New York, NY – In the wake of the recent credit crisis, the big three credit ratings agencies – Standard & Poor’s, Moody’s and Fitch – have all been the target of criticism by lawmakers and regulators over their overly optimistic ratings, particularly in light of the significant conflicts of interest inherent in these ratings agencies business models. Chicago-based mutual fund and stock research firm Morningstar has decided that these conditions make it an opportune time to enter the business of publishing ratings on US corporate debt issuers.
Consequently, last week Morningstar published its first credit ratings on 100 companies using a similar alphabetical scale used by the other major ratings agencies. However, it is important to note that the approach taken by Morningstar is different from the incumbent ratings agencies in a number of ways.
Unlike S&P, Moody’s or Fitch, Morningstar does not charge the companies that it rates for their ratings. In fact, Morningstar rates whoever it chooses, and makes these ratings freely available to all on its website (http://www.morningstar.com/credit-rating/corporate.aspx). The firm plans to commercialize this effort by charging investors for the underlying research and analytical rationale for these ratings.
As a result of this commercial independence, Morningstar has little or no interaction with the companies it rates. Consequently, these firms don’t have any input into Morningstar’s ratings.
At least for the present, Morningstar also plans only to rate corporate issuers, rather than rating individual bonds or structured products as S&P, Moody’s or Fitch does.
According to the Wall Street Journal, of the 100 companies rated thus far by Morningstar, approximately 70% of companies had similar ratings to those provided by S&P, Moody’s or Fitch, while 30% were different. In most of these cases, Morningstar’s ratings tended to be higher than those published by the incumbent ratings agencies.
Morningstar is producing these credit ratings primarily by leveraging their existing 100 equity analysts. Thus far, Morningstar has hired only 2 credit specialists, with an expectation that they will hire 10 more in the coming months as the firm ramps up its ratings to close to 1000 issuers.
Morningstar did not jump into this effort without considerable preparation. In fact, management of the firm state that they have been working on their credit ratings process for at least a year.
Like with Morningstar’s equity analysis, their bond ratings emphasize a few familiar factors including economic moats and competitive analysis, the size and sustainability of free cash flows, and the assessment of the uncertainty surrounding a firm’s operations and future profitability. For each issuer rated, Morningstar calculates four separate scores to help arrive at their ultimate credit rating. This includes:
- An assessment of a firm’s Economic Moat and other inherent business characteristics in a Business Risk Score.
- A Cash Flow CushionTM metric compares Morningstar’s projections of future cash flows to debt and other financial commitments.
- A Solvency ScoreTM uses ratios of current financial performance that have shown a tendency to predict default before it actually occurs
- A Distance to Default metric uses option-pricing theory to appraise the risk that a firm’s assets will turn out to be worth less than its liabilities.
These four factors are combined to create a ranking system for measuring an individual corporation’s financial strength against that of other firms in Morningstar’s coverage universe. All of these factors are then reviewed by Morningstar’s credit rating committee made up of senior members of the research staff, where additional adjustments to rankings may be made. The committee then decides on the final rating—AAA through C—to award the company. Click here for more details on Morningstar’s ratings process:
At first blush, the team at Integrity Research is impressed by Morningstar’s efforts to enter the credit ratings business, particularly given the legislative and regulatory scrutiny given to ratings agencies in the past few quarters. However, it is also clear to us that Morningstar has a long way to go before it can deem its credit ratings business a success. Some of the more obvious markers along the way include:
Nationally Recognized Statistical Rating Organization: Morningstar has not yet applied for regulatory approval as an NRSRO. An NRSRO is the formal term used to describe a credit rating agency that provides ratings that are recognized by the U.S. government for several regulatory purposes. Ratings provided by Nationally Recognized Statistical Ratings Organizations are used frequently by investors and are used as benchmarks by federal and state agencies. Generally, to be considered an NRSRO, the agency has to be “nationally recognized” in the U.S. and provide reliable and credible ratings. Also taken into consideration is the size of the credit rating agency, operational capability and its credit rating process.
Increased Coverage: Currently, Morningstar rates 100 companies with the plans to increase their ratings coverage to 1000 companies within 6 months. This compares to S&P, for example, that covers 3,300 companies. We suspect that investors will take Morningstar’s ratings more seriously the more companies it covers.
Ratings Must Gain Traction: Currently there are ten NRSROs that are rating various issuers in the US. For Morningstar to succeed, the firm’s ratings must be viewed as more credible than the ratings produced by many of these competitors. While we suspect that there is room in the marketplace for a number of credit ratings agencies, it is likely that most investors won’t be able to focus their attention on more than 3 or 4 ratings agencies. As a result, Morningstar will need to capture significant mindshare to be able to gain traction with the investor community.
Commercial Success for Credit Research: Morningstar plans to finance its credit ratings operation by selling its credit research to investors, rather than charge issuers to be rated (like S&P, Moody’s, or Fitch does). Thus, to be successful, Morningstar will need to be able to penetrate the independent credit research market in order to support the costs of its credit rating operation. This means the firm must successfully compete with a number of existing credit research firms like Gimme Credit, CreditSights, or KDP Investment Advisors. Fortunately, Morningstar is planning to leverage existing analytical resources, and only hiring a limited number of new credit analysts (10 to 12) to augment its existing team. This means Morningstar won’t need to capture too much market share to support its credit ratings business.