Debt Ratings | some thoughts on the industry and prospects for the future

It is a Sunday morning in State College, PA. I spent time this morning thinking about reading and research I have done over the past weeks about the business of credit ratings. I will share some thoughts.

Background

The US market for credit rating agencies, also known in SEC parlance as NRSRO, includes nine competing firms: AM Best Rating Services, Fitch Ratings, Japan Credit Rating Agency, Kroll Bond Rating Agency, DBRS, Egan-Jones, HR Ratings, Moody’s Investor Service, and S&P Global Ratings. Among these nine firms, Moody’s, S&P, and Fitch are clearly the largest.

What does a ratings agency do? Here is a description I found online:

“A rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts. The rating assigned to a given debt shows an agency’s level of confidence that the borrower will honor its debt obligations as agreed.

Each agency uses unique letter-based scores to indicate if a debt has a low or high default risk and the financial stability of its issuer. The debt issuers may be sovereign nations, local and state governments, special purpose institutions, companies, or non-profit organizations…

Rating agencies assess the credit risk of specific debt securities and the borrowing entities. In the bond market, a rating agency provides an independent evaluation of the creditworthiness of debt securities issued by governments and corporations. Large bond issuers receive ratings from one or two of the big three rating agencies. In the United States, the agencies are held responsible for losses resulting from inaccurate and false ratings.

The ratings are used in structured finance transactions such as asset-backed securities, mortgage-backed securities, and collateralized debt obligations. Rating agencies focus on the type of pool underlying the security and the proposed capital structure to rate structured financial products. The issuers of the structured products pay rating agencies to not only rate them, but also to advise them on how to structure the tranches.

Rating agencies also give ratings to sovereign borrowers, who are the largest borrowers in most financial markets. Sovereign borrowers include national governments, state governments, municipalities, and other sovereign-supported institutions. The sovereign ratings given by a rating agency shows a sovereign’s ability to repay its debt.“

Source: This URL from Corporate Finance Institute

The “Big 3” referred to by the above quote include Moody’s Investor Services (MIS), Standard and Poor’s (S&P), and Fitch Group.

I grabbed the description of $MCO from the Fidelity platform. Here is the description of Moody’s:

Moody's Corporation operates as an integrated risk assessment firm worldwide. It operates in two segments, Moody's Investors Service and Moody's Analytics. The Moody's Investors Service segment publishes credit ratings and provides assessment services on various debt obligations, programs and facilities, and entities that issue such obligations, such as various corporate, financial institution, and governmental obligations; and structured finance securities. This segment provides ratings in approximately 140 countries. Its ratings are disseminated through press releases to the public through electronic media, including the internet and real-time information systems used by securities traders and investors. This segment has rated approximately 5,000 non-financial corporates; 3,600 financial institutions; 16,000 public finance issuers; 145 sovereigns; 47 supranational institutions; 459 sub-sovereigns; and 1,000 infrastructure and project finance issuers, as well as 9,100 structured finance deals. The Moody's Analytics segment develops a range of products and services that support the risk management activities of institutional participants in financial markets; and offers subscription based research, data, and analytical products comprising credit ratings, credit research, quantitative credit scores and other analytical tools, economic research and forecasts, business intelligence and company information products, commercial real estate data and analytical tools, and on-line and classroom-based training services, as well as credentialing and certification services. It also offers software solutions, as well as related risk management services; and offshore analytical and research services with learning solutions and certification programs. The company was formerly known as Dun and Bradstreet Company and changed its name to Moody's Corporation in September 2000. Moody's Corporation was founded in 1900 and is headquartered in New York, New York.

Moodys investment by Buffett

Warren Buffett’s firm, Berkshire Hathaway, has deep experience in the business of debt ratings. As disclosed in the 2001 annual report, Berkshire owned 24 million shares at a cost of USD $499 million, or $20.79 per share. Also, Berkshire was still an owner during the Great Financial Crisis:

“Buffett made one oblique reference to “ratings agencies” in his 2008 letter to shareholders. He blamed the raters and others, without naming Moody’s, for failing to heed the crash in the manufactured housing industry at the beginning of the decade. “Investors, government and rating agencies learned exactly nothing from the manufactured-home debacle. Instead, in an eerie rerun of that disaster, the same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments.”

Michael Corkery article in WSJ from June 1, 2010

It appears this investment has been very worthwhile for Hr. Buffett. By my read of the most recent SEC Form 13F, Berkshire owned at the end of Q3 24,669,778 shares worth USD $8.8 billion, or $356.71 per share.

When you compare agains the performance of the S&P 500 over the period since Buffett’s first purchases, it appears to have been quite a good (absolute and relative) return.

Trends

So, where are there trends in the marketplace for debt ratings? As a major player in the global market, $MCO should be positioned to offer some insights. From their Q3 investor presentation, I found the following slide:

So, the takeaways I note:

• Operating margins are attractive and are expected to continue to be attractive
• Overall demand, measured by total issuances, is expected to continue to grow, partially as a function of “subscription-based products”
• Structured finance is expected to double in issuance (i.e. 100% growth)

When I delve a bit deeper into the $MCO Q3 10Q, this seems reasonable based upon recent results.

The business of providing credible opinions and ratings on debt is one which has a relatively long history with high margins and an outlook for future secular growth (including an industry tailwind in the form of emerging ratings of ESG.)

Thoughts about investment opportunities

There are barriers to entry in the US and Europe through the registration processes within the SEC and ESMA, respectively. However, there is a clear opinion at ESMA reflected in ESMA Report on Trends, Risks, and Vulnerabilities that entry in this (highly concentrated) industry is beneficial. Specifically:

In Europe, the three largest CRAs have for years had an overall market share of more than 90 %. EU legislators sought to reduce this imbalance 10 years ago by supporting the use of small CRAs in Europe. This article applies SupTech-related techniques to take stock of market conditions since then, using a unique dataset containing all EU ratings issued and outstanding since 2015 (when the CRA Regulation’s reporting requirement entered into force), covering EUR 20 tn worth of EU financial products and nearly 6 000 issuer ratings. Using network analysis techniques, it is clear that the landscape for small CRAs at the EU level is a challenging one: small CRAs are used almost exclusively in local single-rating markets (the ‘periphery’), and are locked out of the larger ‘core’ market (of issuers seeking more than one rating for their products or themselves). This larger market is shared almost exclusively among the three largest CRAs, and the associated industry-wide Herfindahl-Hirschman Index (HHI) levels are consistently at levels usually deemed to be “highly concentrated”. Lastly, the article introduces a simulation exercise for alternative legislative rules designed to boost competition in EU markets for credit ratings. Strengthening legislative requirements to make use of small CRAs when seeking an additional rating for a product or issuer is associated with an average reduction in overall EU CRA industry concentration of roughly 40 to 55 %, leading to HHI levels that are no longer “highly concentrated” from a competition perspective.

So, perhaps there is an opportunity to capitalize on the growing market, emerging demands for ratings of ESG and structured vehicles, and European political zeitgeist favoring increasing competition across smaller credit ratings agencies?

When I think about attractive industries for investment, finding growing markets with barriers to entry and strong, consistent profit margins are important attributes to seek out. Berkshire Hathaway has performed extremely well with a thesis in this space over the past twenty years; I wonder if this is a situation where, when thinking about the performance of credit rating agencies over the next twenty years, history will rhyme. If so, I wonder if smaller agencies will provide the outperformance and consolidate to draw share from the Big 3. To be continued…