Raymond McDaniel Jr. isn’t riled easily. As CEO of ratings agency Moody’s Corp. during the financial crisis, he came under spirited attack from regulators, politicians and the general public for giving triple-A ratings to the securities that led to the U.S. mortgage-market meltdown. During three separate congressional hearings, a contrite but confident McDaniel admitted that his firm had underestimated the severity of the credit problem. He defended the integrity of its ratings as well as detailed the lessons it had learned to improve both its own operations and, more generally, the U.S. mortgage origination and securitization process.
“Moody’s has gone through as much legal and regulatory scrutiny as any business and in many ways has emerged as a stronger business,” says Alex Baring, a partner and analyst at hedge fund firm The Children’s Investment Fund (U.K.), which owns more than 5 percent of the company. “A lot of the credit for that goes to Ray. He’s a clever man with an even temperament and the combination has been important for a CEO of a leading rating agency in the years through and since the financial crisis.”
Founded in 1909, Moody’s is the oldest and largest independent provider of credit rating opinions in the world. Operating under the Moody’s Investors Service (MIS) name, the rating business accounted for 69 percent of Moody’s Corp.’s $2.97 billion in revenue last year. Moody’s Analytics (MA) generated the other 31 percent. The MA business is built around credit research, data and analytics services, and risk management and measurement software; more than half of its revenue comes from research created by MIS credit analysts. TCI’s Baring likes the diversification of Moody’s business model, which he says should be able to grow annual revenue by 10 to 15 percent a year for the foreseeable future. (Its average annual growth is 13 percent over the past 27 years.)
McDaniel probably wouldn’t be CEO of Moody’s if it hadn’t been for the Tax Reform Act of 1986, one of the last truly bipartisan pieces of Washington legislation. The 56-year-old Emory University School of Law graduate spent the first four years of his career involved in surety bonding for tax-advantaged investments at National Union Fire Insurance Co., a unit of American International Group. The landmark 1986 bill made his group irrelevant by lowering the overall tax rate and eliminating loopholes. A year later McDaniel joined Moody’s as an analyst in its securitization area. He transferred to London in the ’90s, eventually managing the company’s European business, and returned to New York in 1996 to oversee its entire international business, the role he held when Moody’s was spun out of Dun & Bradstreet as a public company in September 2000. McDaniel was elevated to his current position in April 2005 following the retirement of former CEO John Rutherfurd Jr.
Institutional Investor Editor Michael Peltz met with McDaniel in early September at Moody’s world headquarters in lower Manhattan to discuss his company’s strategy six years after the financial crisis.
Institutional Investor: When did the extent of the crisis become clear?
Ray McDaniel: In mid- to late 2006, we started to see some softness in the U.S. housing market and implications for mortgage-backed securities. It was really in 2007 that the potential size of the problem became more apparent. And then in 2008, with the Lehman and AIG problems, the overall situation legged down once again. So there was a series of stages where the scope and depth of the problems became more clear.
What did Moody’s do to address what was going on in the market?
Well, research commentary and rating action, certainly. And then, after the problems in the housing market had become fully realized, we looked at what we needed to do in terms of lessons learned. There was for many people — and I don’t think we were exempted from this — a sense of comfort in these mortgage-backed securities, that the geographic dispersion of the assets, the zip codes that were in these pools of mortgages, was going to be very protective of the overall portfolios. There had been so many decades of performance in the housing market where we had not seen a nationwide downturn in housing — certainly nothing as dramatic as what came about in 2008 — so that even if there were isolated problems in one part of the country or one part of a state, they were not likely to spread throughout a portfolio of geographically diverse assets. And at the end of the day, it proved to be a poor assumption for what happened.
In 2010 you testified alongside Warren Buffett, Moody’s largest shareholder, before Congress’s Financial Crisis Inquiry Commission. That must have been interesting.
I can think of many circumstances where I would enjoy sitting with Warren Buffett, but that wouldn’t have been my first choice. But it was part of the process for the policy reaction and the inquiry process — again, what are the lessons to be learned from the financial crisis.
Buffett really defended Moody’s.
I think he was very candid in expressing his point of view, that many, many people did not predict what was going to happen and, again, the breadth and depth. I know Moody’s — and I’m sure most everyone else who didn’t predict the extent of the financial crisis — would prefer to have been more accurate in their views and their assumptions. And I think that came out in the testimony.
What were the biggest lessons learned?
From a credit analysis standpoint, I think we had been raising our standards, our criteria, for the highest ratings that we were giving. But as it turned out, the changes we were making were insufficient by a large measure, in terms of accounting for what actually happened. And as I mentioned, a big part of that was the fact that we were looking at data going back decades, which encouraged a sense of comfort with the models and how the assets, the securities, would perform under stress and really did not accommodate the extent and pace of the downturn.
So a big lesson learned was to incorporate what is now real-world information into our modeling — and to also incorporate a more top-down macroeconomic view in terms of, in this case, what is happening with housing policy in the United States — what’s happening with the housing market, what’s happening with developments in mortgage products and how do those impact the credit risk of these instruments.
Did the crisis change your business strategy?
From a business strategy standpoint, we are always trying to provide the highest-quality ratings we can. We are in a reputation-based business — reputation for accuracy, for independence — and that’s why having a problem like we saw in the housing market and its implication for large numbers of ratings was so harmful to the business. And we very much prioritize the quality, the predictive content and the insight in the research and ratings that we have. So from that standpoint the business strategy didn’t change, because that was always a priority. But it was also why it was so damaging, because we really are in a reputation-based business.
Is Moody’s less reliant on the credit side of its business since the crisis?
Moody’s Analytics was created as a separate operating company in 2007. We had made that decision six to nine months ahead of the actual move, so although it was coincident in time with some of the biggest stress in the financial market, the decision had been made before that was evident.
Moody’s Investors Service, the rating agency, was left to do ratings and research, with all of our other data, risk measurement, risk management and professional services work being done in this sister operating company, Moody’s Analytics. We have grown the Moody’s Analytics business since then. It’s about 30 percent of our revenue today. And it is a diversification of our business, away from purely credit ratings and research. In addition to that, we’ve expanded internationally over the last half dozen years. And so the growth of Moody’s Analytics and the growth of Moody’s international business, both on the ratings side and on the analytics side, has diversified our business.
What do you think is the least understood part of Moody’s?
Traditionally, I would say, Moody’s Analytics is a not very well understood part of our business. When many shareholders or potential shareholders are thinking about Moody’s, they’re thinking about the credit rating agency. That’s what they associate with the Moody’s brand; it’s what they’re most familiar with. Moody’s Analytics sells research that Moody’s Investors Service analysts write, but it also sells its own research and data and economic analysis. And, importantly, it has a software business selling platforms to financial institutions to meet regulatory demands for enhanced risk management and risk measurement. One of the consequences of the financial crisis was clearly a prioritization of enhanced risk management.
Is it somewhat ironic that the increased regulation following the financial crisis sets up nicely for you?
Like probably most every other firm in the world, we would have preferred not to have gone through the financial crisis. But there are lessons that are learned; there are reactions that can be helpful to the marketplace. And that’s what we’re trying to do: react in a way that helps become a part of the next solution.
Where do you see the most growth going forward?
A few areas. One is growth in the bond markets, coming from disintermediation of financial assets out of the banking system and into the bond market. Second is international growth, and that’s really the development of domestic and regional bond markets. So it’s a close complement to the disintermediation that we’re seeing and has a lot of attributes that would look the same.
A lot of what’s happening in the financial institution sector — capital adequacy, directives, stress-testing demands, the need for financial institutions to curtail some of the business activities they might have been in previously and the pressure that puts on profitability, the deleveraging that is occurring in the financial system — is really driving a lot of change. And we’re trying to position ourselves again to be a constructive service provider in those areas of change.
As you’re doing more internationally, especially in emerging markets, do you need analysts with different skill sets to be able to analyze things like political risk?
Yes. Our political risk starts with the analysis coming from our sovereign teams. But then our analytical teams in various disciplines have to incorporate political risk into their analysis, to different degrees. But to the extent that there are political risks present that may affect a company or an industry’s ability to generate sufficient cash flow to meet its obligations, we have to factor that in. And so it does become a part of the credit process.
What about interest rates? We’re at unusually low levels.
We are at low levels. I had anticipated that rates would be higher by this time, but, like many, I was premature in my estimate of when rates would begin to move up. When they do begin to move up, we often get questions about the impact on our business from a rising-rate environment. My answer is, it depends. If we have rates rising because there’s economic momentum, and the economic momentum is breeding business confidence, mergers and acquisition activity, capital expenditure, maybe more share repurchases by companies, things of that sort, then I think we have a good set of conditions for our business going forward. We wouldn’t see the opportunistic refinancing that we’ve seen in recent years in a rising-rate environment, but we will see other reasons for borrowing that have been dampened in recent years because of a lack of strong global growth and associated business confidence.
If we see rates rising under some kind of stagflation scenario, I do think that’s harmful to our business on a cyclical basis. We would not see a lot of business confidence in that kind of a scenario, and there would be more caution about investing and expanding. And we would not have the opportunistic refinancing going on. So we would be losing a number of potential cylinders for driving the business forward, at least on a cyclical basis.
Do you have much interaction with Berkshire Hathaway or Buffett?
No, we do not have much interaction with Berkshire Hathaway at all. And as a matter of fact, I have not spoken to Mr. Buffett in a number of years.
Is that a good sign?
I think it is. Certainly, if he had concerns, he wouldn’t be hesitant to express them. But he’s been a long-term shareholder in Moody’s, and obviously we’re very pleased about that.
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