On the morning of Aug. 8, bankers and politicians in Madrid awoke to a sense of dread about their tattered financial system. It was an easy feeling to have in a country where one in four people is unemployed, the government is nearly insolvent, and many of the banks were on daily bailout watch.
But on this particular day, there was yet another reason to feel queasy in Spain. In recent months, Moody’s, Standard & Poor’s and Fitch—the three biggest names in the credit rating business—had all dramatically downgraded Spain’s sovereign debt. They had ratcheted down their assessment of the reliability of Spain’s bonds not just one notch, but had inflicted a humbling degradation of as many as three rungs in a single decision. Spanish bullfighters have a word for this kind of thing—cornada. That’s when the matador is gored.
Sovereign credit ratings measure the confidence that a country can pay back its debt on time, and in full. Triple-A is the gold standard, but Spain was now plumbing the depths of investment-grade status. It wasn’t quite junk-bond territory, but it was a perilous step in the wrong direction. If you lent a dollar to Spain, the chances were that you might not get it all back, according to the raters.
Under normal circumstances, a trio of significant downgrades from the Big Three firms that dominate the ratings industry would have dealt a serious blow to the country, sending borrowing costs sharply higher. But in recent years, a fourth ratings agency has emerged on the scene in Europe, and this player now held a significant chunk of the Spanish banking system’s fate in its hands.
If it followed suit and slashed Spain’s credit rating to below A-status, the impact would be swift, and serve to compound the country’s problems. Without a minimum single-A rating, government bonds would be instantly less valuable to the banks that use them as insurance on loans from the European Central Bank: The banks would immediately have to post 5 per cent more collateral. With more than €375 billion in loans outstanding, that extra 5 per cent equalled as much as €18.75 billion–money that the debt-ridden country and its teetering banks would be hard-pressed to produce.
Thus the new kid on the ratings block, Dominion Bond Rating Service of Toronto, suddenly has a pivotal role in the euro crisis, with billions of dollars at stake.
DBRS has a tendency in Europe to issue its ratings after the Big Three have already weighed in, which can give its decisions extra clout, tilting the balance one way or the other. “One could argue,” a report by JPMorgan said last spring, “that rating changes by DBRS are the most important for sovereign bonds held as collateral at the ECB.”
With the eyes of Europe now fixed on DBRS, what would the upstart from Canada do?
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Credit ratings are now ubiquitous in the machinery of the world’s financial system. But Walter Schroeder remembers a time when his biggest job was telling companies why they needed a rating at all. “I used to have to explain to people, this is what a rating is, here’s how we do it, and this is why it’s important,” says the founder and chairman of DBRS. “I call it speech one.”
It was a speech Schroeder, who is now 71, delivered often in the early 1970s, when he was a hungry young credit analyst at Wood Gundy Ltd. on Bay Street. When corporate clients came looking to raise money in the bond market, Schroeder’s job was to help them secure ratings from the Big Three credit agencies.
But on countless trips to New York brokering meetings with the raters, one thought kept running through his mind: These companies were making a lot of money issuing ratings. But if you had the skills–a mix of accounting, finance and market knowledge–and the right contacts, it wasn’t that tough to figure out. When it came to issuing ratings for Canada, he could do this job better himself, Schroeder believed. “Everybody around the world seemed to rely on Moody’s and S&P,” he recalls. “Those two were supreme.”
In 1976, while driving to Montreal on a family vacation, Schroeder started sketching out a business plan in his head. By the time his Volkswagen Beetle had reached its destination, his mind was made up. He would build a bond ratings agency from scratch. “It was a volatile market–interest rates were 18 per cent back then–and there was a need for credit research of some sort, but there was none available in Canada. It was an extremely lucrative market potentially.”
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