Rating Public Pension Funds?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Last week Tara Perkins of the Globe and Mail reported that rating agencies are at the crossroads:

Just
like the investment portfolios of most Canadians, Walter Schroeder is a
shrunken version of his former self in the wake of the financial crisis.

The
67-year-old founder of credit rating agency DBRS Ltd. has lost a
noticeable amount of weight, something that acquaintances point to when
speaking of the stress he and his team have endured over the past
couple of years.

More than three decades after conceiving a
brazen business plan for a Canadian credit rating agency during a
family road trip in his Volkswagen Beetle, Mr. Schroeder succeeded in
building DBRS into the country's pre-eminent rating agency.

But
a year after Lehman Brothers imploded, DBRS, along with other credit
raters, is battling the fallout of having given high ratings to a
number of securities that cratered. Now, the agencies are under fire
from investors, regulators and politicians who are introducing new
rules for the sector.

For Mr. Schroeder, “this is easily the
worst” economic cycle in recent history. “I've seen them all, from '72,
'82, '92, to 2002,” he said.

In the years leading up to Lehman,
credit raters became a backbone of the financial system. Their ratings
affect everything from the interest rates companies pay to raise money,
to the amount of capital banks must hold, to pension funds' investment
decisions.

In the aftermath of Lehman, the rating agencies are
fighting some of the proposed reforms and also searching for ways to
maintain profits. The recession has bitten into their revenues, and
some proposed regulations could leave teeth marks deep enough to cause
permanent scars.

The outcome of this evolution will not only
change the ratings business, but the way that many investors make
choices about where to park their money.

Long before Lehman
failed, the credit crisis reared its head in Canada and quickly turned
the spotlight on DBRS. Canada's homegrown rating agency was the only
one to rate $33-billion worth of third-party asset-backed commercial
paper, and assigned high ratings to most of it. The ABCP market froze
in August, 2007, when investors suddenly panicked about potential
exposure to subprime mortgages. That became the biggest financial
headache this country would face as a direct result of the crisis.
Other rating agencies say they refused to rate the paper because of
possible risks it posed.

The ABCP
crisis left thousands of Canadians unable to tap into portions of their
savings. In the finger-pointing that ensued, the country's banking
regulator questioned why investors would buy a product that only one
agency had weighed in on. DBRS, like all of the main players in the
third-party ABCP market, was eventually protected from a flurry of
lawsuits by way of a special indemnity clause that was written into the
plan to restructure the market.

DBRS is a private company and
doesn't disclose financial results, but it is one of the biggest
players in a sector with estimated sales of more than $5-billion (U.S.)
a year. Larger rivals Standard & Poors Corp. and Moody's Investors
Service Inc. each saw revenues from their ratings businesses fall by
more than 9 per cent in the latest quarter, but their sales still
amounted to hundreds of millions of dollars apiece.

Globally,
the big three rating agencies – S&P, Moody's and Fitch Ratings –
have borne the brunt of the criticism, and their businesses could
change dramatically as policy makers figure out ways to serve investors
better.

Whether agencies should be legally liable for their
ratings is one of dozens of questions regulators are considering as
they debate reforms. Until now, U.S. courts have struck down major
lawsuits against the agencies on the basis of free speech.

Imposing
more liability on agencies could motivate them to give out low ratings,
Fitch's chief executive officer Stephen Joynt told the U.S. House of
Representatives in May.

“A Fitch rating is our opinion about the
future financial capacity of a company or other issuer to pay its
debt,” he said. “It is not a statement of fact or a professional
judgment. It is not a recommendation to buy a security, it is not
investment advice, it is not an advertisement or an offer to buy or
sell a security.”

Beyond liability, one of the most talked-about proposals is changing the way agencies earn money.

Since
the 1970s, they have been charging companies and other issuers of debt
fees for ratings. For instance, S&P, which publishes a general fee
schedule, charges corporations, such as banks, a minimum of $70,000 or
up to 4.25 basis points per transaction. (A basis point is 1/100th of a
percentage point.)

Critics charge that it's a conflict of interest for agencies to be taking fees from companies they rate.

“A
good way to do it, and a fair way to do it, would be to have investors
who use their services – research and ratings – pay for it,” says Paul
Rivett, a spokesman for Fairfax Financial Holdings Ltd. “If [the agency
is] not good and the analysis is not sound, no one's going to pay.”

The
industry argues that people who use ratings also have a vested interest
in them. “Potential conflicts exist regardless of who pays. The key is
how well the rating agencies manage the potential conflicts,” Moody's
CEO Raymond McDaniel said in hearings at the U.S. House of
Representatives.

Ironically, many officials in the ratings
business argue the market's reliance on ratings goes beyond what they
were intended for. As S&P states in a subscriber contract: “Any
user of the information contained in any of the services should not
rely on any credit rating or other opinion contained therein in making
any investment decision.”

Ratings look at a company's or other
borrower's ability to repay debt. While they serve an important
purpose, “investors benefit from having multiple perspectives, can't
rely on single sources, and must do their own due diligence,” says Don
Guloien,
chief executive officer of Manulife Financial Corp., whose previous job
was running the company's massive investment portfolio.

Charles
Dallara, managing director of the Washington-based Institute of
International Finance, says “investors perhaps do bear their own share
of responsibility for undo reliance on ratings, but that does not
absolve the rating agencies from their inadequate management of the
rating process on these structured products.”

For his part, Mr. Rivett believes that switching to a user-pay model would spur competition in the ratings business.

The
ratings business, dominated by the big three rating agencies, is the
most concentrated business in the world, Mr. Schroeder claims.

DBRS
is one of 10 agencies the U.S. Securities and Exchange Commission deems
to be a Nationally Recognized Statistical Rating Organization (NRSRO).
It's a designation that once applied only to the big three, but the SEC
has been trying to foster competition. (More than 50 other competitors
have not applied for the designation.)

It might have been trying
too hard. In August, its auditor-general released a report criticizing
it for not doing enough due diligence before approving some agencies.

The
report also noted that increased competition could actually reduce the
quality of ratings by spurring “forum shopping,” where a company seeks
a rating from multiple agencies and hires the one that provides the
highest.

Meanwhile, the head of the SEC wants a requirement that
all agencies be registered, something that the G20 favours and the
Obama administration has proposed. The European Union has already
adopted a law requiring registration.

In Canada, the Canadian
Securities Administrators (CSA) has recommended that the business be
regulated. Securities regulators should have the authority to review,
and require changes to, the practices and procedures of rating
agencies, it suggests. The CSA made the recommendation last fall and is
still looking at the issue while watching to see what other
jurisdictions do so that it can develop regulations that are consistent.

More
regulations are likely to increase costs, if not reduce revenue, for
agencies that have already laid off staff as a result of the crisis.

For
DBRS, the timing of the crisis was particularly bad. It finally had its
name emblazoned in lights on top of a tower in Toronto's financial
district. It was making inroads in the United States, and had opened
offices in Europe.

It closed its three European offices last
year, laying off 43 people in London, Paris and Frankfurt, and some
staff in North America. Its worldwide headcount is down to about 175,
from 280 before the crisis.

“We felt that European rating
assignments could be handled by our New York and Toronto-based
analytical teams, and decided that three local offices were not
necessary, given the credit crunch,” says Huston Loke, co-president of
DBRS's Canadian business. One of the changes that European regulators
are now looking for is ensuring that agencies have an on-the-ground
presence. With markets stabilizing, DBRS is considering opening a
European office in the future, Mr. Loke says.

Meanwhile, Mr.
Schroeder moved from president to chairman in December, initiating a
series of management changes that left his son David, 38, CEO.

Mr.
Loke and Peter Bethlenfalvy were promoted to co-heads of the Canadian
business. They acknowledge that they have had a lot of tough
conversations with debt issuers and users of their ratings, and say
that they're learning from those.

“We've evolved,” Mr.
Bethlenfalvy says. DBRS wants to move beyond ratings to become more of
a credit information provider, by issuing newsletters, research and
“thought pieces.”

It has new products. One is something it calls
an impact assessment, where DBRS tells an issuer what the rating impact
will be following a major strategic deal. For example, when an oil
patch company considered splitting into separate oil and natural gas
companies, DBRS told it with certainty what the ratings would be on
each business following the split.

It sounds eerily similar to
the so-called reverse engineering of ratings that agencies have come
under fire for – helping issuers put together structured products in
such a way that they receive top ratings – but Mr. Bethlenfalvy said
impact assessments are different because “we only rate capital
structures and businesses as presented, and do not structure or give
any advice.”

Another is called
transparency rating meetings, where DBRS hosts a session for clients
who want to better understand how the agency's methodologies work, and
the drivers that affect the client's rating.

“Over the long term, we want to do much more – provide information, transparency, and help with understanding,” Mr. Loke says.

Mr.
Schroeder still says foreign markets are key. “I think Canada is
probably a very stable market,” he says. “I think the growth is going
to be outside of Canada for us.”

The company's reorganization
saw Dan Curry recruited to head the U.S. business. He has dedicated
much of his time to the agency's relationship with regulators.

“We
were complaining to the Fed and anyone else who would listen that they
seemed to have a bias towards relying on the three large U.S.-based
rating agencies,” says Mr. Curry, who was previously a managing
director at Moody's.

Ironically, he saw it as a big breakthrough
when DBRS began receiving calls to testify at hearings about the
problems in the industry. “We captured some mind share, so when they
think about industry issues they're interested in our input as well.”

A
major coup was the Fed's decision in May to include DBRS on the list of
agencies whose ratings will be recognized on commercial mortgage-backed
securities (CMBS) that are eligible under the U.S. government's program
designed to boost credit and the economy by trying to revive part of
the securitization market.

Originally the Fed was going to limit
participation to the big three agencies, and DBRS worked to convince
them to include a fourth, Mr. Curry says. The Fed said in May that CMBS
had to have at least two triple-A ratings to be eligible for the
program, and it would recognize those from the big three as well as
DBRS and another agency called Realpoint.

Warren Buffett's
decision to sell some of Berkshire Hathway Inc.'s shares in Moody's
Corp. this summer was read as a negative sign for future profits in the
industry.

But “it's still a reasonably good business,” Mr.
Schroeder says. He suspects that new oversight will scare away some
entrepreneurs who might otherwise have started an agency.

“With
regulation and everything happening on control and transparency, it's
going to get tougher and tougher for more competition to develop in
this market, simply because it's going to get much more complex,” he
says. The technology and software required for modeling, accounting,
auditing and surveillance is increasing significantly.

“When we started out, our biggest capital expenditure was just a shade over $1,000.”

Yesterday, the Investment Executive reported that according to DBRS, Canadian public pension funds hard hit by downturn are still solid:

Public
pension plans and asset managers have been rocked by poor returns, but
their credit ratings remain strong, DBRS Ltd. said Monday.

Pension
plans rated by DBRS include the Caisse de dépôt et placement du Québec,
Canada Pension Plan Investment Board, Ontario Teachers’ Pension Plan
Board, OMERS Administration Corp. and Public Sector Pension Investment
Board.

According to new
research from the credit rating agency, while the public pension funds
and asset managers it rates “have been adversely affected by the
challenging economic environment that prevailed in 2008 and into 2009”,
they remain solid credits. DBRS points to several factors that support
their high credit ratings, including low leverage, superior liquidity
positions and strong sponsorship, along with large asset bases.

DBRS
notes that the funds and mangers it rates were certainly hurt by the
financial market turmoil, reporting returns of -15% to -25% in the last
fiscal year. “The poor investment performance had the effect of
significantly shrinking their asset base and eroding their funding
position, suggesting that the risk level in certain portfolios may have
been higher than originally measured. This situation also generated
considerable attention among investors trying to assess the potential
impact of the losses on the credit profiles of these organizations,” it
says.

Moreover, the rating
agency allows that the downturn has reduced the financial flexibility
of these operations, and that it will likely take several years to make
up for the poor performance. However, it maintains that they retain
“considerable resilience” and that these factors keep them highly
rated. “DBRS believes that these credits have the necessary flexibility
to weather the downturn, provided leverage is kept under control and no
attempt is made to recover the recent losses through increased
risk-taking,” says Eric Beauchemin, managing director at DBRS.

Let's set aside the potential conflicts of interest of having DBRS
rate Canadian public pension funds who bought ABCP paper based on their
ratings (Caisse, PSP Investments, and Ontario Teachers).

I agree
with DBRS, it will take several years for these funds to make up for
the poor performance, but I question the assumption of "low leverage
and superior liquidity positions". There is plenty of leverage and low
liquidity in private equity, real estate and infrastructure holdings
and to a lesser extent, hedge fund holdings.

More importantly, how can DBRS or any rating agency rate these public pension funds without conducting thorough independent performance and operational audits?
To do that, they need full transparency on the benchmarks governing
internal and external investments. That information is not readily
available, especially for private markets.

Finally, I am not sure that leverage will
remain "under control" or that no attempts will be made to "recover
recent losses through increased risk-taking". There too, I agree with
DBRS, but I fear that the pension parrots will crank it up once again,
especially if they're underperforming their peers.

It's not just
rating agencies that are at the crossroads, but pension funds are at
the crossroads too. We need a governance overhaul that introduces more
transparency and a compensation system that rewards risk-adjusted
returns. The status quo at rating agencies and pension funds is totally
unacceptable.

***UPDATE: Moody's accused of issuing inflated ratings***

Based on news from the WSJ, Reuters reports that Moody's accused of issuing inflated ratings:

A
former analyst with Moody's Corp has accused the credit ratings agency
of issuing inflated ratings, and has taken his concerns to U.S.
congressional investigators, the Wall Street Journal reported on
Wednesday.

In
a letter dated July, obtained by the paper, Eric Kolchinsky accused
Moody's Investor Service of issuing a high rating to a complicated debt
security in January, in spite of it being aware it was planning to
downgrade assets backing the securities.

"Moody's
issued an opinion which was known to be wrong," Kolchinsky wrote, along
with detailing other instances of inflated ratings issuance, according
to the paper.

The paper
said a Moody's spokesman declined to comment on the January rating
under scrutiny, but had said Kolchinsky refused to cooperate with an
investigation into the issues he raised, and was suspended with pay.

Kolchinsky
is scheduled to testify on ratings firm reform before the House
Committee on Oversight and Government Reform on Thursday, the paper
said.

Moody's was not available to comment.

Inflated
ratings only serve to distort the true financial health of a company or
pension fund. The model governing rating agencies and pension funds
needs to be revisited.

Comments

[Dogfather]

That comment was directed at the Shroeder dude, the rest of the article as too tedious to complete, snore-City....

[Dogfather]

Whatever this breed of leech is, he is most probably related to the American Home Appraisal Professional, still waiting for a clue.

[Anonymous]

I've always felt that last October's true bailout recipients were the pension funds. Many would have been irreversibly ruined by an AIG default to counterparties.

Now the catchup growth provisions DEMAND accelerated risk. None of the defined benefit plans are scaling back expectations. In fact, these plans are just entering into a new more perilous phase....the CRE MBS issue. All rated AAA, I presume.

It's another setup for the big KA-BOOM !!

[Leo Kolivakis]

***UPDATE: Moody's accused of issuing inflated ratings***

Based on news from the WSJ, Reuters reports that Moody's accused of issuing inflated ratings:

A former analyst with Moody's Corp has accused the credit ratings agency of issuing inflated ratings, and has taken his concerns to U.S. congressional investigators, the Wall Street Journal reported on Wednesday.

In a letter dated July, obtained by the paper, Eric Kolchinsky accused Moody's Investor Service of issuing a high rating to a complicated debt security in January, in spite of it being aware it was planning to downgrade assets backing the securities.

"Moody's issued an opinion which was known to be wrong," Kolchinsky wrote, along with detailing other instances of inflated ratings issuance, according to the paper.

The paper said a Moody's spokesman declined to comment on the January rating under scrutiny, but had said Kolchinsky refused to cooperate with an investigation into the issues he raised, and was suspended with pay.

Kolchinsky is scheduled to testify on ratings firm reform before the House Committee on Oversight and Government Reform on Thursday, the paper said.

Moody's was not available to comment.

Inflated ratings only serve to distort the true financial health of a company or pension fund. The model governing rating agencies and pension funds needs to be revisited.

[Daedal]

Indeed.

[Anonymous]

As an insider, (deal with and have extensive knowledge of my employer's pension plan in assets), I can tell you some problems in no specific order, and most likely can be attributed to most publically traded companies:

1) Pension plans are under-funded substantially -- duh.

2) People running pension plans are morons (to qualify: since many pension funds rely on outside managers (equity, bonds, fixed, hedge fund) those in charge possess lay man knowledge of investing, yet they control asset allocation.

3) Pension accounting is a bitch and a headache for company's budgeting team. Actuarial estimates can be overly rosy (expected annualized returns of 8%, for instance, is a common industry estimate). Yet, when performance is not met, company liabilities go up tremendously -- profits suffer.

4) MANY companies are looking toward LDI solution (Liability Driven Investment). However, in order for that to even come close to working, you have to be fully funded. What does it mean? It means many companies are trying to get to 100%, and this rally is deluding them into thinking that at current pace, that will be possible soon.

5) During last year, and especially in March, many companies panicked -- withdrawing from Fund of Funds, going >50% into cash, not abiding by 60/40 balanced approach and allowing assets to fall below target, etc. Those companies are playing catchup even moreso b/c they are far more screwed.

6) Some companies have frozen retirement plans for new hires.

7) Threat of a wave of upper management retirement will increase the underfunded gap.

8) Those in charge of pension funds are being misguided by money managers. I've sat in with many managers, countless, of top mutual funds and fund of fund mangers in the country and all of them are parrots pitching a long term approach, with various BS statistics. Now, I'm not going to be arguing their points here, but I want to point out that they have a conflict of interest, that being -- they get paid for managing money, not for performance. Even, Hussman, who I respect greatly in his latest article (I believe referenced today in an earlier post) is expecting 6.6% annualized return. Can he possibly expect any less return and not have his clients pull out of his fund?

9) I might be missing some points, but I think that covers the jist of it. Pensions are screwed. My advice to any retiree, or people nearing retirement, once you're eligible to get your pension, take it... take the lump sum, fuck the fee and taxes. There may be nothing left. Remember, if the company goes bankrupt or market capitulates and it has no way to meet its obligations to you, then it can't print money like Bernanke.

[McGriffen]

DBRS is 4th on the list of NRSRO, at least US-based credit rating firms, to be thrown under the bus.  And if it's moodys or S&P, I'm backing the bus up a few times to make certain those carcasses carry the rightful amount of tire trackings.

I think pension funds have a whole host of issues, coming to bear in the next 2-10 years. Defined benefit promises made 15-20 years ago may not hold water..