When ratings agencies are right, the results are uneventful. Like a plane that lands safely, a correct rating never makes the news. But when ratings are wrong, the results can be catastrophic, and there have been a few of those in the last decade or so. The collapses of Enron and WorldCom in 2001-’02 cast ratings agencies in a new and unfavourable light. Enron and WorldCom were both businesses built on false numbers and financial sleight of hand. But by the time S&P and Moody’s got around to marking them down below investment grade, the firms had already combusted. In the case of Enron, the company suffered a downgrade just four days before its demise. The early warning system had failed, miserably.
Investors didn’t have to look very far for a culprit. At congressional hearings probing the debacle, a ratings analyst for S&P admitted he hadn’t read all of Enron’s key financial filings. He had, however, taken Enron management at their word.
The Enron and WorldCom disasters prompted a shakeup of the rating industry. U.S. regulators feared the financial system was relying on too few ratings agencies. Adding new players would increase competition, which, it was hoped, would boost accuracy as well as reducing the dependency on one or two powerful firms.
The shakeup was a break for DBRS. It had been trying since 1990 to expand into the U.S. market, but had been turned away by regulators loath to give it the coveted NRSRO designation. Thanks to Enron et al., the Canadian agency was finally admitted to the club in 2003.
Though DBRS ran a distant fourth to the Big Three in size–it is about a quarter the size of Moody’s–Schroeder was now at the helm of a pre-eminent North American ratings agency. (Privately held, DBRS does not disclose financial data. Its head count stands at 280, dispersed in Toronto, New York, Chicago and London.)
But more competition in the ratings world would lead to a different set of problems only a few years later. By the mid-2000s, a new monster was lurking in the financial world: structured finance.
In order to make the riskier sort of loan–such as subprime mortgages–palatable for conservative investors hungry for higher yields, lenders started packaging those debt products together with lower-risk investments, and marketed the bundles as safe. These bundles needed ratings, and with competition now on the upswing, ratings agencies were anxious to fight for a slice of this rapidly growing market. Many of these complex investments were given top ratings from the agencies, suggesting they were safe–a mistake now seen as irresponsible, if not reckless. When the subprime housing market crumbled in the U.S., it took the structured finance market down with it. And these supposedly safe investments were suddenly worth pennies on the dollar.
In Canada, the fallout had its own particular ugliness, and DBRS was in the middle of it. Canada’s structured finance market was driven by asset-backed commercial paper (ABCP). The investment houses selling these bundled products needed two things: an investment-grade rating from an agency, and a liquidity backstop for the paper they were peddling, in case the market froze. Banks and other financial institutions agreed to provide the backstop for a fee. But there was a problem: Under Canadian-style liquidity arrangements, the banks would only have to pay out on this liquidity commitment in the event of a “general market disruption.”
The conditions that had to be met for such a fix set the bar extremely high–so long as there was any paper trading, there was no market disruption. Moody’s and S&P looked warily at the “general market disruption” clause and determined the paper was too risky to rate. DBRS disagreed and figured the assets were safe, because the chances the market would implode were remote. After all, ABCP carried only small amounts of subprime mortgages at worst, and the asset mix was healthy. Breaking from the pack, DBRS stamped one of its highest ratings on ABCP, and the products were snapped up by institutional and mom-and-pop investors alike.
But when fears over subprime mortgages began to emerge in the U.S., much of the ABCP market in Canada–about $35-billion worth of paper–froze. Nobody was buying, so no one could sell, which cast the entire asset class into doubt. However, several banks disagreed that the market had suffered a “general disruption” that would require them to kick in funding, since some segments of the market were still functioning.
Investors were stuck with no access to their money. Amid the chaos, it took more than a year for the banks, lawyers and a bankruptcy judge to unravel the mess. The frozen paper was restructured: The ABCP notes were exchanged for long-term paper. That meant even though investors would get much of their money back, it would take many years. Those who bailed out and sold took a hit. Fingers were pointed squarely at DBRS.