These aren’t particularly happy days for the world’s key rating agencies, and Canada’s own DBRS Ltd. has certainly been served its own portion of misery.

The Toronto-based firm took a blow to its reputation — some say deserved, others say not — over its role in the asset-backed commercial paper fiasco that hit the Canadian debt market this past August, and which is still being sorted out as part of the wider Montreal accord.

In the U.S. and Europe, regulatory bodies and legislators are taking a closer look at how rating agencies operate and investigating whether reform is needed. Any changes coming out of these hearings and investigations is sure to affect DBRS, which does business in both places.

And in January, DBRS followed the lead of U.S.-based rating giants Moody’s Investors Service Inc. and Standard & Poor’s Corp. in announcing layoffs and restructuring. DBRS is closing its European offices and laying off some 80 employees out of a total of 270 in Europe and North America.

The world market for debt issues has dried up dramatically, affecting revenue at all rating agencies, which make their business — a lucrative one, by all accounts — by charging issuers fees to rate their debt issues. DBRS, a private company, doesn’t release financial statements.

For its part, DBRS says it stands by its performance in rating ABCP as well as other debt securities, and that the company’s future prospects remain strong despite recent challenges.

“We continue to be the dominant rating agency in the Canadian marketplace,” says Jerry Marriott, DBRS’s managing director of Canadian residential mortgage-backed securities and asset-backed securities. “We have established a business in the U.S. in both corporate and structured finance, and we continue to build on that base.”

Although the global credit crunch originated with the U.S. subprime mortgage mess, it has manifested itself most dramatically in this country in the form of the ABCP crisis.

Issued by financial entities called “conduits,” ABCP is short-term debt that packages together underlying securities made up of different forms of debt, including, what turned out to be toxic U.S. subprime mortgages. ABCP was an attractive investment for lenders, as it offered high rates of interest and received strong debt ratings.

Although ABCP was backed up by liquidity guarantees from major banks, a unique feature of the Canadian market was that the issuers had to prove that there was a “general market disruption” before qualifying for emergency funds. When a credit crisis related to the subprime mortgage market hit the U.S. in the summer of 2007, the market for non-bank-issued ABCP suddenly dried up completely. However some banks refused to come through on their liquidity guarantees, arguing that since bank-issued ABCP was still being bought, no market disruption had occurred.

A quickly negotiated agreement among the banks operating in Canada to freeze non-bank ABCP, called the Montreal accord, prevented the whole market from collapsing entirely.

In the aftermath of the ABCP crisis, investors and other market players wondered how the whole mess could have been allowed to happen. Where were the rating agencies?

“Any time there’s an unexpected event that the rating agencies have not totally seen coming, they’re going to take some flak and inves-tors will look for scapegoats,” says Stephen Foerster, professor of finance at the Richard Ivey School of Business at the University of Western Ontario in London, Ont.

Foerster doesn’t see DBRS as being the culprit in the ABCP mess, because the main problem was not the creditworthiness of the paper. “The bigger issue was more one of liquidity,” he says, “and failing to recognize that what can grind these markets to a halt is if no one wants to trade these securities.”

Laurence Booth, professor of finance at the Rotman School of Management at the University of Toronto, says that the issuers of the paper are more deserving of brickbats than is DBRS.

“The rating agency couldn’t go into every one of these deals and check exactly who held the mortgages and what the underlying assets were,” Booth says. “That due diligence is what the investment dealers are supposed to do.”

But not everyone is ready to let DBRS off the hook for its role in the ABCP crisis, nor other global rating agencies for their role in the wider global mortgage-backed securities crisis.

@page_break@“[The rating agencies] need to wear this — they need to wear this a lot,” says Blair Carey, an analyst with Toronto-based Abacus Private Equity Group and chairman of the Canadian Advocacy Council for Canadian CFA Institute Societies. “In the future, purchasers of these loans will take those rating agency reports with a very large grain of salt.”

DBRS’s Marriott argues that the ABCP crisis was rooted in three things: the subprime mortgage crisis in the U.S. that sparked the global credit crunch; too little transparency in what the debt instruments held; and the fact that some banks chose not to provide emergency funds, as DBRS believes they had contracted to do.

“We were as taken aback as anyone else,” Marriott says, “when there was less than 100% performance [in terms of honouring guarantees].”

However, many financial services industry observers have argued that the fault lies in the fact that the Canadian regulatory environment allowed banks to give conditional, or “Canadian-style” liquidity guarantees, which are less costly, rather than global-style liquidity guarantees, which are more expensive but compel the guarantor to provide an ironclad guarantee of emergency liquidity.

In 2002, S&P announced that it would not provide ratings for Canadian ABCP because of the Canadian liquidity standards, but DBRS chose to do so. That is, it did until the credit crisis.

Just weeks after the ABCP crisis hit, DBRS changed its policy to require all new Canadian ABCP issuers to make sure they had liquidity guarantees that met global standards.

“That’s a huge blow to DBRS’s prestige,” says U of T’s Booth. “I think you’ll see Standard & Poor’s rating the Canadian money market when everything gets back to normal. [S&P is] going to become way more important in Canada because of this.”

S&P purchased Canadian Bond Rating Services eight years ago and has said it is interested in growing in Canada.

DBRS defends its previous policy of rating general market disruption liquidity paper, saying that the Canadian debt market had run successfully for 20 years using that type of guarantee. “It had worked through the liquidity issues around the 1998 Long-Term Capital Man-agement LP crisis, through Y2K, through 9/11 and SARS,” says Marriott. “It’s not as if [GMD liquidity] hadn’t been tested.”

DBRS is certainly not alone in its struggles, as other major rating agencies are dealing with declining demand and the loss of reputation.Last month, U.S.-based McGraw-Hill Cos., the parent of S&P, announced it would cut 172 jobs in its financial services unit, though not all from S&P. That news came only days after Moody’s said it would cut 275 employees. Both firms have blamed turmoil surrounding the credit crisis for declining business.

DBRS says that its North Amer-ican-based analysts will take over coverage of European companies for now and that it will look to reopen its European offices when market conditions improve.

In both the U.S. and Europe, ratings agencies have come under regulatory scrutiny as legislators look to see if the way that rating agencies operate can be improved. Several changes have been suggested — including adopting a market value-based approach to ratings, or fostering more competition (the global industry is dominated by a handful of players) — but there doesn’t appear to be consensus about what changes would be an improvement over the long term.

“I don’t think the system is going to change,” Abacus’ Carey says.

Industry observers agree that the service the ratings agencies provide is vital for investors, who can’t do the due diligence on each debt security they purchase. And, certainly, no one is suggesting the ratings agencies should carry all the blame for the entire credit crisis.

“Perhaps investors were lulled to sleep by the rating agencies that said the [mortgage-backed] vehicles weren’t as risky as they turned out to be,” UWO’s Foerster says. “But, in retrospect, there was almost a global underestimation of the riskiness of these kinds of securities.”

Adds Booth: “There’s plenty of blame to go around for
everybody.” IE