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Monday, May 18, 2015 3:29 AM

Rate Shopping Whores and Chicago's Bond Rating

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Moody's vs. S&P Rating of Chicago

On May 12, Moody's downgraded Chicago's GO bonds to Junk.

I commented on that downgrade in Moody's Cuts Chicago Bond Rating to Junk; City Faces $2.2 Billion in Various Termination Fees; Irresponsible to Tell the Truth.

On May 14, S&P Downgraded Chicago General Obligation Bonds from A+ to A-. That rating is three levels above junk.

Two Questions

  1. Why was the S&P slow in the downgrade?
  2. Why does Moody's rate Chicago as junk while the S&P rate Chicago three levels higher than junk.

Rate Shopping Whores

The answer to both questions is rate shopping.

Mark Glennon at WirePoints explains S&P, slated to rate upcoming Chicago bond sale, goes comparatively easy on downgrade. Hmmm.

"Chicago plans to price offerings of $201 million and $182 million on May 19, as reported yesterday by Bloomberg. And guess who is one of the two agencies slated to rate the new offering, hired by the city? You take it from here. What a system."

Origin of Rate Shopping

It did not use to work like this. And I have been harping about the underlying problem for years. A good starting point is my September 28, 2007 post Time To Break Up The Credit Rating Cartel.

Here is a recap.

The rating agencies were originally research firms. They were paid by those looking to buy bonds or make loans to a company. If a rating company did poorly it lost business. If it did poorly too often it went out of business.

Low and behold the SEC came along in 1975 and ruined a perfectly viable business construct by mandating that debt be rated by a Nationally Recognized Statistical Rating Organization (NRSRO). It originally named seven such rating companies but the number fluctuated between 5 and 7 over the years.

Establishment of the NRSRO did three things (all bad):

  1. It made it extremely difficult to become "nationally recognized" as a rating agency when all debt had to be rated by someone who was already nationally recognized.
  2. In effect it created a nice monopoly for those in the designated group.
  3. It turned upside down the model of who had to pay. Previously debt buyers would go to the ratings companies to know what they were buying. The new model was issuers of debt had to pay to get it rated or they couldn't sell it. Of course this led to shopping around to see who would give the debt the highest rating.

Instead of rating agencies getting paid on the basis of how well they rated debt, the rating agencies got paid on how much debt they rated!

Explaining CDO Garbage Rated AAA

If you were looking for a reason all that CDO tranch garbage was ever rated as AAA, you now know. Rating agencies made money by rating it AAA.

Back to Mark Glennon: "Guess who is one of the two agencies slated to rate the new offering, hired by the city?"

Looking for another questionable Chicago debt rating? If so, I just happen to have one.

On May 11, BusinessWire reported Kroll Bond Rating Agency Assigns A- Rating with a Stable Outlook to Six Series of Reoffered City of Chicago, Illinois General Obligation Bonds.

Please note KBRA is registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization (NRSRO).

Kroll Background

How did Kroll break into the bond rating business? A February 2011 New York Times article explains: A Corporate Sleuth Tries the Credit Rating Field.
FEW people ever penetrate the dark side of money, but Jules Kroll is one of them. Fortunes plundered, ransoms paid, deals cut — the uncovering of such secrets, and the million smaller confidences that are his history, have made Mr. Kroll a rich man.

Which is why his latest venture seems at once so unusual and yet so very Kroll. At 69, an age when other multimillionaires are working on their backswings, he is getting into — of all things — the credit ratings business.

You might wonder why anyone pays attention to them anymore. After all, the financial crisis of 2008 and 2009 laid bare the conflicts at the heart of the ratings game. The world learned that the three dominant services — Moody’s, Standard & Poor’s and Fitch — had stamped sterling ratings on mortgage investments that turned out to be nearly worthless. It was a lesson that nearly brought down the financial system.

Some small ratings services have challenged the establishment by having investors — that is, the people who actually buy securities — pay for ratings. But for all his talk about shaking up this industry, Mr. Kroll is hewing to the status quo. Like Moody’s, S.& P. and Fitch, Kroll Bond Ratings will be paid by the issuers, just as the big three are.

“What does he know about giving me a rating on a security?” asks Richard X. Bove, an analyst at Rochdale Securities.

 Mr. Kroll, for his part, is thinking big — as he always has. He wants to grab 10 percent of this $4 billion-a-year industry within five years.

But even that seemingly modest goal may be a reach. Moody’s and S.& P. each have about 40 percent of the ratings market. The remainder is spread among Fitch and several lesser-known agencies.

“I think it’s a tough industry to break into, but if anyone can do it, it’s Jules Kroll,” says Michael Charkasky, the chief executive of Altegrity, which acquired Kroll Inc. last year.
How To Gain Market Share

Gaining market share is easy. All you have to do is give junk an AAA rating when the other guy won't.

The debt rating scam is such that you lose business if you do the job better than others. I repeat what I said in 2007: Time To Break Up The Credit Rating Cartel.

Mike "Mish" Shedlock

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