01 Jun 2012
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Good as Our Word

Breaking into the bond ratings business
by Maggie Starvish

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For most of the 20th century, three bond ratings agencies—Moody’s, Fitch, and Standard & Poor’s—controlled 97 percent of the credit ratings market. The status quo was disrupted, however, by the 2008 global economic recession, an event that the Big Three contributed to by giving overly optimistic ratings to highly complex and opaque mortgage- and asset-backed securities.

How had the rating agencies gotten it so wrong? In the recent case “Kroll Bond Rating Agency,” HBS assistant professor Bo Becker offers an overview of the bond ratings industry, including its history, its major players, who uses ratings, and how they are used. The case concerns the strategic options facing a new entrant hoping to exploit the potential crack in the dominance of Moody’s, Fitch, and S&P. Becker was spurred to write it when he realized the bond ratings industry isn’t explicitly taught to HBS students. “This is one of those corners of finance that is very useful to understand, whether or not you work in finance,” he says.

In 2008 and 2009, when the field of ratings seemed ripe for upheaval, Becker learned of several planned rating agency start-ups, including what would become the Kroll Bond Rating Agency (KBRA). When the firm lured away Moody’s executive Jerome Fons, whom Becker knew, “I contacted him to say this might be a fantastic opportunity to write an exciting case about this topic.”

Enter Jules Kroll, widely recognized as creating the corporate intelligence industry. He plans for KBRA to set itself apart from the pack with uncompromising integrity and accuracy, especially in the rating of structured finance products such as asset-backed securities. Although Becker never spoke with Kroll directly while writing the case, Kroll’s legendary reputation speaks for itself. The corporate intelligence firm he started in the early 1970s was just a decade later digging up assets hidden by powerful individuals, including Jean-Claude “Baby Doc” Duvalier, Ferdinand and Imelda Marcos, and Saddam Hussein. Kroll’s work even inspired the 2000 movie Proof of Life. Kroll had been formulating a plan for KBRA as early as 2008; in his mind, Moody’s, Fitch, and S&P sold their souls to win business in the short run. KBRA would, says Becker, “value integrity above everything else.”

The case begins in April 2010, as Fons, Kroll’s EVP, is about to propose a strategy to launch KBRA. Students are asked to consider several key questions: Should KBRA enter this business, which despite the economic crisis is still dominated by the Big Three? Should it focus its business on a single sector such as structured products or attack multiple sectors? How could enough skilled analysts be recruited quickly? And finally, how would the firm acquire status as a Nationally Recognized Statistical Rating Organization, an SEC designation that is considered a key “must-have” by many credit ratings customers?

In the classroom, Becker says, students have a great interest in the role of ratings in the financial crisis, and in the firm itself. “The business models used and the whole structure of the industry are complex, and it can take us a while to sort that out,” he notes. “But it’s worth the trouble, because understanding the industry and its output, the credit ratings, is essential for anyone who wants to interact with financial markets, even indirectly.”

It’s still too early to evaluate KBRA’s results, although in 2011 the firm came in third place in the first market where it chose to compete (commercial-backed securities with a single borrower), replacing Standard & Poor’s. In a January interview with the BBC, Kroll readily conceded that his firm loses business when organizations shop around for—and receive—a higher rating elsewhere. “On the other hand, when our name is on something, and our name is on the line, it will mean more than the word of others,” he stated firmly. “You’ve got to have standards…even if it means you don’t get every bit of business you’d like to get.”

—Maggie Starvish is a freelance writer for HBS Working Knowledge.

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