HBS Cases: A Startup Takes On the Credit Ratings Giants
Moody's, Fitch, and Standard & Poor's dominated the credit ratings industry for decades. Could the recession weaken their hold? Professor Bo Becker discusses his case on super startup Kroll.
For most of the 20th century, three bond ratings agencies—Moody's, Fitch, and Standard & Poor's—dominated the credit ratings industry, recently controlling 97 percent of the market.
But the status quo was disrupted by the 2008 global economic recession, an event that the Big Three contributed to by assigning overly optimistic ratings to highly complex and opaque mortgage- and asset-backed securities. The high ratings signaled to investors that the financial instruments had little chance of default, but the burst of the real-estate bubble created massive losses on such securities, including several instances where the highest rated securities (AAA) defaulted. The resulting financial meltdown pushed the US and the rest of the world economy into recession.
In the recent case "Kroll Bond Rating Agency," Bo Becker, an assistant professor at Harvard Business School, offers an overview of the bond ratings industry, including its history, its major players, who uses ratings, and how they are used. The case concerns the strategic options facing a new entrant hoping to exploit the potential crack in the dominance of Moody's, Fitch, and S&P.
Becker studied the credit ratings industry in the wake of the financial crisis. In a paper published in the Journal of Financial Economics, he examined the role of competition between raters. One important distinction, in his view, is between corporate bonds, on the one hand, and structured products, such as mortgage-backed securities, which experienced large losses.
"There's a fascinating discrepancy there," says Becker. "Something works for decades, for a century, really, with corporate ratings, and it failed utterly with structured products."
Becker was spurred to write the case when he realized the bond ratings industry isn't explicitly taught to HBS students. "This is one of those corners of finance that is very useful to understand, whether or not you work in finance," says Becker.
"Something works for decades … and it failed utterly with structured products"
In 2008 and 2009, when the field of ratings seemed ripe for upheaval, Becker learned of several planned rating agency start-ups, including what would become KBRA. When the firm lured ex-Moody's executive Jerome Fons, whom Becker knew, "I contacted him to say this might be a fantastic opportunity to write an exciting case about this topic."
Although Becker never spoke with Jules Kroll directly while writing the case, Kroll's reputation is legendary enough to speak for itself. The corporate intelligence firm he started in the early 1970s was just a decade later locating hidden assets by some very powerful people, including Jean-Claude "Baby Doc" Duvalier, Ferdinand and Imelda Marcos, and Saddam Hussein. Kroll's work even inspired the 2000 movie Proof of Life.
Nearly a decade after the movie debuted, Kroll was still going strong. Although he'd sold his original corporate intelligence firm for nearly $2 billion, he remained active in venture capital, start-ups and charity work. In 2009 he founded the risk management consulting firm K2 Global Consulting with his eldest son. That was also the year he asked Fons to come up with the business plan that would lead to KRBA.
Sold their souls
Kroll had been formulating a plan for KRBA as early as 2008; in his mind, Moody's, Fitch, and S&P sold their souls to win business in the short run. KRBA would, says Becker, "value integrity above everything else." But would it be a success?
The case begins in April 2010 as Fons is about to propose a strategy to Kroll to launch KBRA. Along with Fons, an economist specializing in credit risk and rating agency issues, students are asked to consider several key questions:
- Should KBRA enter this business, which despite the economic crisis is still dominated by the Big Three.
- Should it focus its business on a single sector such as structured products or attack multiple sectors?
- How could enough skilled analysts be recruited quickly?
- How would the firm acquire status as a Nationally Recognized Statistical Rating Organization, an SEC designation that is a key must-have by many credit ratings customers?
A century of competition
The seeds of the bond ratings industry, Becker explains in the case, are found in the credit record collection firms (such as Dun & Bradstreet) of the late 19th century. The three agencies that dominate today were there at the beginning. John Moody issued the first bond ratings in 1909. Fitch and the precursor to S&P did so in the 1920s. The industry continued on a relatively stable path until 1970, when its business model shifted from raising revenues by selling books of ratings to investors, mainly through subscriptions, to charging issuers of securities being rated. While the "investor pays" business model allows a wide sharing of ratings to investors for free, it has raised concerns about conflict of interest, since raters' derive their revenue and profits from the firms they analyze.
With the new model, a host of potential competitors have been squeezed out. Small raters employ the subscription-based business model, and large firms use the investor pays model. "There's limited room for medium-sized raters," Becker explains. "Either you're tiny or you're one of the big ones."
And the industry might have continued as it had for decades were it not for the growth of a different type of financial product. Structured finance instruments, described in the case as securities "constituting a claim on a pool of multiple assets," had been around a long time, but beginning in the new millennium they underwent a period of rapid growth. The assets of issuers of asset-backed securities more than doubled over a five-year period.
Because structured finance instruments were composed of many assets-student loans, car loans, mortgages, and the like-the burden on the rating agencies was different from that involved in rating corporate or municipal bonds.
In particular, most structured products could only be rated based on information released by the issuer, whereas corporations that issue bonds usually are well known through annual reports, regulatory filings, and the media, and can be rated without any interaction between the issuer and rating agency. Typically, structured products are rated by only a single agency.
Further, while there are thousands of corporate bond issuers, "there's only a handful of banks issuing structured finance instruments," says Becker.
Ratings agencies end up in a very tight spot.
"You could see how S&P would say to any individual corporate, 'Well, I'm not going to be lenient with you because I have a reputation to maintain, and you are only a tiny fraction of my revenue,' " explains Becker. "But if there's five investment banks, now all of a sudden each client becomes pretty important, representing millions and tens of millions of dollars in revenue."
"Understanding the industry is essential for anyone who wants to interact with financial markets"
Such pressure might explain how an industry giant that's been in business for nearly a century decides to assign a triple-A rating to a product that should be triple-C.
The effects of such errors in judgment are far-reaching. Ratings are used by a variety of people and entities: individual investors consider them as part of their overall investment decisions; fund managers employ them when describing the contents and risks of their bond portfolios; market makers use them to set debt prices. In addition, they're part of the regulatory processes of big banks.
Given that the incumbent raters did worst in their rating of structured products, KBRA may hope to make the biggest impact there. At the moment, however, structured finance issuance is at a near-standstill since the financial crisis.
"Parts of the structured market have gone away, and we don't actually know that it will come back," says Becker.
Becker says that students have a great interest in the role of ratings in the financial crisis, and in the firm itself, Becker says.
"The business models used, and the whole structure of the industry, are complex, and it can take us a while to sort that out. It is worth the trouble, because understanding the industry and its output, the credit ratings, is essential for anyone who wants to interact with financial markets, even indirectly."