It didn’t take much to start a firm back then. Schroeder spent $400 on an IBM typewriter, purchased two calculators (for $200 each), a few desks, a couple of chairs and some filing cabinets. The total bill came to less than $1,000.
Respect, however, was much harder to come by. The day DBRS opened its doors, in a tiny 1,500-square-foot office on Toronto’s University Avenue, a crowd gathered outside Schroeder’s door. He soon saw what the commotion was about: Posted on the wall was a makeshift placard–a jab from his old colleagues at Wood Gundy–proclaiming the office as the new home of Sexy Susie’s Body Rub Parlour Inc. Schroeder says, “The people were outside laughing.”
But then, the beginnings of the entire industry, a century earlier, were also modest. During the railway boom, Henry Varnum Poor published detailed financial information about the sector in his Manual of the Railroads. By 1909, journalist John Moody was putting out his own manual, which used letter grades to rate railroad (and, later, corporate and government) securities. The letter-grade concept was popular with investors, so competitors soon followed suit–Poor’s in 1916, Standard Statistics in 1922 and Fitch in 1924. Standard and Poor’s would merge in 1941 to create S&P; in tandem with Moody’s, it would come to dominate the industry.
Just as stock analysts exist to figure out which equities are worth buying, bond ratings agencies evolved to inform investors which bonds were likely to be paid back, and which were the more risky bets and should be priced accordingly.
However, it was regulation–not entrepreneurial spirit–that ultimately solidified ratings agencies as a lucrative and heavily influential business. Soon after the 1929 stock market crash, the U.S. government began requiring banks to book the value of their bond portfolios according to ratings, in the hope of creating an early warning system for financial failures. At the same time, large investors began implementing internal policies stipulating that they would only carry bonds with an acceptable rating. By the 1970s, institutional investors such as pension funds universally required top ratings on all bonds they purchased, which essentially made the ratings agencies indispensable, for better or worse.
It also turned the market on its head. Investors were no longer the primary customer; that role belonged to the corporations issuing the bonds.
This was the industry’s game-changing moment. Suddenly each ratings agency became exponentially more profitable, given the number of corporations that needed ratings. This in spite of the obvious conflict of interest: The parties that the agencies were rating were also their customers. In the face of criticism, the Big Three insisted those conflicts were manageable, since no rater would willingly risk its good reputation by allowing itself to be influenced. A specific rating could not be bought, the industry argued.
The final piece of the puzzle came in the mid-1970s, when the Securities and Exchange Commission, concerned about fly-by-night agencies rushing into the market to make a quick buck with shoddy ratings, gave the agencies the only thing they didn’t already have–a licence, in effect.
The new designation, Nationally Recognized Statistical Rating Organizations, or NRSROs, effectively enshrined the ratings agencies in law, and cemented the Big Three’s hold. Yet there was no real reason to believe that only three firms had a monopoly on the skills involved. “I don’t think there is something particularly powerful in the ratings agencies in their ability to process information,” says Lynnette Purda, an associate professor of finance at Queen’s University. “But we’ve built them into legislation and regulations so that we only invest in particular products that have a particular rating from a particular firm.”
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Despite the influence that bond raters now wield, the process of how ratings are derived is poorly understood. In the popular imagination, the agencies are painted as judges deliberating a verdict, disappearing behind closed doors only to emerge days or weeks later with an alphabet soup of letters and symbols–AAA, A (low), BB+, CCC–upon which the fate of a company or a government’s financial situation can turn.
In fact, behind each agency there is no star chamber, but rather a ratings formula and a team of bond analysts. Analysts at DBRS work in pairs, each assigned to cover up to 15 to 20 companies or 10 countries. Much like equity analysts would, the analysts meet regularly with corporate management or government officials to discuss the financial state of affairs. These conversations, held in strict confidence, help form the rating, along with ongoing analysis of public and private financial data.
The rating is voted on by a committee and, whenever a material event occurs–say, a company makes a major acquisition, a government produces a new budget, or debt covenants are breached–the committee votes to maintain or change its rating.