Inside Meredith Whitney's ratings agencyFebruary 3, 2011: 11:51 AM ET
The ubiquitous Wall Street analyst hopes to launch a ratings agency, hiring up to 650 analysts at an average salary of $225,000. But what about her methodology?
When Meredith Whitney said last fall that she would build a rating agency to rival the Standard & Poor's/Moody's duopoly, the news was accompanied by few details.
The prominent analyst said her firm, Meredith Whitney Advisory Group, currently provides ratings (on a subscription basis) comparable to those issued by S&P. But she declined to say how many of her employees are dedicated to the task, how many people she planned to hire, or what methodology she uses to rate credit.
Whitney, however, adamantly told the Financial Times that her firm's work is "far more transparent" and "the credibility is far greater" than that of her big, downtown rivals. So she's applying to become a Nationally Recognized Statistical Ratings Organization (NRSRO), that magic designation that makes a firm's opinions the final word on creditworthiness for key players in the Wall Street machine. Pension funds, money market funds, and many big insurers can only buy debt rated "investment grade" by an NRSRO; and bank capital regulation is based on NRSRO credit ratings.
Fortune reviewed a skeletal presentation (see below) Whitney submitted to Securities and Exchange Commission chairman Mary Schapiro -- the outline sheds some light on just what kind of organization she plans to build, and how she's going to attack her large, well-capitalized, and systemically essential competitors.
At this point, Whitney's rating organization is predictably small, with nine analysts looking at financial institutions, six at structured finance, and 12 at public project finance. It's unclear whether that group of 27 researchers is distinct from the team that produces the equity research that generates the bulk of her firm's revenue.
If all goes according to plan, headcount will hit 200 employees in year one (apparently inclusive of sales people) and blossom to 650 in year three. Whitney declined to comment on the document, given that her firm is still in the application phase.
By comparison, S&P and Moody's each have more than 1,200 analysts and analyst supervisors, according to an SEC report issued this January. Given their abysmal performance on structured real estate securities and their tarnished reputations in the aftermath of the financial meltdown, it's safe to say that numbers don't guarantee results.
But you do have to be big to do what Whitney wants to do: compete with the global breadth and depth that Moody's and S&P bring to the table. She says her headcount projection would make her similar in size to the fifth-largest NRSRO, DBRS, but the number of securities rated by DBRS equals about 4% of the total rated by Moody's. One must assume that her employee numbers will continue to grow even after year three. It's also unclear whether Whitney is applying for official approval in Europe or Japan. Without that, her product would be of limited utility to large, global institutions.
Whitney's hagiography as a star analyst is well known, and she is staking her tough and critical reputation on this new venture. When she started her own firm in 2009, she expanded her coverage universe from examining financial firms to looking at consumer credit, housing, and (infamously) municipal bonds. Even so, her equity research is still her bread and butter, and her company coverage does not stray far from banking.
Hopefully her reputation and her compensation packages will attract the sort of top notch talent that can make her firm a player. Jules Kroll is already stealing employees from S&P and Moody's for his start up rating agency, KBR.
Whitney will pay employees $225,000 a year to best Moody's and attract better talent. (Moody's pays $212,000). This makes headcount her largest expense, at $45 million in the first year alone. If the New York Observer is correct and subscriptions to her research begin at $100,000 a year, then she'll have to sell a ton of research reports (and of course, ratings) to stay in the black.
The proposal says her ratings-generated revenue will grow significantly with the passage of the Restore Integrity to Credit Ratings amendment (also known as the Franken amendment), which would allow a government-created board to assign work to NRSROs. While the amendment does seem to have a lot of upside for smaller NRSROs, it's no sure thing. As part of the sweeping financial regulation passed by Congress, creation of such a board was reduced to being part of a study to solve conflicts of interest in ratings. If no better plan is found, then the board will happen. And that's a big if.
When asked to comment on the outlines of Whitney's planned venture, S&P had a tepid response. "We welcome competition because we think the market benefits from a variety of opinions on credit risk," the firm said in a statement. "We believe investors continue to find value in the transparency and comparability of our ratings and the quality of our research, which is produced by more than 1,300 analysts worldwide."
At the end of the day, we know that Whitney has grand ambition, but don't know the most important thing: her rating methodology. That's what will make or break this venture. In order to really compete, she'll have to show that she can bring something more than just reputation to the game. She'll have to compete based on rigorous, transparent analysis that differentiates her diligence and her results.