Understanding the Role of Credit Rating Agencies
What if I told you that based on my analysis, which is more or less my gut feeling, the debt that is held in the books of IBM, or Coca Cola (based on your preference) is safe? The next time they offer a bond issue, the bonds would be secured and it can be expected that the company would come through in paying off its debts completely. Your response can vary from looking at me with doubt to disregarding me completely and walking away. That is justified…
Knowing that I am no authority on this issue, my analysis is much more of a 50-50 prediction that the company might or might not be able to pay off its debt. I have the likelihood of being right half the times based on the theory of averages. This is where the credit rating agencies come in. They are the ones responsible for carrying out their own research and then deciding whether the bond is a safe investment or a risky one. These include Standard & Poor (S&P), Moody’s and Fitch. Based on your risk preference, you can either go for a high-risk, high-return bond which is high yielding. Or you can go for a large blue chip company which is safe, will hold true on its debts and you will see your investment at the end of the bond’s life.
For a long period of time, there was blind trust in the abilities of rating agencies to do their job with due diligence. After a thorough review, an appropriate rating was given and that was taken as the true word. The rating agencies were the ‘be-all and end-all’ of finance world and based on the competition that they had with each other, they had a hunger to serve the markets and the investors in a proper manner. This motive was tarnished during the global financial crisis of 2008 where companies had started using the rules and standards set by the companies to their own advantage.
First of all, the companies had started building their own Collateralised Debt Obligations (CDOs) which were based on risky or subprime mortgages that would never be paid off or most likely be defaulted on. They then used the names of their firms as collateral rather than the actual worth of the mortgages that made up the CDO. This meant that a security which should have had been rated lowly (around C or B+++) was actually rated highly (AA or A).
This was made possible due to two major reasons: First of all, the companies had made an effort to only reach the minimum required standard in order to get the rating in their favour. The second reason was that rating agencies had started working for the companies themselves and in order to earn commission, they would rate the bulk of the securities in order to line up their own pockets rather than look out for the capital markets on a whole. When the crisis hit, it became apparent that the rating agencies were involved in it as well and this left a black stain on their credibility.
On the back of this, the recent interview by David Jacob, the former head of structured finance at S&P, shines light on the trust gap that exists in the markets. He says that big investors do not believe in the rating system anymore and that they are there as a formality rather than a tool for investment analysis. He said that there is a trust deficit with Wall Street when it comes to rating companies and that in order to restore it, the regulatory bodies should do their best in order to restore its good old days.
The rating companies have recently come under more fire as they went on a flurry of downgrading the US sovereign debt, first time in its history, in addition to the recent downgrades of European banks and nations. After the debacle of 2008, many dismissed the downgrade as a farce and there was a sentiment against these companies questioning their legitimacy.
Contenders would still claim that free markets have an in-built system to correct the price of the bond by taking its risk into account. The information available in the market would allow the investors to make an independent informed decision by themselves which render the rating agencies obsolete.
Still, rating agencies are important to, first of all, standardise the process and create a level playing field for every company with regards to its disclosure regardless of their size and cash flow. It also provides a quick snapshot to retail investors who do not have the time or resources to carry out a detailed analysis while making their decision. This means that credit ratings should be considered by any investor. However, it should be ‘an input’ in the whole framework of analysis rather than the ‘only input’.
In response to the recent crisis, US regulators have passed rules in the Dodd Frank Act which disregards references to rating agencies in terms of key company specific variables. The EU has also taken steps to have a rotation policy in place to avoid any crisis in the future. It is clear that a solution is required to mend the situation as it is in order to reinstate the institutions of finance that existed once and to regain the lost confidence of investors and markets alike. It would take time and effort but it is clear that the system has broken down and now it needs necessary rehabilitation. The magnitude of the problem at hand can be summarised in a few words in Jacob’s interview. He says that he worked for S&P for three and a half years and still doesn’t understand the rating system. The same letters are used to mean entirely different things.
Zain Naeem is the head of equity research at Maan Securities (Pvt) Ltd. He is a Lahore-based commentator with more than 3 years of experience in trading and research at the Karachi Stock Exchange and Lahore Stock Exchange. He enjoys writing and commenting on the finance front and presenting it to various audiences in different forums. Zain is deeply interested in politics, business and finance and is fascinated at how the three intermingle with each other.