Investors To Rating Agencies: Rate The Middlemen

In the wake of the investment banking collapse and with Citigroup faltering, leveraged loan and high yield bond investors are concerned about how a broken-down middleman, or agent bank, could affect the deals in their portfolios. To address this concern, some investors say that the rating agencies should not only rate the issuer of the debt, but explicitly rate the agent bank involved in the deal-something they currently don't do.

Some investors say the market has entered a stretch of time where issuers and agent banks are distressed. They worry because the agent banks are responsible for distributing payments to investors and are the ones who handle what happens next if a borrower should default on its debt.

"This would be really important for [factoring] how much you're going to get back," said a New York-based investor. "Something that focused on the agent would really help the [leverage finance] market."

Out of all the elements an issuer is rated on, its recovery rating is the most important, some debt investors say. And with such a shaky market, a rough patch for an agent bank means a rough patch for investors as well. "All underwriters are equally poor," said another New York-based investor. If an agent bank were to fall on hard times, payments could be interrupted, and if an issuer were to default around the same time, investors would get mixed up in the ensuing legal and administrative muddle.

Sources said this happened with Lehman Brothers when it filled for bankruptcy last year, though they did not cite specific deals. While that may have seemed like a once in a lifetime event, consider how close Citigroup was to meeting the same fate. And Citi, in terms of its market share of the leveraged loan and high yield bond markets, is one of the biggest players. In 2008 Citigroup's market share of the high yield bond market was 7.5% and its share of the leveraged loan market was 6.1%.

For Standard & Poor's and Moody's Investors Service, the question of whether the rating agencies should rate the middlemen is coming into view. "While our recovery ratings approach does not explicitly include an analysis of agent banks, they are one of many factors that we consider in our recovery ratings analysis," said Bill Chew, head of S&P's recovery ratings group. "Going forward, we are looking to see how effectively they are able to influence recoveries as we move into this very difficult credit and restructuring environment. We will comment on this as part of our ongoing commentary on recoveries and the factors driving them in early 2009."

Neal Schweitzer, a senior vice president with Moody's, said, "We rate all the agent banks individually, but do not rate them in specific deals. Moody's, though, is constantly looking at where are we relevant, whether that means unbundling ratings or looking at new subrating categories, like an agent bank's performance. The stars are unusually aligned for this sort of question. Not only are there stressed borrowers but stressed banks."

Calls to Fitch Ratings were not returned by press time.

Another situation that could surface, sources said, concerns revolvers. If an issuer needs to withdraw a portion of its revolver to cover costs, and the agent bank can't fund it, that could impact the issuer's liquidity. "I saw this several times with Lehman-led deals, where Lehman still owned 10% of a company's revolver, and when the company drew down their revolver, Lehman was unable to fund it because they were in bankruptcy. The company therefore only received 90% of the funds they would have otherwise," said a New York-based managing director for an investment management firm. This scenario, however, he added, is less likely going forward because underwriters are holding less and less.

If the rating agencies were to add this into their rating methodology bag, the ratings should be based on an agent bank's administrative strength-its ability to distribute payments to third parties; its balance sheet so the borrower doesn't run out of operating cash; and its history with post-default issuers, sources said. Almost any bank would attest that it is fully capable in all of these areas. However, as a Chicago-based investor put it, no one has absolute confidence in a bank's word these days.

An agent bank's rating, some investors said, could be easily put into words, as when the rating agencies describe, for example, an issuer's weak liquidity profile, its high financial leverage, or poor track record. From there, the rating agencies could use whatever scale they wanted to, they added.

However, some market participants do not support the call for such a rating. "This is probably not the best idea," said a New York-based investor. "Banks vary significantly in their underwriting standards based on a number of factors that may include their risk appetite. That will change over time, and their staffing and the experience within that staff. It could be intentional, driven by management, or unintentional, like the loss of key persons. This is very difficult to accurately measure at any given time because the methodology has not been established to rank these groups by the rating agencies." He added that since the early '90s, ratings agencies have ranked certain asset managers; and some previously "highly-ranked" asset managers are now out of business.

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