A change in credit rating is big news. If the media is used as a measuring stick, there are not many things out there that are as vital to the everyday running of the global financial sector as credit rating agencies. This dependence however is hard to comprehend once it is taken into account that these independent agencies are not a regulatory body and in fact are simply giving ‘opinions about credit risk’ (Standard and Poor, 2016).
The instrument of credit ratings has the ability to provide an injection of confidence into an issuer of debt securities, or inversely to damage their reputation when given a low rating.
The market for giving out these ratings is dominated by the ‘Big Three’, making up 95% of the total market share combined (Council on Foreign Relations, 2015). The most well-known credit rating company and also the original contributor of bond ratings since 1909, Moody’s, has a scaling system based on Aaa being the highest quality. Standard and Poor also holds around 40% market share with a maximum positive rating of AAA progressing through a similar general grading system all the way down to D for default. Fitch, the smallest of the agencies despite having generated revenue of approximately $950 million, has the most simple system of the triad: AAA, AA, A, B…D. In general terms, the lower the credit rating, the greater the risk to the investor.
The credit ratings role in mediating the financial market is to determine the creditworthiness of a borrower as a summation of all information made available publicly. This also includes assessing their ability to repay a debt and their likelihood of defaulting. The value of these ratings therefore lies in it being an independent evaluation away from pressure or influence of those being assessed. However, in the light of events such as the Global Financial Crisis (GFC), investors are starting to lose confidence in this very independence credit rating agencies pride themselves on.
PILLAR OF SUPPORT
The very existence of credit rating agencies has been attacked in an effort to delegitimise the agencies. However, the fact that they still exist and operate till this day may be suggesting that they play an essential and irreplaceable role in the capital market.
In his speech to the United Nations General Assembly in 2013, Paul Taylor, President and CEO of Fitch Group reiterated this point, asserting that ratings agencies close the information gap between buyers and sellers of bonds. While issuers may wish to present an image of being liquid and reliable, perhaps to appear as a worthwhile partner for investment or trade, it is credit rating agencies who ensure that only true and impartial information is communicated to all parties. Every investor deserves to understand the level of risk associated with their investments and credit rating agencies are here to provide that fair assessments and give warning should they need to.
It is on this point that the argument for credit rating agencies is strengthened. The veracity of the judgements of the Big Three Agencies, is affirmed, approved and supported by the Securities and Exchange Commission, who has listed S&P, Moody’s and Fitch as Nationally Recognised Statistical Rating Organisations.
Apart from reducing information asymmetry, the need of a positive rating from the agencies could incentivise institutions to improve their liquidity. If investors are turned away from an institution due to their credit rating, said institution will be encouraged to prove the fact that they can consistently repay debt to demonstrate their reliability to investors. Having a higher credit rating also allows institutions to borrow money at more favourable interest rates (Smith, 2011). In essence, the nature of a credit rating encourages improvement and facilitates an atmosphere of wanting to honour debt obligations in order to reap the benefits of a positive rating such as the ability to expand their business cheaply.
LEAN ON ME?
One need not look further than the GFC in 2008 to see the impact that credit rating agencies had on aggravating the near-bursting economic bubble. The GFC was a result of a toxic concoction of avarice, irrational behaviour and information asymmetry, of which credit rating agencies were deemed to be the one of the greatest contributors.
The subprime-mortgage crisis began in the United States of America in 2007, with the incessant underwriting of subprime housing loans, i.e. loans to borrowers with weak creditworthiness (The Economist, 2013). To bring home a bigger paycheck at the investor’s expense, a new security called Credit Debt Obligations (CDOs) was created out of the “ingenuity” of Wall Street financial engineers. They were purported to be low risk assets due to the underlying principle of risk diversification. At this point in time, there’s no doubt that they were nowhere near as good as what they claimed to be. However, investors then failed to realise the true value of these assets due to the combination of irrational bullish sentiment and the obfuscation of highly risky assets behind investment-grade ratings given by the credit rating agencies (The Economist, 2013).
The quasi-regulatory body status given to credit rating agencies by the US government has only accelerated the amount of CDOs that were issued into the market (Mulligan, 2009). As mentioned earlier, credit rating agencies serve as agents of confidence due to their reputation as trustworthy assessors of borrower creditworthiness. Investors rely heavily on their analyses on a borrower’s probability of default. Incentivised by profits and competition among each other, the Big Three gave the highest ratings on most of the debt issued during the lead-up to the GFC, including the catalyst of the GFC itself – subprime loans (Smith, 2008). Consequently, “irrational exuberance”, as coined by the former Federal Reserve Chairperson Alan Greenspan, was amplified by the misguidance.
Another issue inherent within the credit rating agencies’ dealings leading up to the GFC is the conflict of interest between investors and the agencies itself (Davis, 2011). A credit rating agency’s revenue is contingent upon the fees they charge the loan issuer for a credit rating, which is known as the issuer-pay model. This model opens the opportunity for monetary solicitation of higher ratings in order to improve the value of the bank-issued securities (Cole & Cooley, 2014). An email by an analyst in S&P with the quote “Lets hope we are rich and retired when this house of cards falter,” clearly unveils the immorality behind the workings of credit rating agencies during that period (Smith, 2008).
IN WHOM WE TRUST
Investors are reliant on credit rating agencies because they believe the experts know best. However, some suggest otherwise.
Moody’s Investor Service has recently downgraded China’s government bond rating from “stable” to “negative” on grounds of weakening fiscal metrics, falling foreign exchange reserve and the uncertainty surrounding the authorities’ ability to implement reforms (Moody’s Global Credit Research, 2016).
The downgrading is unwelcomed by the Chinese officials, many of whom have publicly criticised it as baseless. The Ministry of Finance has also quickly issued a statement in response to Moody’s actions, claiming that it has failed to grasp the overall picture of China’s economic and financial conditions (Xinhua, 2016). The statement further pointed out that contrary to Moody’s understanding, balancing economic growth, structural reform and market stability would be a complementary process instead of a conflicting one (Xinhua, 2016). In fear of sending the wrong signal to the market, the Ministry of Finance urged rating firms like Moody’s to develop a deeper understanding on their local market before making similar calls (Xinhua, 2016).
The credibility of both the report from Moody’s and claims from the Chinese authority remain unknown for now, and the Chinese market is still relatively stable. Investors could be taking their time to understand the rationale behind the downgrade or are still in the midst of forming an expectation on China’s economic outlook. However, it is worth noting here that if negative sentiments were to form from Moody’s downgrading, it could potentially cause a massive capital flight out of China and would render its attempt to stimulate economic growth through investments useless. In fact, on a separate occasion, when Moody’s raised questions on 61 Chinese companies listed on the Hong Kong Stock Exchange on one of its reports, both the share and debt markets in Hong Kong tumbled. The report was called the “Red Flags for Emerging-Market Companies: a Focus on China” and it outlined the said companies to have poor corporate governance, opaque business models as well as suspicious accounting practice.
Moody’s uses 20 different indicators to detect possible weaknesses in corporate governance, business model and financials as part of its risk assessment framework (Armstrong, 2011). However, many analysts suggested that not only Moody’s has failed to take into account sector-specific factors, the appropriateness of the indicators is questionable (Armstrong, 2011).
Apart from that, Moody’s has been accused of providing incorrect information to the market. In the case of a Chinese property developer called Kaisa, Moody’s raised a red flag for its auditor change. The problem in that was that Kaisa had always stuck to the same auditor, as indicated on its filings. This triggered an investigation from the Securities & Futures Commission in November 2011. On March 2016, The Hong Kong Securities and Futures Appeals Tribunal has ruled Moody’s for breaching the substantive general principles under the code of conduct by providing misleading information to the market (The Business Times, 2016). The tribunal found that there was an obvious failure from Moody’s to set out the true nature and purpose of its red flagging framework (The Business Times, 2016). As a result, it was fined for approximately $1.84 million.
REDEMPTION
Rightfully or wrongfully, investors and institutions depend on credit ratings in order to make economic decisions on investments and borrowings. At times, the success or otherwise of a security issue can be interpreted from this one rating, a rating which is not entirely independent, or necessarily an accurate portrayal of a firm’s ability to repay a debt. However, we have yet to reach the crossroad of deciding whether credit rating agencies should go or not, as it still holds a vital role in facilitating information flow in the capital market.
The Securities and Exchange Commission should intervene more in the inner workings of credit rating agencies to guarantee their independence by overseeing the issue of conflicting interest arising from the issuer-pay model. Another strengthening initiative could be to conduct a review on the credit rating agencies’ existing framework to increase the authenticity of their analyses. In summary, the ratings in their current form serve an important service to the public but are in need of further revision and structural guidelines if they are to truly be employed to their full potential.
Reference List
Armstrong, R. (2011). Moody’s China red flag report under scrutny by HK regulators. Retrieved from http://www.reuters.com/article/us-china-accounting-idUSTRE76K29L20110721
Cole , H. L., & Cooley , T. F. (2014). Rating agencies. Cambridge: National Bureau of Economic Research.
Council on Foreign Relations. (2015). The credit rating controversy. Retrieved from http://www.cfr.org/financial-crises/credit-rating-controversy/p22328
Davis , K. (2011). Explainer: The role of credit ratings agencies. Retrieved from http://theconversation.com/explainer-the-role-of-credit-ratings-agencies-2629
Moody’s Global Credit Research. (2016). Moody’s changes outlook on China’s Aa3 government bond rating to negative from stable; affirms Aa3 rating. Retrieved from https://www.moodys.com/research/Moodys-changes-outlook-on-Chinas-Aa3-government-bond-rating-to–PR_343931
Mulligan , C. (2009). From AAA to F: How the Credit Rating Agencies Failed America & What Can Be Done to Protect Investors. Boston College Law Review, 50(4 ), 1275-1304.
Smith , E. B. (2008). Bringing down Wall Street as ratings let loose subprime scourge . Retrieved from http://marketpipeline.blogspot.com.au/2008/09/bringing-down-wall-street-as-ratings_25.html
Smith , E. B. (2008). ‘Race to bottom’ at Moody’s, S&P secured subprime’s boom, Bust. Retrieved from http://marketpipeline.blogspot.com.au/2008/09/bringing-down-wall-street-as-ratings_25.html
Smith, K. (2011). History of credit rating agencies and how they work. Retrieved from http://www.moneycrashers.com/credit-rating-agencies-history
Standard and Poor’s Rating Services. (2016). Understanding ratings. Retrieved from https://www.spratings.com/en/understanding-ratings
The Business Times. (2016). Moody’s fined HK$11m as Hong Kong tribunal sides with SFC. Retrieved from http://www.businesstimes.com.sg/banking-finance/moodys-fined-hk11m-as-hong-kong-tribunal-sides-with-sfc
The Economist. (2013). The origins of the financial crisis: Crash course . Retrieved from http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article
Xinhua. (2016). Moody’s China outlook downgrade misses big picture: MOF. Retrieved from http://www.chinadaily.com.cn/business/2016-03/31/content_24206300.htm
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