Credit Rating Agencies - Need for Reform - posted 18 Oct 2007
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
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
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
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
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.)
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
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
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
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.
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