Credit Rating Agencies – Need For Reform

1. Crisis – Spotlight on Credit Rating Agencies

Credit-rating agencies use their control of information to fool investors into believing that a pig is a cow and a rotten egg is a roasted chicken. Collusion and misrepresentation are not elements of a genuinely free market – US Congressman Gary Ackerman

The smooth functioning of global financial markets depends, in part, upon reliable assessments of investment risks, and Credit Rating Agencies play a meaningful role in boosting investor confidence in those markets.

The above rhetoric, although harsh, beckons us to focus our lens on the functioning of credit rating agencies. Recent debacles, as enunciated below, make it all the more important to examine the claim of Credit Rating Agencies as fair assessors.

i) Sub-chief Crisis: In the recent sub-chief crisis, Credit Rating Agencies have come under increasing fire for their covert collusion in favorably rating junk CDOs in the sub-chief mortgage business, a crisis which is currently having world-wide implications. To give some background, loan originators were guilty of packaging sub-chief mortgages as securitizations, and marketing them as collateralized debt obligations on the secondary mortgage market. The agencies failed in their duty to warn the financial world of this malpractice by a fair and transparent assessment. Shockingly, they gave popular ratings to the CDOs for reasons that need to be examined.

ii) Enron and WorldCom: These companies were rated investment grade by Moodys and Standard & Poors three days before they went bankrupt. Credit Rating Agencies were alleged to have favorably rated risky products, and in some instances put these risky products together for a fat fee.

There may be other over-rated Enrons and WorldComs waiting to go bust. The agencies need to be reformed, to permit them pin-point such cancer well-in-improvement, thereby increasing security in the financial markets.

2. Credit Ratings and Credit Rating Agencies

i) Credit rating: is a structured methodology to rank the creditworthiness of, broadly speaking, an entity, or a credit commitment (e.g. a product), or a debt or debt-like security as also of an Issuer of an obligation.

ii) Credit Rating Agency (CRA): is an institution, specialized in the job of rating the above. Ratings by Credit Rating Agencies are not recommendations to buy or sell any security, but just an indicator.

Ratings can further be divided into

i) Solicited Rating: where the rating is based on a request, say of a bank or company, and which also participates in the rating course of action.

ii) Unsolicited Rating: where rating agencies claim to rate an organisation in the public interest.

Credit Rating Agencies help to unprotected to economies of extent, as they help avoid investments in internal tools and credit examination. It thereby enables market intermediaries and end investors to focus on their chief competencies, leaving the complicate rating jobs to dependable specialized agencies.

3. Credit Rating Agencies of observe

Agencies that assign credit ratings for corporations include

A. M. Best (U.S.)

Baycorp Advantage (Australia)

Dominion Bond Rating Service (Canada)

Fitch Ratings (U.S.)

Moodys (U.S.)

Standard & Poors (U.S.)

Pacific Credit Rating (Peru)

4. Credit Rating Agencies – strength and Influence

Various market participants that use and/or are affected by credit ratings are as follows

a) Issuers: A good credit rating improves the marketability of issuers, as also pricing, which in turn satisfies investors, lenders or other interested counterparties.

b) Buy-Side Firms : Buy side firms such as mutual funds, pension funds and insurance companies use credit ratings as one of several important inputs to their own internal credit assessments and investment examination, which helps them clarify pricing discrepancies, the riskiness of the security, regulatory compliance requiring them to park funds in investment grade assets etc. Many restrict their funds to higher ratings, which makes them more attractive to risk-averse investors.

c) Sell-Side Firms: Like buy-side firms many sell side firms, like broker-dealers, use ratings for risk management and trading purposes.

d) Regulators: Regulators mandate usage of credit ratings in various forms for e.g. The Basel Committee on banking supervision allowed edges to use external credit ratings to determine capital allocation. Or, to quote another example, restrictions are placed on civil service or public employee pension funds by local or national governments.

e) Tax Payers and Investors: Depending on the direction of the change in value, credit rating changes can assistance or harm investors in securities, by erosion of value, and it also affects taxpayers by the cost of government debt.

f) Private Contracts: Ratings have known to considerably affect the balance of strength between contracting parties, as the rating is inadvertently applied to the organisation as a whole and not just to its debts.

Rating downgrade – A Death spiral:

A rating downgrade can be a vicious cycle. Let us visualise this in steps. First, a rating downgrade acts as a cause. edges now want complete repayment, anticipating bankruptcy. The company may not be in a position to pay, leading to a further rating downgrade. This initiates a death spiral leading to the companys ultimate collapse and closure.

Enron faced this spiral, where a loan clause stipulated complete repayment in the event of a downgrade. When downgrade did take place, this clause additional to the financial woes of Enron pushing it into thorough financial trouble.

Pacific Gas and Electric Company is another case in point which was pressurised by aggrieved counterparties and lenders demanding repayment, thanks to a rating downgrade. PG&E was unable to raise funds to repay its short term obligations, which aggravated its slide into the death spiral.

5. Credit Rating Agencies as victims

Credit Rating Agencies confront the following challenges

a) Inadequate Information: One complaint which Credit Rating Agencies have is their inability to access accurate and reliable information from issuers. Credit Rating Agencies cry, that issuers deliberately withhold information not found in the public domain, for example undisclosed contingencies, which may adversely affect the issuers liquidity.

b) System of compensation: Credit Rating Agencies act on behalf of investors, but they are in most situations paid by the issuers. There lies a possible for conflict of interest. As rating agencies are paid by those they rate, and not by the investor, the market view is that they are under pressure to give their clients a favourable rating – else the client will move to another obliging agency. Credit Rating Agencies are plagued by conflicts of interest that might hinder them from providing accurate and honest ratings. Some Credit Rating Agencies let in that if they depend on investors for compensation, they would go out of business. Others strongly deny conflicts of interest, defending that fees received from individual issuers are a very small percentage of their total revenues, so that no single issuer has any material influence with a rating agency.

c) Market Pressure : Allegations that ratings are expediency and not logic-based, and that they would resort to unfair practices due to the inherent conflict of interest, are dismissed by Credit Rating Agencies as malicious because the rating business is reputation based, and incorrect ratings may lower the standing of the agency in the market. In short reputational concerns are sufficient to ensure that they exercise appropriate levels of diligence in the ratings course of action.

d) Ratings over-emphasised: Allegations float that Credit Rating Agencies actively promote an over-emphasis of their ratings, and encourage corporations to do like-wise. Credit Rating Agencies counter saying that credit ratings are used out of context by no fault of their own. They are applied to the organizations per se and not just the organizations debts. A favourable credit rating is unfortunately used by companies as seals of approval for marketing purposes of unrelated products. A user needs to bear in mind that the rating was provided against the stricter scope of the investment being rated.

6. Credit Rating Agencies as Perpetrators

a) haphazard adjustments without accountability or transparency: Credit Rating Agencies can downgrade and upgrade and can cite without of information from the rated party, or on the product as a possible defence. Unclear reasons for downgrade may adversely affect the issuer, as the market would assume that the agency is privy to certain information which is not in the public domain. This may render the issuers security volatile due to speculation.

Sometimes eextraneous considerations determine when an adjustment would occur. Credit rating agencies do not downgrade companies when they ought to. For example, Enrons rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the companys problems for months.

b) Due diligence not performed: There are certain glaring inconsistencies, which Credit Rating Agencies are reluctant to resolve due to the conflicts of interest as mentioned above. for example, if we focus on Moodys ratings we find the following inconsistencies.

All three of the above have the same capital allocation forcing edges to move towards riskier investments like corporate bonds.

c) Cozying up to management: Business logic has forced Credit Rating Agencies to develop close bonds with the management of companies being rated, and allowing this relationship to affect the rating course of action. They were found to act as advisors to companies pre-rating activities, and suggesting measures which would have advantageous effects on the companys rating. Exactly on the other extreme are agencies, which are accused of unilaterally adjusting the ratings, while denying a company an opportunity to explain its actions.

e) Creating High Barriers to entry: Agencies are sometimes accused of being oligopolists, because barriers to market entry are high, as the rating business is reputation-based, and the finance industry pays little attention to a rating that is not widely recognized. All agencies consistently reap high profits (Moodys for example is greater than 50% gross margin), which indicate monopolistic pricing.

f) Promoting Ancillary Businesses: Credit Rating Agencies have developed ancillary businesses, like pre-rating assessment and corporate consulting sets, to supplement their chief ratings business. Issuers may be forced to buy the ancillary service, in lieu of a popular rating. To compound it all, except for Moodys, all other Credit Rating Agencies are privately held and their financial results do not separate revenues from their ancillary businesses.

7. Some Recommendations

a) Public Disclosures: The extent and the quality of the disclosures in the financial statements and the balance sheets need to be improved. More importantly the management discussion and examination should require disclosure of off-balance sheet arrangements, contractual obligations and contingent limitations and commitments. Shortening the time period, between the end of issuers quarter or fiscal year and the date of submission of the quarterly or annual report, will permit Credit Rating Agencies to acquire information early. These measures will enhance the ability of Credit Rating Agencies to rate issuers. If Credit Rating Agencies conclude that important information is unavailable, or an issuer is less than forthcoming, the agency may lower a rating, refuse to issue a rating or already withdraw an existing rating.

b) Due Diligence and competency of Credit Rating Agencies Analysts: Analysts should not rely solely on the words of the management, but also perform their own due diligence, by scrutinising various public filings, probing opaque disclosures, reviewing proxy statements etc. There needs to be a tighter (or broader) qualification to be a rating agency employee.

c) Abolition of Barriers to Entry: Increase in the number of players may not completely curtail the oligopolistic powers of the well-entrenched few, but at best it would keep them on their toes, by subjecting them to some level of competition, and allowing market forces to determine which rating truly reflects the financial market best.

d) Rating Cost: As far as possible, the rating cost needs to be published. If revealing such sensitive information raises issues of commercial confidence, then the agencies must at the minimum be unprotected to intense financial regulation. The analyst compensation should be merit-based, based on the demonstrated accuracy of their ratings and not on issuer fees.

e) Transparent rating course of action: The agencies must make public the basis for their ratings, including performance measurement statistics, historical downgrades and default rates. This will protect investors and enhance the reliability of credit ratings. The regulators should oblige Credit Rating Agencies to disclose their procedures and methodologies for assigning ratings. The rating agencies should conduct an internal audit of their rating methodologies.

f) Ancillary Business to be independent: Although the ancillary business is a small part of the total revenue, Credit Rating Agencies nevertheless need to establish extensive policies and procedures to firewall ratings from the ancillary business. Separate staff and not the rating analysts should be employed for marketing the ancillary business.

g) Risk Disclosure: Rating agencies should disclose material risks they uncover, during the risk rating course of action, or any risk that seems to be inadequately addressed in public disclosures, to the concerned regulatory authority for further action. Credit Rating Agencies need to be more proactive and conduct formal audits of issuer information to search for fraud, not just restricting their role to assessing credit-worthiness of issuers. Rating triggers (for example complete loan repayment in the event of a downgrade) should be discouraged wherever possible and should be disclosed if it exists.

These measures, if implemented, can enhance market confidence in Credit Rating Agencies, and their ratings may become a meaningful tool for boosting investor confidence, by enhancing the security of the financial markets in the broadest sense.

List of resources

i)[http://www.zyen.com/Knowledge/Articles/assessing_credit_rating_agencies.htm]

ii)http://www.chasecooper.com/News-Regulatory-Basel-II-2007-10-01.php

iii)http://www.blackwell-synergy.com/doi/abs/10.1111/j.1468-0491.2005.00284.x?cookieSet=1&journalCode=gove

iv)http://www.house.gov/apps/list/speech/ny05_ackerman/WGS_092707.html

v)http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2373869.ece

vi)http://www.cfo.com/article.cfm/9861731/c_9866478?f=home_todayinfinance

vii)http://en.wikipedia.org/wiki/Credit_rating_agency