Taking Stock / Rating the Agencies

The rating sector is roiling and boiling.

After 12 years of monopoly, Maalot has had competition for the last year: Midroog.

Maalot, of course, doesn't like it. Companies scurry between the two rating agencies, Midroog's chairman has already announced that the company is profitable, and both companies have lugged out their heaviest PR guns.

Nothing beats competition. It is the best driver of improvement. Absence of competition generally translates into mediocrity, inefficiency, animated suspension and sometimes worse.

Competition usually leads to better, more innovative products, better service and lower prices. And, indeed, Midroog's advent breathed new life into the rating sector. Prices fell, the speed at which reports were prepared accelerated, and the customers don't feel like a captive audience any more. They have a choice.

Wait a second, though. Who are these customers?

Are they the provident funds, the mutual funds, the insurance companies, the analysts, the portfolio managers, the bankers - in short, all the bodies that rely on the rating agencies' reports to make investment decisions in corporate stocks and bonds?

No, no, no. Make no mistake: The customers are the ones who pay. The ones that pay the rating agencies are the companies that commission the rating reports. Midroog chairman Yaakov Laskov says the company gets NIS 80,000 for a small job and NIS 300,000 for a big one.

That is the business model of the rating agencies in a nutshell. Companies that want to raise capital come knocking at their doors, write a check and hit the markets a few weeks later armed with their certification, the rating report, which opens the minds and wallets of people who manage other people's money.

The credit crunch at the banks during the last three years made Dorit Salinger, the chief executive of Maalot, and her analysts tremendously powerful people. Their initial ratings and then subsequent follow-ups could determine a company's fate.

And many companies had been feeling in the last year that Maalot wasn't delivering the goods. They felt it wasn't providing the reports fast enough, that its analysts were stubborn, and worse - that they had become more cautious. They didn't always serve up the desired AA rating, which generally assures that a company can help itself to money from the people who manage other people's money.

And then Midroog came along.

For whom the competition tolls

Obviously competition is good for the issuing companies. They want to receive the best possible service from the rater, as fast as possible and for the lowest possible price.

But the more important question is how the competition can benefit the nonpaying customers of the ratings, namely the ones that actually use them in order to make investment decisions.

Here is where risk lies. The most important thing to most of the companies raising capital isn't really the service or the speed of the rating agency, it's the rating itself. It dramatically affects the cost of capital. Sometimes it affects whether a company can raise any at all.

The competition between Maalot and Midroog can only enhance the agencies' temptation to bend toward the companies paying their bills. If one of the agencies gets too tough, the issuer may well storm out and go to the other.

Yes, the rating agencies have to preserve their good name. If they heap superlatives on lousy companies and rate them too high, they stand to lose the market's confidence.

But not that fast. You see, most of the institutional investors that use the rating reports basically use them not for information, but to cover their behinds. The investment managers want to buy the merchandise, they just need a note from Maalot or Midroog in order to pass the order through their investment committees.

Whence our concern? The same thing happens in every advanced financial market in the world. Maalot applies the Standard & Poor's methodology while Midroog uses Moody's, and these models are the two biggest rating agencies in the world.

We are concerned because Israel is still a young country with an even younger capital market, and there is no long-standing evolved culture of ratings, the capital market is dominated by a handful of players and it is rife with conflicts of interest. Maalot belongs to the banks and brokers, while Midroog belongs to a whole lineup of big businessmen.

The two agencies are fighting tooth and nail over customers and prestige, but would do well to remember who their real consumers of their products are.

Midroog chairman Laskov boasts that his company can compile an initial report on a company within 28 days. But his true test, and that of Maalot, isn't how fast they write an initial report. It is how fast they notice that conditions at a company have dramatically changed, for better or worse, after the company raised money.

The institutional investors, which manage our money, are not the direct customers of the two rating agencies. But if they want to do their jobs properly, they have to critique, supervise, ask and probe about the ratings produced by Maalot and Midroog, to assure that the competition between the two benefits not only the issuing companies, but the people risking their money, too.