The letter was entirely polite and businesslike, but something about it chilled Wilhelm Zeller, chairman of one of the world's largest insurance companies.
Moody's Investors Service wanted to inform Zeller's firm — the giant German insurer Hannover Re — that it had decided to rate its financial health at no charge. But the letter went on to suggest that Moody's looked forward to the day Hannover would be willing to pay.
In the margin of the letter, Zeller scribbled an urgent note to his finance chief: "Hier besteht Handlungsbedarf."
We need to act.
Hannover, which was already writing six-figure checks annually to two other rating companies, told Moody's it didn't see the value in paying for another rating.
Moody's began evaluating Hannover anyway, giving it weaker marks over successive years and publishing the results while seeking Hannover's business. Still, the insurer refused to pay. Then last year, even as other credit raters continued to give Hannover a clean bill of health, Moody's cut Hannover's debt to junk status. Shareholders worldwide, alarmed by the downgrade, dumped the insurer's stock, lowering its market value by about $175 million within hours.
What happened to Hannover begins to explain why many corporations, municipalities and foreign governments have grown wary of the big three credit-rating companies — Moody's, Standard & Poor's and Fitch Ratings — as they have expanded into global powers without formal oversight.
The rating companies are free to set their own rules and practices, which sometimes leads to abuse, according to many people inside and outside the industry. At times, credit raters have gone to great lengths to convince a corporation that it needs their ratings — even rating it against its wishes, as in the Hannover case. In other cases, the credit raters have strong-armed clients by threatening to withdraw their ratings — a move that can raise a borrower's interest payments.
And one of the firms, Moody's, sometimes has used its leverage to ratchet up its fees without negotiating with clients. That's what Compuware Corp., a Detroit-based business software maker, said happened at the end of 1999.
Compuware, borrowing about $500 million, had followed custom by seeking two ratings. Standard & Poor's charged an initial $90,000, plus an annual $25,000 fee, said Laura Fournier, Compuware's chief financial officer. Moody's billed $225,000 for an initial assessment, but didn't tack on an annual fee.
Less than a year later, Moody's notified Compuware of a new annual fee — $5,000, which would triple if the company didn't issue another security during the year to create another Moody's payment. Fournier said Moody's didn't do anything extra to earn the fee. But the company paid it anyway — $5,000 in 2001; $15,000 a year later.
"They can pretty much charge the fees they want to," she said. "You have no choice but to pay it."
Moody's declined to comment on Compuware, but the firm said it now charges an annual flat fee of $20,000 for monitoring a corporate borrower to remove any confusion.
Dessa Bokides, a former Wall Street banker who founded a ratings advisory group at Deutsche Bank AG, said rating firms are continually finding new circumstances to extract fees. Frequently, she said, they charge clients for many different securities, even if the ratings all amount to the same thing: an assessment of a company's finances.
"They are rating every [bond issue] and charging for each [bond issue], but in reality, they're only rating the corporate" health, Bokides said. "It's a great business if you can get it."
For Moody's, the numbers add up: It rates more than 150,000 securities from about 23,000 borrowers, whose debt amounts to more than $30 trillion. Its revenue more than doubled in four years, to $1.25 billion in 2003, while its profit jumped 134 percent in that time.
The company said a rating costs between $50,000 and $300,000 for corporate borrowers. Moody's declined to provide a fee schedule, but according to a list obtained by The Washington Post, if it is the applicant's first rating in the past 12 months, there's an additional $33,000 fee. Then there's the monitoring fee ($20,000), a "rapid turnaround fee" ($20,000) and a cancellation fee (at least $33,000). For $50,000 more, a client can get an initial confidential rating.
S&P's fees are similar, according to a price list obtained by The Post.
The former finance chief of a major telecommunications firm was stunned when Moody's and S&P sent their initial bills. Each was six figures, not counting the annual maintenance fee. "I remember thinking their fees were outrageous," said the former executive, who spoke on the condition of anonymity for fear of angering the rating firms. When he asked his banker about the fees, the banker said, "You've got to pay S&P and Moody's."
So he paid.
"Yeah, it's expensive for a few phone calls and a little analysis," the former executive said. "But guess what? Especially when you're a public company, your options are limited. Really, you've only got S&P and Moody's."
Many schools and cities take the same view. The credit companies rate their debt as well, but charge much less, typically in the thousands or tens of thousands, depending on the size of the bond offering. Still, every fee seems to count.
Louis J. Verdelli Jr., a financial adviser to school districts and other localities, knows as much. A municipality dissatisfied with a credit rater can have a difficult time getting rid of it, said Verdelli, a managing director of Public Financial Management Inc. of Philadelphia.
If, for example, a municipality stops paying a rating fee, the credit company may remove its ratings on previous bonds, which could raise questions in investors' minds and make it harder for the municipality to sell new bonds.
One investment banker in the Southwest said he encountered such a situation. Several years ago, he began representing a cash-strapped school district. Things had gotten so bad, the district raised the price of school meals.
To save money, the banker suggested that the district drop one of its two credit ratings. That would save less than $10,000, but would be better than cutting textbooks. Moody's fee was lower, so the banker decided to drop S&P. That is, until he heard from S&P. The credit rater gave him an option: Pay $5,000 for S&P's service, or it would pull all of its ratings.
The investment banker said he had no choice: He decided to pay for both ratings, which the school district continues to do. "We're just paying off Standard & Poor's, and we're costing taxpayers an additional $5,000, because we're concerned that the negative association of their pulling the rating would cost more than $5,000," he said. He spoke on the condition of anonymity, declining to identify the school district for fear of angering the credit raters.
Vickie A. Tillman, S&P's executive vice president, said, "We reserve the right to withdraw our opinion" when the firm does not have enough information to reach a conclusion, and S&P would never "compromise its objectivity and reputation" by withdrawing it for any other reason.
Unsolicited opinions
Some U.S. lawmakers have raised another area of concern: The credit raters have a privilege but little responsibility under a government rule that gives them access to confidential information from a company being rated.
The rating companies say they need such inside data. But when they miss financial meltdowns such as Enron Corp., WorldCom Inc. and the Italian dairy company Parmalat Finanziaria SpA, the raters argue that despite having had insider access in many cases, they can't be blamed for investor losses because they can't detect fraud. "The job of insuring the accuracy of those source materials belongs to auditors and regulators," said Frances G. Laserson, a Moody's spokeswoman.
Rating companies sometimes give yet another perspective about inside information. When rating a company without its cooperation, the credit raters occasionally say they don't need non-public information. They call such ratings "unsolicited"; others in the industry call it a hostile rating.
Moody's estimates that less than 1 percent of its ratings are unsolicited. Tillman said S&P rarely does unsolicited ratings, and generally only if a company borrows more than $50 million, explaining that the credit rater considers it a public service to rate major offerings. James Jockle, a Fitch spokesman, said that more than 95 percent of the companies it rates "agreed to pay our fees."
However, corporate officials, investment bankers and others familiar with the rating firms' strategies say there's a reason unsolicited ratings don't appear common: Companies approached that way by credit raters usually agree to pay a fee rather than risk a weak rating made without their cooperation.
An S&P executive, who spoke on the condition of anonymity because the firm hadn't authorized her to comment, said that S&P maintains a sales force — what it calls an "origination team" — whose goal is to improve revenue by finding companies to rate and charge a fee. "Some of it is cold calling," she said.
Northern Trust Corp., the big Chicago -based bank, said in a recent letter to the SEC that it "has been sent bills by rating agencies for ratings that were not requested by Northern, and for which Northern had not previously agreed to pay." In his letter, James I. Kaplan, then the bank's associate general counsel, continued, "On occasion, we have paid such invoices in order to preserve goodwill with the rating agency, but we feel that this practice is prone to abuse." Northern Trust declined to elaborate.
In 1996, the Justice Department looked into similar unsolicited practices by Moody's. At about the same time, a Colorado school district sued Moody's, claiming it got an unsolicited negative rating — a hostile rating — because the district had refused to buy the Moody's service. The Colorado case was dismissed in 1997, after a judge ruled the rating firm's statements about the school district were opinions protected by the First Amendment. Justice took no action, but did fine Moody's $195,000 in 2001 for obstructing justice by destroying documents during its investigation.
Fitch also has been criticized for unsolicited ratings. In the late 1990s, after being dropped as a paid credit rater of Simon Property Group Inc., the largest U.S. owner of regional shopping malls, Fitch did an unsolicited rating of the company. Some mall company officials were dismayed that Fitch didn't announce that its rating was done without Simon's cooperation.
Fitch said any requirement that it disclose unsolicited ratings would "inappropriately interfere in the editorial process of the rating agencies."
When asked by The Post about unsolicited ratings, S&P's Tillman said her firm is "in the process" of changing its policies so investors will be able to tell whether they are looking at a rating done with a borrower's cooperation. Moody's said the last time it issued an unsolicited rating without identifying it as such was in 2000. And in October, the company began to publicly identify unsolicited ratings.
Greg Root, a former official of the Canadian rater Dominion Bond Rating Service Ltd. who also worked at S&P and Fitch, said that making such disclosure is important because, "when a rating agency does a rating, there's the impression there's a formal due diligence and that they get non-public information. Investors assume there's a strong ongoing dialogue."
Whether an unsolicited rating is a form of coercion to earn fees is another matter, Root said: "It's always a fine line."
A hard sell
Moody's danced along that line when it began its push into Europe in the late 1980s, according to former company officials. It began writing letters to European companies, saying it was planning to rate them. Moody's invited the companies to participate in the ratings process; however, if they didn't, the credit rater said it felt it had adequate public information to do a rating anyway.
"That was the hook. That's where we were trying to get into the door and send them the bill," said W. Bruce Jones, now a managing director at Egan-Jones Ratings Co ., a small rival of Moody's. "The implied threat was there."
Moody's took a similar approach in mid-1998 when it approached Hannover, the big German insurance company that provides insurance for other insurance companies, helping to spread the risk in the event of a major catastrophe.
Hannover had become one of the largest reinsurers in the world, with about half of its business in the United States. Insurers must be able to demonstrate to outsiders that they have the financial strength to make good on their policies. Hannover was already paying fees for that purpose to S&P and A.M. Best Co., a leader in the insurance rating industry. They had both given Hannover high ratings.
"So we told Moody's, 'Thank you very much for the offer, we really appreciate it. However, we don't see any added value,' " said Herbert K. Haas, Hannover's chief financial officer at the time.
As Haas recalls it, a Moody's official told him that if Hannover paid for a rating, it "could have a positive impact" on the grade.
Haas, now chief financial officer at Hannover's parent company, Talanx AG, laughed at the recollection. "My first reaction was, 'This is pure blackmail.' " Then he concluded that, for Moody's, it was just business. S&P was already making headway in Germany and throughout Europe in rating the insurance business. Moody's was lagging behind. And, Haas thought, Hannover represented a fast way for the credit rater to play catch-up.
Within weeks, Moody's issued an unsolicited rating on Hannover, giving it a financial strength rating of "Aa2," one notch below that given by S&P. Haas sighed with relief. Nowhere in the press release did Moody's mention that it did the rating without Hannover's cooperation. But, Haas thought, it could have been worse.
Then it got worse. In July 2000, Moody's dropped Hannover's ratings outlook from "stable" to "negative." About six months later, Moody's downgraded Hannover a notch to "Aa3." Meanwhile, Moody's kept trying to sell Hannover its rating service. In the fall of 2001, Zeller, Hannover's chairman, said he bumped into a Moody's official at an industry conference in Monte Carlo and arranged a meeting for the next day at the Cafe de Paris. There, the Moody's official pressed his case, pointing out that the analyst who had been covering Hannover — a man whom the insurer disliked — had left Moody's. Zeller still declined Moody's services.
Two months later, Moody's cut the insurer's rating by two more notches to "A2." In December 2002, the rating firm put Hannover on review for another possible downgrade. Somewhere along the way, Haas appealed to his boss to yield.
"I said, 'Ultimately, you cannot win against the rating agency. Let's bite the bullet and pay,' " Haas recalled. "But for Willie [Zeller], it was a matter of principle. He said, 'I'm not going to pay these guys.' "
In March 2003, Moody's downgraded Hannover's financial strength rating by two notches and lowered its debt by three notches to junk status, sparking a 10 percent drop in the insurer's stock. S&P and A.M. Best, both of which were privy to the German insurer's confidential data, continued to give Hannover a high rating.
Industry analysts were confounded. "The scale of the Moody's downgrade was a surprise," said Damien Regent, an analyst at UBS AG, in a research report at the time. "There was no new information in the public domain to justify a three-notch downgrade."
Larry Mayewski, A.M. Best's executive vice president, said he thinks Moody's has been using unsolicited ratings to get companies like Hannover to buy its services.
Moody's declined to comment for this article about Hannover, but in its reports on the insurer, it said it was concerned that the German company had "high levels of financial and operational leverage" and a "high level of reinsurance recoverables" due to it. Since then, Moody's has softened its stance, raising Hannover's outlook from "negative" to "positive." But it still rates Hannover's debt as junk.
Zeller called the latest downgrade "ridiculous." But when his company's stock dropped sharply, he began to wonder whether he had any recourse.
As in the United States, lawmakers in Germany and elsewhere in Europe have taken a look at credit raters. But there has been no action. And Zeller isn't optimistic about the prospects of change.
"They have built up such a franchise," he said, "it's difficult, if not impossible, to do anything against it."
