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| ARTICLES > Credit Rating Agencies - Need for Reform - posted 18 Oct 2007 |
Credit Rating Agencies - Need for Reform - posted 18 Oct 2007[off-topic] Credit Rating Agencies (CRAs) - Need for Reform 1. Crisis - Spotlight on CRAs "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 CRAs play a significant 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 scrutinize the claim of CRAs as fair assessors. i) Sub-Prime Crisis: In the recent sub-prime crisis, CRAs have come under increasing fire for their covert collusion in favorably rating junk CDOs in the sub-prime mortgage business, a crisis which is currently having world-wide implications. To give some background, loan originators were guilty of packaging sub-prime mortgages as securitizations, and marketing them as collateralized debt obligations on the secondary mortgage market. CRAs failed in their duty to warn the financial world of this malpractice through a fair and transparent assessment. Shockingly, they gave favorable ratings to the CDOs for reasons that need to be examined. ii) Enron and WorldCom: These companies were rated investment grade by Moody’s and Standard & Poor’s three days before they went bankrupt. CRAs 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 Enron’s and WorldComs waiting to go bust. CRAs need to be reformed to enable them pin-point such cancer well-in-advance thereby increasing security in the financial markets. 2. Credit Ratings and CRAs 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 CRAs are not recommendations to purchase 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 process. ii) Unsolicited Rating: where rating agencies claim to rate an organisation in the public interest. CRAs help to achieve economies of scale as they help avoid investments in internal tools and credit analysis. It thereby enables market intermediaries and end investors to focus on their core competencies leaving the complex rating jobs to dependable specialized agencies. 3. CRAs of note 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.) Moody’s (U.S.) Standard & Poor’s (U.S.) Pacific Credit Rating (Peru) NRSRO: The US SEC officially permits financial firms to use an NRSRO (Nationally Recognized Statistical Rating Organization) agencies’ ratings for regulatory purposes. Arguably, investor protection is the underlying philosophy behind NRSRO designation. 4. CRAs - Power 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 analysis which helps them identify 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 banks 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. USA government restrictions typically require that the credit rating agency have NRSRO status which has been described earlier. e) Tax Payers and Investors: Depending on the direction of the change in value, credit rating changes can benefit or harm investors in securities through erosion of value and it also affects taxpayers through the cost of government debt. f) Private Contracts: Ratings have known to significantly affect the balance of power 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 happens. Banks now want full repayment anticipating bankruptcy. 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 full repayment in the event of a downgrade. When downgrade did take place, this clause added to the financial woes of Enron pushing it into deep 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. CRAs as victims CRAs face the following challenges a) Inadequate Information: One complaint which CRAs have is their inability to access accurate and reliable information from issuers. CRAs cry that issuers deliberately withhold information not found in the public domain for instance undisclosed contingencies which may adversely affect the issuers’ liquidity. b) System of compensation: CRAs act on behalf of investors but they are in most cases paid by the issuers. There lies a potential 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. CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. There are conflicting noises with some CRAs admitting 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 CRAs 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 process. d) Ratings over-emphasised: Allegations float that CRAs actively promote an over-emphasis of their ratings and encourage corporations to do like-wise. CRAs counter saying that credit ratings are used out of context through 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. CRAs as Perpetrators a) Arbitrary adjustments without accountability or transparency: CRAs can downgrade and upgrade and can cite lack 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, Enron’s rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company’s problems for months. b) Due diligence not performed: There are certain glaring inconsistencies which CRAs are reluctant to resolve due to the conflicts of interest as mentioned above. For instance if we focus on Moody’s ratings we find the following inconsistencies. All three of the above have the same capital allocation forcing banks to move towards riskier investments. c) Cozying up to management: Business logic has compelled CRAs to develop close bonds with the management of companies being rated and allowing this relationship to affect the rating process. They were found to act as advisors to companies’ pre-rating activities and suggesting measures which would have beneficial 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 and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). All agencies consistently reap high profits (Moody’s for instance is greater than 50% gross margin), which indicate monopolistic pricing. f) Promoting Ancillary Businesses: CRAs have developed ancillary businesses like pre-rating assessment and corporate consulting services to complement their core ratings business. Issuers may be forced to purchase the ancillary service in lieu of a favorable rating. To compound it all, except for Moody’s all other CRAs 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 analysis should require disclosure of off-balance sheet arrangements, contractual obligations and contingent liabilities 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 enable CRAs to obtain information early. These measures will improve the ability of CRAs to rate issuers. If CRAs 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 even withdraw an existing rating. b) Due Diligence and competency of CRAs 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: NRSRO status among others has proved to be a barrier to entry for new CRAs. 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 least be subject 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 Process: 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 CRAs 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, CRAs still 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 process or any risk that seems to be inadequately addressed in public disclosures, to the concerned regulatory authority for further action. CRAs 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 instance full 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 improve market confidence in CRAs, and their ratings may become a key 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
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