Kroll ascends to No. 3 in CMBS ratings business

Thu Jul 19, 2012 11:48am EDT

NEW YORK, July 19 (IFR) - Just one year after rating its first commercial mortgage-backed securities deal, newcomer Kroll Bond Ratings has grabbed the No. 3 market-share spot in year-to-date CMBS ratings, eclipsing some of its more experienced competitors, including Big 3 agency Standard & Poor's, according to IFR Markets deal data.

The rating agency, started by storied corporate-investigations pioneer Jules Kroll two years ago, has rated about $10.6 billion worth of CMBS year-to-date via 11 offerings. These include private-label deals issued by bank lenders, as well as transactions backed by loans on multifamily properties underwritten by Freddie Mac, according to IFR Markets.

This places the newcomer at the No. 3 market-share ranking behind Fitch, which rated about $17.5 billion, and Moody's, which rated the largest amount of CMBS so far this year -- nearly $18 billion.

Kroll also narrowly beat out two other more-tenured competitors who have been rating CMBS for years: Toronto-based DBRS, which captured the No. 4 spot for year-to-date market share, and Morningstar, which came in at No. 5.

Kroll's ascendance was no doubt helped by the fact that S&P, once a leader in CMBS ratings, found itself all but locked out of the market to rate CMBS offerings after a slip-up a year ago on a $1.5 billion deal.

The episode, which involved discrepancies that S&P found in its ratings for a July 2011 deal, led to bonds being pulled from the market post-sale, and eroded S&P's credibility.

The debacle allowed companies like Kroll to steal away part of the sector's business. S&P has recently overhauled its ratings criteria in an attempt to regain a foothold in the market.

But Jules Kroll, who points out that his agency rated its first CMBS transaction prior to the S&P incident -- and has now rated a total of 19 deals -- says that it is instead a focus on deep due diligence, insightful analysis, and very selective hiring of seasoned professionals that has allowed his firm to quickly gain investors' and issuers' trust.

"Given my legacy, the tone we try to set is that due diligence counts," said Mr. Kroll, whom many credit with inventing the modern corporate investigations industry.

"The incumbent rating agencies make a point that it's not their responsibility to do due diligence, that they're only reviewing what's presented to them. But the tone we try to set is that the ultimate goal is to give investors as much as we can give them to make their own judgments."

Kroll Bond Ratings has already expanded into municipal-bond ratings and asset-backed securities, and plans to issue its first corporate rating in the Fall, continuing down that path with an emphasis on grading financial institutions. However -- sticking to its strengths -- it will not attempt to rate the debt of sovereign nations.

"Our views, our approach, our embracing of due diligence over time with surveillance and detailed write-ups, are of people who are trying to restore trust," Mr. Kroll told IFR.

GAINING TRACTION

It's not an accident that the agency has excelled in CMBS. After initially spending money and time in 2009 developing non-agency residential mortgage-backed securities (RMBS) ratings models, Mr. Kroll finally realized that the sector was not returning anytime soon, and instead turned his attention to the nascent post-crisis renaissance in commercial mortgage bonds, another battered asset class.

He sought out some of the most seasoned and well-known analysts in the industry to head up his new structured finance ratings business.

"We offer more than a rating; what we view as a product is the insight into the analysis," said Kim Diamond, who joined Kroll in December 2010 to head up the firm's structured finance business.

Diamond was a 21-year veteran of S&P who headed up the CMBS new-issue ratings group for years and eventually headed the entire mortgage-bond ratings unit during the tumultuous time after the crisis hit in 2008.

Frustrated by some decisions that S&P upper management made in the aftermath of the crisis, Diamond left the firm in 2010.

Diamond herself commanded the overwhelming respect of the CMBS investor and issuer community, making her a perfect choice to head up Kroll's new structured finance unit.

"She was well known, seasoned, and emerged from the crisis with an unscathed reputation," Mr. Kroll said.

Shortly thereafter, Diamond recruited another respected CMBS colleague from S&P, Eric Thompson, to head up Kroll's structured-finance surveillance efforts.

"We were known entities to the industry, just resident in a different place. So there was a predictability of outcome" to what investors were getting, Diamond said.

While many of the Kroll analysts have rating agency backgrounds, Diamond says that the firm has made a point to also recruit professionals from the buy-side, sell-side, bond-structuring professions, research, and appraisal and workout backgrounds.

"Rather than taking the standard academic or didactic approach that many agencies take -- which tends to be very disconnected from the real world -- we brought in perspectives of those that had taken part in different parts of the business. That makes our perspective much more holistic at the end of the day," she said.

OVERCOMING A STIGMA

Still, it was an uphill battle to gain the trust of investors or convince underwriters and banks to choose the upstart to rate new issues.

"It was not written in the Bible that anybody had to put a Kroll rating on anything," said Mr. Kroll.

One stigma that was hard to overcome: Kroll used the same pay structure as Moody's, S&P, and Fitch, the harshly criticized "issuer-pays" model.

The conflicts of interest arising from this model -- the notion that the agencies were serving the wrong master in the run-up to the crisis and therefore were swayed to stamp toxic securities with Triple A ratings -- have been sharply lambasted by Congress, investors, and pundits.

"It's become a bit of a shibboleth that 'issuer-pay' doesn't work," Mr. Kroll said. "Well, what's the alternative? The investors don't want to pay."

To get his start in the bond-ratings business, Mr. Kroll acquired an SEC-registered boutique credit rating agency in 2010, Lace Financial, that used an investor-pays model, but soon discovered that the pay structure was not viable.

"It quickly became clear that investors didn't want to pay," he said. Mr. Kroll says his firm recognizes the inherent conflict that's involved with 'issuer-pays', so there is a tendency to be more conservative on some ratings, and "that has cost us some business."

But company executives also point out that the investor-pays model has its own conflicts, including the fact that large, influential asset managers have their own vested interests: for instance, they don't like volatility or downgrades, they like access to analysts, and there could be the perception that they're receiving more information than smaller shops.

"The reason that the issuer-pays model got a bad name is because it was combined with opaque criteria," said James Nadler, president and chief operating officer at Kroll, as well as a former executive vice president at Fitch.

Pre-crisis, the rating agencies had unclear criteria, and therefore could rate securities however they wanted, saying that an issuer's rationale for a Triple A "generally fit" within the methodology, Nadler said.

"When the 'issuer-pay' model is combined with transparent criteria, and transparent analysis, there are fewer conflicts," he said.

EXPANDING THE BUSINESS

Mr. Kroll feels that the quality of his firm's analysis is what distinguishes it from the Big 3 rating agencies, and that there is still opportunistic room for a boutique shop in the ratings business, especially after the pummeling that the large raters took over the last few years in the court of public opinion.

"The level of criticism and condemnation that these folks have taken now for several years is non-stop," he told IFR. "If I was running one of these places, the first thing I would do is apologize. And offer an explanation."

That may be hard to do for S&P, Moody's, and Fitch, however, Mr. Kroll said, as they are constrained by lawyers protecting them from litigation, regulators, and the Dept. of Justice.

But the tattered reputation of the other agencies means that Mr. Kroll sees selective near-term opportunities in other areas where his ratings company can prove its analytical worth.

The agency hopes to replicate the success it has found in CMBS this past year in other sectors, and has already rated a subprime auto ABS transaction, with two more in the queue, and is in the process of rating its first container-lease deal.

Moreover, the bigger picture for Kroll Bond Ratings expands beyond just grading transactions and companies: Mr. Kroll intends to acquire an information provider/data company and combine it with the agency over the next year.

"It is not our intent to only be a ratings business," he said.

In order to make such an acquisition, however, and for it to be profitable, he has to make sure that there is a sturdy platform to build on.

"I'm not doing this as a religious experience," Mr Kroll said. "I'm doing this to achieve an economic return, and I think the marketplace will ultimately reward us economically if the product is viewed as independent and of high quality."

"The minute it's not viewed as independent and high quality, we're toast."

(The International Financing Review is a Thomson Reuters publication;)

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