Monday, December 24, 2007

Slings, arrows nothing new for DBRS

(Globe & Mail) In the 31 years since Walter Schroeder quit his job at investment dealer Wood Gundy Ltd. to start up Dominion Bond Rating Service, he's seen the credit-rating industry come under fire multiple times.

“I've been around in this industry for a long time and seen the cycles – the good the bad and the ugly,” he says.

“And that would go back to '82, '92, and partly 2001, 2002. Rating agencies come under criticism every time they cut ratings.”

In the four months since this summer's market turmoil erupted, numerous politicians, regulators and investors have heaped scorn on the world's major rating agencies for failing to downgrade much of the debt that's tumbled in value, and sent shockwaves through the global financial system.

In Canada, fingers have been pointing at DBRS Ltd. – as Mr. Schroeder's company is now called – for its role in the country's $33-billion market for third-party asset-backed commercial paper (ABCP). Toronto-based DBRS was the only major credit-rating agency to rate that paper, much of which received its highest rating.

But the agency's spunky, straight-talking president – who has said he hatched the business plan for DBRS in a Volkswagen Beetle during a 1975 family road trip from Toronto to Montreal – suggested that knocking credit-rating agencies is an inevitable part of any economic downturn.

“If there's a rating cut, [critics say] you should have cut it six months earlier.

“If there's a problem, you should have seen it a year earlier, or you should have never rated the thing in the first place,” is another typical criticism, he said.

“I think it comes with the territory in the industry. It's a tough industry.”

Mr. Schroeder spoke in an interview from the office tower in Toronto's financial district that was recently adorned with the DBRS logo in bright red lights. Sitting next to his son David, now the agency's chief operating officer, Mr. Schroeder was hours away from boarding a plane to his hometown of Winnipeg, where he spends the holidays.

David Schroeder, who is currently more active in the day-to-day business, said “rating agencies globally have to rebuild some of the trust and confidence that investors have, and the understanding of structured finance products.

“You've seen so many parts of structured finance that haven't performed as rating agencies expected them to, so that's the challenge going forward,” he said.

But “the marketplace needs third-party opinions that are independent as part of their investment process; that's not going to change long-term,” he added.

In the short-term, DBRS, like its competitors, is suffering from the decrease in new structured credit products and debt issues. Roughly half of the agency's analysts rate corporate debt, while the remainder rate structured credit products. Like other rating agencies, DBRS earns money by charging debt-issuers for its ratings.

Revenue has gone down as market activity has gone down, said the elder Mr. Schroeder. The Schroeder family still owns 100 per cent of DBRS, which does not publicly release its financial results.

Structured finance industry volumes are down about 90 per cent in Europe since September, and roughly 70 per cent in the United States, David said.

“The good thing is those are still small markets for us, so when you have a smaller market share it doesn't affect you as much. But certainly with that kind of industry drop, it affects the structured finance business.”

DBRS's strongest market share is in Canada, where volumes have fallen, but less dramatically, he said.

“Companies are having difficulties doing debt deals because the investor has gone on holiday,” Walter said. “Not a holiday, a strike.”

As a result of the current situations, “the pool for bonuses [at DBRS] is lower this year; that's, I think, to be expected,” David said.

Employees at the rating agency have been putting in long hours in recent months, particularly on the structured-credit side. “The guys have never been more busy,” he said. “Investors have never been more interested in understanding what's going on and what the risks are. So, they've been spending a ton of time with investors, a ton of time with issuers, working everything out.”

But morale hasn't suffered, the Schroeders suggested.

“It's one of those experiences,” David said. “It's a good team-building experience when you're having to go through more challenging times, working on solutions for some of the challenges.”

And he believes that the recent turmoil is creating some new opportunities for DBRS, although he declined to get into details just yet.

The agency has been making inroads with its ratings of U.S. financial institutions, commercial mortgage-backed securities, and in some areas of asset-backed securities and student loans, David said.

As it hunts for new possibilities, DBRS is also examining its methods, which continue to evolve.

While credit-rating agencies may have been down this road before, that doesn't mean the current situation won't prompt significant changes.

“What's changed the industry is that the structured market grew so quick, so fast, in such a short time period, there was so much liquidity around; and people bought product that they were challenged to really analyze,” Walter said.

“So, I think the industry is going to change in that sense. It's going to change in the form of having to educate the investor and be more open and provide more data to the investor on the structured side.”

Structured credit is a new beast.

“On the corporate side, you've had 200 years of development there, of transparency,” David noted.

“You've got equity analysts covering them, you've got annual reports, you've got excellent transparency.”

Globally, financial institutions had in recent years been adding traders as opposed to credit specialists, David said.

“Now they're in a position where they're not able to trade it, and they don't have the credit people to understand exactly what they have.

“So, I think for people to regain confidence in structured finance products you need – and we're going to be part of this too – [to be] increasing the transparency, increasing the knowledge of the products. It's the unknown that scares people away.”

Walter believes that much of the criticism that's been aimed at DBRS will dissipate when the frozen $33-billion market for third-party asset-backed commercial paper comes back to life.

A committee headed by Toronto lawyer Purdy Crawford yesterday unveiled a rescue plan for the market, without placing a price tag on the assets.

So, as he looks ahead to the new year, Walter is optimistic about the situation in Canada. But he won't claim to have seen the events of the past few months coming.

“I used to say that anything that ended with a two is bad, because recessions usually occurred in twos: '72, '82, '92, 2002,” he said. “I thought I had till 2012, so I thought I was safe.”

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