Moningstar (fmr
3.3.2. Ancillary services
Next to the fees earned from rating securities, the provision of ancillary services is also a major source of revenue for CRAs and this further complicates the remuneration debate. A Goldman Sachs executive described the relationship between his bank and CRAs as one constituting a “multi-faceted relationship”.267 The interconnections referred to in his statement revolve around instances where: (i) CRAs rate Goldman Sachs itself;
(ii) CRAs rate the securities products that the bank constructs, and where; (iii) CRAs rate
266 Passed in Senate vote 61 to 38 in favour, with one abstention. See also, Bainbridge, supra note 211, at 1796-97 (citing the Cantwell- Schumer Shareholder Bill of Rights as an example, Bainbridge acknowledges that tougher measures were either excluded entirely or only their drastically watered-down versions were included in the final version of the bill).
267 See, section 3.3.1.4. above.
securities for issuers for whom the bank acts as an advisor. The ancillary services268 are often understood to refer to consultative and advisory services that CRAs make available to clients, but which also include providing risk management software, economic analysis, training and professional services which transcend the period from pre- to post-rating of a security instrument. Moody’s Analytics was created in January 2008 by Moody’s Corporation as a reportable segment to house the ancillary non-rating commercial activities of the firm by providing products and services to support the risk management activities of the firm’s institutional clients. More typical when rating structured financial products than other instruments, is that discussions are held in an iterative or ‘offer and counter offer’ process cycle until a structure and a matching rating is agreed to by both parties (i.e. the CRAs on one side of the transaction and the issuers or their advisors on the other).
It should be noted that financial services firms have over time acquired significant expertise in structuring securities in order to optimize the credit ratings assigned by CRAs to securities. In essence, the process itself involves a series of submissions of potential structures to CRAs who in turn respond with comments and hypothetical scenarios and the potential ratings such structures and adjustments would receive.269 This process allows issuers to gain an indication of both the security’s potential rating in order for them to be able to better gauge investors’ appetite for the envisaged product.
268 S&P define ancillary service to mean “a product or service that S&P Ratings Services provides or sells that is not a Credit Rating or Credit Rating Activity and is either a market forecast, an estimate of economic trends, a pricing analysis, other general data analysis, or distribution services related to a Credit Rating, a market forecast, an estimate of economic trends, a pricing analysis, or general data analysis”, available at http://www.standardandpoors.com. Similarly, Moody’s define ancillary services as those products and services that “are market forecasts, estimates of economic trends, pricing analysis, or other general data analysis, as well as related distribution services”, and are not therefore not directly considered as credit rating services, available at http://www.moodys.com.
269See e.g., Jesse Eisinger, Moody’s Ratings Fiasco, PORTFOLIO.COM, (2007).
However, it is this behind-the-scenes horse-trading that most clearly underlines the conflict of interest charge leveled at CRAs. The IOSCO 2008 report noted that, when compared to traditional bonds, the rating process for structured products appears to be in reverse.270 The reversal in question refers to the point at which the rating is determined in the rating process; namely, whereas the rating of traditional bonds starts with a bond that seeks an ‘objective’ CRA rating; the rating of structured products starts first with a desired target rating for the respective tranches and then financial engineering specialists proceed to structure a constellation of these tranches (within acceptable limits) into a product tailored to “fit” the desired rating. AAA-rated securities are coveted because they are significantly more liquid and have a larger market than lower rated securities. Not surprisingly, as reported by Fitch in 2007, 60 percent of all global structured products were AAA-rated, in contrast to less than one percent for corporate issuers.271
Rate-shopping is a practice by which either the issuers or the advisory firms representing them seek out the CRA prepared to assign their securities the highest possible credit rating, or obtain several ratings and only elect to disclose the highest rating. It seems likely to have occurred in instances where issuers or their advisors were able to simply walk away from a rating agreement, or merely threaten to do so, when faced with the prospect of receiving a rating that they were not satisfied with. As a consequence of this practice CRAs came under significant pressure to ensure that their ratings would be attractive enough so as not to impede their future rating transaction pipeline with the clients or their advisors.272
270 IOSCO, Ratings in structured finance: what went wrong and what can be done to address shortcomings, Comm. on the Global Fin. Sys., No. 32, at 5 (2008).
271 Joshua D. Coval, Jakob Jurek & Erik Stafford, The Economics of Structured Finance 5 (HBS Finance Working Paper No. 09-060, 2008).
272 See, Carl Levin & Tom Coburn, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, SENATE COMM.HOMELAND AND GOVERMENTAL AFFAIRS April 13, 2011.
Figure 6 below depicts the McGraw-Hill Group of Companies’ revenue distribution for 2010 in which S&P’s contribution to total group revenue was 28 percent. This placed it behind MH Education with 39 percent but comfortably ahead of both MH Financial and the Information & Media groups with 19 percent and 14 percent, respectively. S&P’s high operating margins allowed it to earn $84 million more in 2010 than for MH Financial and MH Education combined. It is because of the high and sustained profitability of S&P’s business that the accompanying article called for the McGraw-Hill Group of Companies to be split-up as a means of unlocking a projected additional $4.4 billion in market value implied by the value of the sum-of-parts as calculated by Goldman Sachs. The projection estimated the market value of a stand-alone S&P of $8.9 billion, just over 50 percent of the envisaged sum-of-the parts total of $17.7 billion, largely driven by its very high operating margins.
Figure 6: McGraw-Hill revenue distribution 2011
Source: Financial Times, Sept.11, 2011, at 9.
Figure 7: Profitability (Moody's vs. Fitch Ratings)
Source: Fitch Ratings – About us, available at www.fitchratings.com (last accessed Sept. 15, 2013)
Figure 7 (above) compares Moody’s revenues with those of Fitch between 2001 and 2010. The graph shows that Moody’s, similar to S&P, enjoys very high operating margins, averaging between 40 percent and 60 percent over the last five years. However, Fitch’s operating margins which have averaged between 30 percent and 20 percent, are still significantly lower than those of the Big Two. Nonetheless, all three firms are incomparably more profitable than other publishing houses to which they often compare themselves; so much so that their profitability and share price performance has over the last two decades even outstripped that of large investment banks.273 Moody’s also cites financial services firms like Alliance Bernstein and Blackrock in its Annual Report’s Compensation Discussion and Analysis section for example, with the McGraw-Hill Companies, Inc., Morningstar Inc., and MSCI only constituting a minority of its listed
273 Frank Partnoy, Credit Rating Agencies versus Other Gatekeepers, in FINANCIAL GATEKEEPERS:CAN THEY PROTECT INVESTORS? at 97 (2006).
comparable peers.274 The comparison itself is not surprising, particularly when one notes the gross discrepancy in size and profitability between the Big Three and the other NRSROs.
The question which then arises is whether the stellar economic performance by these CRAs is due to superior strategy and execution or due to a market failure?275 The extent to which CRAs can truly be objective and independent in light of the evident assistance and guidance that they provide issuers in the course of structuring securities through the iteration process276 has become a recurring but still unanswered question.277 In other words; can a chef be expected to objectively assess the quality of a meal in which he himself has participated in preparing, more-so where the result of such an assessment is directly tied to their own financial well-being?278 This question has been relied upon to
274 Moody’s 2011 Schedule 14A, (2011), available at http://google.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?ID=8466665&SessionID=IxycFCg1k65_KE2#
D290401DDEF14A_HTM_TOC290401_37 (last accessed Mar. 10, 2015).
275 Justin Pettit’s comment to Chapter 3 in FINANCIAL GATEKEEPERS:CAN THEY PROTECT INVESTORS? at 100-102 (2006).
276 Ben Protess and Lagan Sebert, Courts examine credit raters' 'intimate' relationship with bankers THE CENTER FOR PUBLIC INTEGRITY, Dec. 4, 2009, citing Frank Raiter, a former managing director for Standard
& Poor’s, (referred to “constant contact” between issuers and CRAs). Id., Comment by Frank Partnoy, former investment banker (“It’s one thing to come in after the fact and say, ‘What a beautiful building.’ But it’s another if they first helped build the building.”). See also, Freeman, Lisbeth, Who's Guarding the Gate?
55 VT. L. REV.585, 603 (2009) (noting how iterative process between CRAs and issuers became a
“negotiation”, quoting Paul Stevenson, former Moody’s executive).
277 Ben Protess and Lagan Sebert, Courts examine credit raters' 'intimate' relationship with bankers THE CENTER FOR PUBLIC INTEGRITY, Dec. 4, 2009)(in meetings with rating analysts, financial institutions would be told what they “need[ed] to do to get as many of the senior bonds rated triple-A”). The authors also assert that despite the give and take, critics insist that CRAs do not structure the securities.
278 The Dodd-Frank Act at H. R. 4173-510, Section 939F, (a) and (c), requires the SEC to carry out and study the “credit rating process for structured finance products and the conflicts of interest associated with the issuer-pay and the subscriber-pay models” and to present a report to the Committee on Banking,
anchor numerous lawsuits that have been brought against CRAs, as will be addressed in Chapter 4.