penalized simply for being small. We believe this bias, while often intuitive, is not accurate. Size certainly matters, as it can be an important determinant of a company’s pricing power and competitiveness, but that intuition needs to be examined rigorously, and sometimes, challenged with a different view.
Consider community banks, for example. It is often assumed that economies of scale and scope give big banks a competitive advantage when compared with smaller banks. But research into cost structure shows that smaller banks are not disadvantaged, because government guaranteed deposit funding equalizes funding cost, and economies of scale are reached at far lower asset sizes than is commonly believed. When you factor in community bank local market knowledge and superior responsiveness, community banks can be solid investment grade credits.
Track record. Some rating agencies will heavily penalize, or not rate at all, enterprises with less than some prescribed period in operation, typically three to five years. “There’s just not enough to evaluate,” is sometimes the reasoning. But what if you had an extraordinarily talented and experienced management team that has come together to launch a new business, with substantial capital backing? Fresh thinking about credit rating requires taking such factors into account.
Notching practices through the organizational and capital structures. The dizzying array of bells and whistles debt capital market professionals have attached to capital securities and the myriad issuing entities they’ve created, all to navigate changing regulatory frameworks, have resulted in “a notch for this, a notch for that” from rating agencies. This has created nonsensical — and highly punitive — gaps between senior and subordinated obligations. Instead of continuing down this path, credit rating agencies should steadfastly focus on default/deferral probability and loss given default, resulting in what we call, “sensible notching.”
Monoline risk. Most corporates today are “monoline” businesses, i.e., firms that derive the vast majority of their revenues from one type of business. Legacy credit rating agencies routinely penalize certain financial institutions for being “monoline” — think credit card banks or student loan lenders. This approach is wildly inconsistent with how they look at business risk on the industrial side. We believe credit rating agencies need to have a different approach to business risk, one where diversity takes into account not only business lines, and how competitive each line is, but also spread-of-risk within particular business lines. This produces a better outcome.
“We firmly believe that enlightened credit analysis is more art than science.”
Credit ratings should not be model-driven. We firmly believe that enlightened credit analysis is more art than science. Accordingly, credit rating agencies need not rely on models to drive rating outcomes, for the simple reason that no one model fits all. Every public or private sector issuer is an idiosyncratic mix of revenues and expenses, with its own raison d’etre. While trends in performance metrics should be considered, they tell us only part of the story. Moreover, critical qualitative factors and assessments such as management risk appetite, growth strategies, firm competitiveness or political and economic backdrop can be quite subjective. Insights into those factors are essential elements to ratings and yet cannot be modeled.
Credit rating agencies should be aware of markets. We are credit analysts, not bond analysts. That said, credit rating agencies should pay close attention to markets for what they signal: degree of confidence in future earnings and cash flow, a view of balance sheet integrity, relative relationships between firms within a sector, as well as sectors within an economy. Asking yourself, “What am I missing that the market is seeing?” is a healthy discipline. Those who do that will never be accused of having their heads in the sand.