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
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.
Moody's Grades for a 5 year period
Product
Default Rate
Grade
Period (years)
Corporate Bonds
2.2%
Baa (Lowest Grade)
5
CDOs
Municipal Bonds
24%
0.09%
"
"
"
"
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.14680491.2005.00284.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/articl
e2373869.ece
vi)
http://www.cfo.com/article.cfm/9861731/c_9866478?f=home_todayinfinance
vii)
http://en.wikipedia.org/wiki/Credit_rating_agency