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Brian Neysmith spent his career assessing other people's potential and their problems.

As the former head of Canadian Bond Rating Service, he worked for three decades in the ratings game, before his firm was sold to the giant Standard & Poor's Corp. He and his employees studied companies, governments and other entities that issue debt the way teachers mark their students, assigning them grades based on the perceived risk of default.

In the beginning, the ratings business was that simple, as outfits like CBRS gave grades – backed up with written explanations – that the markets could accept or reject. But as the financial world grew exponentially through the 1980s and '90s, the raters were asked to be tutors as well, guiding securities issuers as well as investors in a risky game itself that may have been at the root of this summer's market turmoil, which damaged investment portfolios around the world.

For Mr. Neysmith, who retired five years ago, there's a simple analogy:Pretend you're a park ranger, and a camper wants to cross a big lake. He tells you he's got a canoe, a paddle and a lifejacket, and asks what his chances are of crossing safely. You ask him what his canoeing experience is, and conclude that his chances are decent.

But then the camper asks what he would have to do for you to conclude that his chances were excellent. And so you tell him that he needs to add a flotation device, heavy weather gear and an extra set of paddles, just in case one falls out. And you say that if he does all that, you'll give him a 100 per cent chance of success.

“In other words, the rating agencies became part of the advice,” Mr. Neysmith says. “It's conjecture, but maybe rating agencies shouldn't be too close to the market. Maybe they should really stand back.”

That perceived conflict is part of what has North America's rating agencies – once a revered source of judgment – under a cloud. Officials in the United States and Europe are calling for new scrutiny and tougher rules for credit-rating agencies. The Securities and Exchange Commission confirmed yesterday that it has begun a review of credit-rating agency policies and procedures, focusing on their role in the subprime debacle. The review will include looking at conflicts of interest and the meanings of ratings.

And unpleasant questions are being asked about the role of ratings companies like S&P, whose president resigned abruptly in late August, and its Canadian rival DBRS Ltd., which is at the centre of the commercial paper crisis. Were they complicit in creating securities that were doomed for trouble? Should they have spotted this financial storm coming? And, if they aren't able to properly advise investors how risky securities are, then what are they there for?

Mr. Neysmith believes the market has come to give credit-rating agencies such a degree of credence that “it basically feels [like] if the rating agencies make a pronouncement, it's the next best thing to Moses handing down the tablets.” What has been forgotten, he says, is that “raters make mistakes. They have a history of making mistakes.”

Of course, it's one thing to develop a Moses-like reputation when times are good and debts aren't defaulting. It's an entirely different challenge when trouble strikes.

But for some of those who still give the ratings, it's an assessment, not a judgment. “It is an opinion,” says Vickie Tillman, executive vice-president of credit market services for Standard & Poor's, a rating giant that issues as many as 10,000 ratings a day. “Opinions are opinions, and people can choose to take stock in the opinions.”

From riding the rails to ruling the roost

These days, rating agencies have become so enshrined in the way debt markets work, they are taken for granted as essential to the process. But it wasn't always so.

They trace their roots back to more than a century ago, a time when the big investment game was railroads. In the late 1860s, Henry Varnum Poor and his son Henry William Poor published the Manual of Railroads of the United States. Chock-full of information for investors, it sold more than 2,500 copies within months, at $5 a pop. By 1910, John Moody had gotten into the game – he published a book analyzing railroads and their outstanding securities, and assigned ratings to them. And just like that, rating agencies were born.

They continued to grow and the crash of 1929 turned out to be a boon to business: The 1930s saw the institution of many investment policies stating that bonds must have a certain rating to be acceptable.

The rating agencies carried on as essentially “little research houses staffed by people who only made their money selling manuals,” Mr. Neysmith said.

The big shakeup came in the late 1960s and early 1970s. For one, rating agencies began to charge debt issuers; in other words, corporations that were issuing debt began paying the agencies for ratings. The ratings agencies say the move was necessary because subscription fees weren't enough to pay the high-quality staff they required.

The agencies also began rating commercial paper, as that market burgeoned.

All this culminated in a fundamental shift in the industry. Up until the late 1960s, raters “looked at the bond market, or they looked at borrowers, they did their work, they published their work, and they went on,” Mr. Neysmith said. “They were not tied up in the system like they are today.”

For instance, because the vast majority of rating agencies' revenue – by most estimates, in excess of 90 per cent – comes from the debt issuers, as opposed to subscription fees paid by investors, the agencies are dependent on new debt being issued in order to keep up profits. New areas of structured finance mean new opportunities to make money.

On the flip side, the debt issuers are dependent on the rating agencies' seal of approval. A plethora of laws require debt issuers to obtain certain ratings, ingraining the agencies into the fabric of how debt markets function.

DBRS is born, and starts looking abroad

Back in 1976, in the midst of this change, Walter Schroeder left Canadian investment dealer Wood Gundy Ltd. to start Dominion Bond Rating Service, a company that rated short-term commercial paper. Thirty-one years on, he has successfully built the firm now known as DBRS into an agency with more than 300 employees who rate thousands of issuers.

The game plan was to grow slowly, out of the company's free cash flow, without taking on any of its own debt. The key to a rating agency's success is to have a trusted brand, and Mr. Schroeder believed that takes time.

But he also recognized early on that a credit-rating agency must expand beyond its own borders, said his son, David Schroeder, currently DBRS's chief operating officer.

In 1990, DBRS tried to break into the coveted U.S. market. But it would be 13 years before the debt-rating agency would receive its designation from the Securities and Exchange Commission to become a Nationally Recognized Statistical Rating Organization, or NRSRO. There was no such obstacle to setting up shop in Canada.

That title was finally bestowed on DBRS in the wake of two high-profile bankruptcies: Enron Corp. and WorldCom Inc. Rating agencies in the United States failed to warn investors of these collapses. Regulators wanted to take action. Mr. Schroeder helped convince them a new entrant would fuel competition.

DBRS became the fourth NRSRO in the American market, pitting it against global heavyweights S&P, Moody's Investors Service and Fitch Ratings. It went on to set up shop in Europe, and has its sights on Asia. DBRS recently had its name put up in lights, with its brand crowning one of the glass towers in downtown Toronto's financial district.

“I think the vision, simply put, is to become the most respected rating agency globally,” said David Schroeder, whose family still owns 100 per cent of the company.

And then the dominoes started to fall

Around the time DBRS was making its strides south of the border, an obscure financing mechanism was also taking off: The commercial paper market had hit a new stage in its evolution.

Asset-backed commercial paper (ABCP) is created by pooling together big packages of loans, such as mortgages or credit card debts or car leases. The receivables are bought and then financed by issuing short-term commercial paper.

The big banks had been doing this for some time, using ABCP to finance their loans as well as those of their customers. But, about seven years ago, financing experts recognized an opportunity and formed companies that began issuing ABCP through their own trusts. The market for non-bank ABCP soared in Canada, and is worth more than $35-billion.

Only DBRS agreed to rate these trusts, with S&P and Moody's deciding a loophole in emergency-funding provisions unique to the Canadian market was too risky. Many of the trusts obtained DBRS's highest rating.

The commercial paper was snapped up by investors ranging from giant institutions such as the Caisse de dépôt et placement du Québec to small mining firms in B.C.

“When you've got cash sitting around, you phone your banker, or you phone your money desk, and you say ‘I've got cash, what can you show me?' ” said Richard Gusella, chairman of Calgary-based Petrolifera Petroleum Ltd. “And they tell you, ‘I've got 30-day Apsley Trust R1-high rated paper, per DBRS, and other people are buying it.' And they say this is better than bank paper, and so you buy it,” he said.

The company had invested about $37.7-million, or more than half its total cash, in asset-backed securities. Its cash management policy had been to invest in short-term securities with DBRS's highest rating, R1-High. On Aug. 15, $31.4-million of the notes became due but were not repaid. Mr. Gusella says the company is not in financial difficulty now – but he wants his money.

This past month, a series of dominoes tumbled fast and furious, whacking the Canadian non-bank ABCP market and leaving many of its investors in a lurch.

The chain reaction began in the United States, where the popularity of subprime mortgages – those offered to home buyers with credit problems – had exploded.

“In the past, your neighbourhood bank would take your credit application and give you a mortgage. And if you paid on it, they'd make money, if you didn't pay, they'd lose money,” said Huston Loke, DBRS's head of global structured finance.

As subprime loans became more popular, more banks were looking to sell them, rather than keep them. That meant they didn't suffer the consequences if the borrower didn't pay. Those consequences were shuffled out through the market in the form of various structured credit products.

Last year, defaults in U.S. subprime mortgages began to rise dramatically. This summer, investors panicked, and fled investments related to subprime mortgages as well as others with too much risk.

ABCP around the world took a hit. But, because of the loophole that scared away S&P and Moody's, some of the emergency-funding lines in Canada didn't come through, and the non-bank ABCP market was tossed into disarray.

It turns out that only a relatively small proportion of those big loan packages underlying the commercial paper is related to U.S. subprime mortgages. But investors weren't sure how much subprime exposure the complicated securities had, and chose to pull the trigger and ask questions later.

Some investors blamed DBRS for a lack of transparency, and for not spelling out the risk involved in these securities. Mr. Loke points out that various other types of securities, which DBRS chose not to rate, were also hammered.

Some observers, such as Mr. Neysmith, believe too many fingers are pointing at DBRS as opposed to investors who didn't do their own homework.

“The problem from the investor side was that, to a certain degree, investors turned over their fiduciary responsibility to analyze and to know everything they bought to the credit-rating agencies,” he said. “If the credit-rating agencies said it was a single-A, it was good enough for them.”

“DBRS didn't cover up anything, and it was well documented,” he added. “Nobody realized that a sequence of events could happen that would back up the whole market.”

Peter Bethlenfalvy, DBRS's managing director of global corporate finance, noted that since its inception, the Canadian ABCP market had sailed smoothly through numerous times of market trouble, such as the terrorist attacks of Sept. 11, 2001, and SARS.

“If you look at all the rating agencies, we've all got our situations where you do your best to give an opinion based on the facts,” he said. “When you reassess, based on fundamental changes, and the facts change, then you've got to have the guts to say ‘this is our new criteria.' ”

DBRS recently took the unusual step of announcing that it is reviewing its rating criteria for Canadian ABCP. That process is not yet complete. One element of it will be to review the use of market disruption provisions. The rating agency also plans to take pains to show it is currently spending more time considering hypothetical situations.

“We believe we should be looking at this and saying ‘okay, these are things that we didn't expect, that the market didn't expect,' [but] we need to give investors confidence as to how this gets overcome the next time around,” Mr. Loke said.

“Do you have regrets? You never feel good,” Mr. Bethlenfalvy said of the situations the rating agencies find themselves in today. “But, if any rating agency tried to map out the worst-case scenario, 300 deviations, we'd all be at triple-C for everything and it would add no value. So, we have to assume that there are somewhat rational markets and rational behaviour.”

Predicting ‘the big one'

While provincial and federal finance officials are concerned about the role DBRS played in the ABCP market's problems, jurisdiction of rating agencies falls between the cracks separating provincial securities commissions, the Bank of Canada and the federal Office of the Superintendent of Financial Institutions. At this point, no Canadian regulator is specifically addressing the issues surrounding ratings agencies.

In the United States, critics are lambasting the three biggest rating agencies – S&P, Moody's and Fitch – alleging they did not sufficiently warn investors of the risk involved in securities related to subprime loans. S&P's has also been under the gun for its role in sanctioning piggyback mortgages, where borrowers take out an additional loan to make a down payment. It has also been criticized for downgrading sizable amounts of securities at once.James Jockle, a spokesman for Fitch, said a recent misconception is the idea that credit-rating agencies are advising on the suitability of an investment.

He compares the agencies to Consumer Reports. If you're buying a car and you want the best engine out there, you could look at the Consumer Reports ratings, which have looked at all of the engines based on certain parameters. Lets say they've concluded the best engine comes from a Toyota Camry. “But my pocket is flush with cash, and I can afford a Porsche, I'm going to buy a Porsche. Our role is similar in that way, to say, ‘security X to security Y, this one has more credit risk than the other one,' and we're going to tell you all the parameters of why we think so.

“We're not [auditing firm] PricewaterhouseCoopers, we're not verifying,” he said. “We're not a regulator. We're coming in and saying, based on the information we have, this tranche versus this tranche, the likelihood that you're going to get paid is better or worse.”

Many observers said credit-rating agencies live and die by their reputations, and would cease to exist if the market lost its faith in them. That creates a natural incentive for raters to give the most accurate opinion they can.

But that argument holds less weight now, considering how integral the raters have become to the system.

The SEC's decision to launch a review comes just months after new legislation was enacted in the United States that clarifies exactly what credit agencies must do to win regulatory approval, a move that is intended to make it easier for new rating agencies to enter the market.

More competition might be one part of a solution. Debt issuers would have more options, and the raters would be kept on their toes. As it stands, many issuers traditionally are required, or choose, to obtain two ratings on their debt (although some choose to obtain three or more, and some one or none). With less than a handful of major globally recognized firms to choose from, the ball is often in the raters' court.

Evidence of that is the fees that raters charge issuers, which vary by agency and then differ between customers based on numerous factors, including the size and complexity of the transaction, and whether the debt issuer does repeat business with the rating agency. By and large, this is a highly profitable business.

DBRS is private and will not disclose profits, but Mr. Schroeder says sales have grown by about 25 per cent in the past three years. S&P, which is part of McGraw-Hill Cos. Inc., publishes a general fee schedule that says its minimum fee for a corporate rating is $65,000 (U.S.). Fees on sovereign debt typically range from $50,000 to $200,000. And of course, “higher fees apply to more complex transactions.”

A standardization of fees, or at least further disclosure in this area, might also be a part of the solution.

What will not help, many observers argue, is a plethora of new rules governing how the rating agencies should operate. “It's not really going to make a big difference,” Mr. Neysmith said. “How do you regulate predicting the future?

“No possible regulation I've ever seen would have stopped what has occurred in the U.S. in terms of subprime. These are errors. These are errors in analysis. These are errors in judgment. I don't think anything is willful.”

The best investor protection in this respect might be exactly what has occurred – a simple awakening to the risks involved in debt securities, and a more realistic view of what rating agencies are.

“Every bond rater, when they go to sleep at night, says a prayer that one day they'll be able to predict the big one,” Mr. Neysmith said. “Every now and then, that happens. But more often than not they miss some of these.”

With files from reporter Andrew Willis