Sunday, June 15, 2008

Credit ratings storm: DBRS faces critics over role in ABCP Fiasco

(Financial Post) Almost a year into the blame game playing out in the wake of the global credit crunch and the commercial-paper meltdown in Canada, Walter Schroeder sits at a boardroom table with his son, David, jotting down notes as he ponders the plight of his embattled company.

Trim and tanned with a neatly coiffed mane of white hair, the 66-year-old Mr. Schroeder betrays no sign of impatience as he listens to accusations levelled against DBRS Ltd., the firm he founded 32 years ago, and the rating industry in which it operates.

Mr. Schroeder, David Schroeder, 36, and the senior staff at DBRS have spent months meeting with stakeholders -- issuers, regulators, subscribers and more than 100 investors -- trying to figure out how to fix the firm's operations in the hope of appeasing critics demanding a fundamental overhaul of the industry.

"We've made some changes in light of what's gone on," explains David Schroeder, chief operating officer. "As a result, we have made wholesale revisions to the way we approach transparency and disclosure."

They're not alone.

Faced with the harsh glare of regulatory scrutiny and rising anger from investors, debt raters, who ultimately function on trust, have been fending off calls for tougher rules and greater oversight.

Major securities regulators around the world have placed a bull's eye on debt-rating agencies since last summer's market debacle. Once revered prognosticators, agencies' integrity, credibility, quality and independence are at the centre of a series of examinations and investigations into the credit-market collapse which has galvanized international regulators.

The U. S. Securities and Exchange Commission, the only regulator that oversees its industry (worth US$5-billion a year), proposed new rules this week to reshape the way rating agencies operate.

In this country, the Canadian Securities Administrators, the umbrella group representing the 13 provincial and territorial regulators, is still "examining" the agencies' role in the securities market.

On Monday, Julie Dickson, the federal superintendent of financial institutions, will testify in Ottawa before the House of Commons finance committee that DBRS was partly to blame for the commercial-paper collapse. According to briefing notes circulated by her office, Ms. Dickson, who oversees banks in Canada, will argue that the rating agency, among other groups, encouraged the use of the flawed liquidity agreements that sparked the turmoil in the commercial-paper market last August.

Meanwhile, the International Organization of Securities Commissions, which represents more than 100 securities regulators worldwide, also released a list of recommended modifications to its 2003 code of conduct for rating agencies, originally issued after the collapse of Enron Corp.

But amid the growing clamour, there is no outward sign of concern inside DBRS's seventh-floor head-office boardroom in a gleaming downtown Toronto office tower.

"The main thing they want is transparency; more information made available to the marketplace. Provide a minimum level of disclosure," Walter Schroeder says sanguinely during an interview.

"This happens every bottom of the cycle. If you look back to the '80s and '90s, you'll find rating agencies were criticized. In the end, you're only as good as your assumptions."

Yet, that established way rating agencies conduct their business is at the very centre of the controversy --and one of the main reasons the fallout from the credit crunch has chipped away at some of the vaunted status they have long enjoyed.

DBRS, Moody's and Standard &Poors and other agencies have built their reputations on investors' confidence in the quality and objectivity of their opinions. As crucial financial gatekeepers, their judgments on the creditworthiness of public companies and securities are often key factors that determine how and at what price companies can raise or borrow money.

But in the wake of the subprime-mortgage crisis, that trust has been seriously eroded.

Central to the debate is the now-famous asset-backed commercial paper, a short-term debt product that mostly received the coveted Triple-A rating even though some of it was exposed to dodgy U. S. home loans.

In Canada, the troubles were particularly serious. Last August, a$35-billion chunk of the ABCP market froze completely after a group of foreign banks that had agreed to provide emergency liquidity to buy up paper in the event of a market failure declined to honour their agreements. As a result, investors holding what they thought were notes backed by a bank guarantee were left on the hook for massive losses.

Perhaps most surprising to investors was that the frozen paper came with the highest rating from DBRS. Indeed, it wasn't until several days after the freeze-up that the company put the stalled ABCP under review.

Ten months later, the market is still tied up in a complex restructuring with holders unable to trade their notes.

"This is amazing that something as simple as residential mortgages could cause all of these problems," says Laurence Booth, a professor at the University of Toronto's Joseph L. Rotman School of Management.

How did the rating agency get it so wrong?

Some point to a lack of objectivity, given that rating agencies earn a healthy portion of their revenue helping companies obtain a certain rating before they take their products to market. Agencies generally disclose when they are paid by the companies they rate, but because DBRS is a private company, Mr. Schroeder would only confirm the firm earns the "bulk" of its revenue from issuers, not subscribers.

Critics, including Anthony Fell, former chairman of RBC Dominion Securities, argue that model is flawed.

"They became part-time investment bankers, working hand in glove with the major banks and dealers as to how the products should be structured," he said in a recent speech. "They were, in effect, rating their own product, which is a clear conflict."

In the case of ABCP, the rating agency worked with trusts that issued the commercial paper. Of the more than 20 trusts that seized up last August, all were sponsored by a handful of boutique financial firms such as Coventree Inc. and Newshore Financial Services, and all were stamped with top ratings by DBRS.

To participate in the market, issuers required a triple-A score. But Moody's and S&P refused to even offer opinions saying -- rightly, as it turned out -- that they didn't trust the Canadian liquidity agreements.

DBRS was the only player willing to rate the paper, which gave rise to an alarming situation: The more ABCP that was issued, the higher the profits for DBRS from fees collected from the firms issuing the paper.

Moreover, not only did DBRS offer opinions on the paper, the company helped craft the investments. First introduced in Canada about two decades ago, ABCP evolved into a highly complex product that went well beyond the understanding of most investors.

Indeed, even the banks and financial firms that sponsored the paper relied on input from the rating agency on how to structure it.

"The root cause of this was that clever investment bankers were able to manipulate the rating agencies," says Mr. Booth.

Observers say the industry is open to criticism because firms are paid by the issuers they rate. It's a fundamental conflict --and the established business model. Sophisticated institutional investors recognize this relationship, which explains why so many employ their own credit analysts.

Worse, some say investors have become too reliant and far too trusting of ratings, especially unsophisticated investors who accept the scores as stamps of approval rather than opinions.

"I've never had a high regard for rating agencies because we understand there are these conflicts," says Mr. Racioppo, adding the money manager does not subscribe to rating agencies. "Too many investors absolutely rely on ratings and it's important to protect the less sophisticated ones that don't understand there are these conflicts."

Walter Schroeder says that criticism is unfair.

"We don't get paid for guaranteeing the debt, nobody pays us for that. We're just giving opinion on the credit quality."

Adds Peter Bethlenfalvy, DBRS's managing director of global corporate finance: "We put out opinions and investors should always use us as a tool. Ultimately, all of us have our reputations and our integrity on the line every time we put out a rating."

Given its level of involvement, it is not surprising DBRS is facing allegations it was in conflict of interest, helping to manufacture the very product it rated.

"They were biased," says Diane Urquart, an independent analyst and shareholder activist. "They became the marketing arm of the ABCP sponsors and the investment dealers."

David Schroeder sees it differently.

"With an issuer-pay model, there are conflicts that everybody knows. With the investor-pay model, there are just as many conflicts. What we have to do is manage it," he argues.

This is not the first time the industry has come under fire for questionable opinions. Over the past few decades, there has been a string of high-profile corporate collapses in which the ratings agencies were accused of failing to provide any warning despite numerous red flags. Glaring examples include the Enron fraud, the collapse of Confederation Life and the spectacular demise of real-estate giant Olympia &York in the early 1990s.

"There hasn't been a problem recently because of the good economy, but what happens is you go into a slowdown and, when people start to lose money, they begin pointing the finger at the credit -rating agencies," says Mr. Booth.

Even so, he says, "the debt-rating agencies will admit they made mistakes."

For one, "they didn't take into account future losses would not be equivalent to historic losses." In other words, Mr. Booth says, they did a lot of "fancy modelling" based on what happened in the past without taking into account how the world was changing.

Mr. Racioppo argues rating agencies aren't trained to be forecasters. "They provide after-the-fact rating," he says. "What purpose does that serve?"

Still, many governments and pension funds are required by securities rules to buy only stocks and bonds that carry a top rating from a major ratings agency. That means money managers such as Jarislowsky, Fraser, which did not purchase ABCP, are forced to rely on ratings when buying and selling certain investments, even when their own credit analysis doesn't agree with the opinions.

"I wish there was a way I didn't have to rely on these rating agencies because it's like putting a straightjacket on us," Mr. Racioppo says.

"It's clear with hindsight that sometimes assumptions that get used across the market need to be revised to reflect what's happening," says Huston Loke, DBRS group managing director, structured finance. "We've learned a lesson on assumptions. We try to make our assumptions now as forward looking as possible." At the same time, DBRS has revised its disclosure rules by publishing monthly

summaries of the asset types and related risks associated with ABCP. It is also setting new internal conflict-of-interest guidelines and, more important, is now focusing on forward-looking assumptions and incorporating a broader range of potential outcomes rather than relying predominantly on historical performance.

"If we had sat back and did not make any changes to the business, then perhaps the criticisms would be more accurate," Mr. Loke says.

The credit collapse cast a spotlight on another shortcoming in the industry in Canada: There is no watchdog overseeing the ratings agencies.

Meanwhile, the SEC proposed new rules to make the industry more transparent and open it up to more competition. More important, among the proposals in its 167-page report is a ban on rating agencies from advising investment banks on how to package securities.

The SEC's initiative emerged a week after the New York Attorney General reached a deal with the world's three largest players --Moody's, S&P and Fitch Ratings -- that will require the firms to provide more information on the products they rate and to avoid conflicts of interest with investment banks.

"At the core of it, they are opinions, they are not recommendations to buy or sell or hold a security," says Mr. Loke. "We can't know the circumstance of all the investors who follow us. I don't think regulators want to second-guess methodology and assumptions, which ultimately are opinions. I don't think that's where regulators want to go."

At DBRS, the initial reaction is relief.

"There's nothing that is game-changing or hugely significant," says David Schroeder of the SEC initiatives.

And although he still has to pore over the voluminous report, his sense is that U. S. regulators "look like they are just adding bureaucratic costs and burdens without really improving the quality of ratings."

DBRS, which has one of the coveted designations to operate in the United States, has 30 days to respond to the proposals. It's clear the challenge to thriving--maybe even surviving-- rests with changing attitudes, and not just the rules.

"There are perhaps unreasonable expectations placed on rating agencies to be perfect in their opinions," observes David Schroeder, as his father nods in agreement. "We'll never be 100%, but the important thing is that we put them out and stand by them. It's not a case of being right all the time."

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