Analysis Group affiliate William Chambers of Boston University spent more than 20 years with Standard & Poor’s, and recently provided an expert report and deposition testimony in the Rohm and Haas v. Dow Chemical case.
Below, he talks about challenges to the credit rating system.
I think that working to refine the current model – which works pretty well – would be more beneficial than trying to restructure it. The priority should be to add more transparency to the ratings process, and the agencies already have published lots of information regarding their criteria and the credit factors that they rely on. But more could be done.
One suggested “reform” of the standard relationship between issuer and an agency involves having investors or brokers pay for rating services. But this could create serious cost allocation problems among a constantly changing field of payers. It also could create new conflicts. For example, an investment bank underwriting a new transaction might have incentive to lobby for a higher rating – as might any investor holding a particular debt issue. On the other hand, investors wanting to short a particular bond issue might lobby for a lower rating.
Another approach to adjusting the system might be to have a tax or transaction fee structure that would fund a pool from which ratings agencies would be paid, although this would pose its own set of challenges. For example, how many ratings agencies would there be? Should all of them receive equal payment regardless of the quality of their work?
“Even though ratings agencies try to examine the available business and financial information as carefully as possible, something can be missed when rapid changes occur.”
Widespread distribution of the actual ratings and the performance of those ratings over time would be useful. S&P, Moody’s, and Fitch already publicize their ratings. Additionally, the agencies publish regular reviews of their ratings performance – looking at the percentage of borrowers rated BBB who default over a one-year, five-year, or 10-year period, for example – to help investors and others assess their accuracy. And the agencies also run periodic seminars on their methodologies. Ironically, some proposals to change the system by making ratings available only to paying subscribers would actually reduce the public availability of rating information.
Finally, it’s important to remember the purpose ratings are supposed to serve. Ratings are opinions about an entity’s ability to repay its interest and principal obligations going forward. Since the future is unknown, any opinion from a ratings agency or other observer has an element of uncertainty attached. The most sensible way for an investor to use agency ratings is to consider them along with other information as part of a thorough analysis of a particular business and its industry.
Discrepancies between credit ratings and actual company values….
In the corporate debt markets, there have been some instances where the agencies got things wrong. But in most of these cases some severe external shock has affected a borrower’s ability to pay.
Financial institutions also are particularly sensitive to changes in investor confidence. If the market’s confidence in a particular entity falters, its position can deteriorate rapidly as its liquidity dries up. The implosions of Bear Sterns, Lehman Brothers and AIG are examples here. Even though ratings agencies try to examine the available business and financial information as carefully as possible, something can be missed when rapid changes occur.
A lot of the criticism of the agencies has arisen in the asset-backed debt area, such as mortgage-backed securities. To assign ratings in this sector, the credit quality of the underlying collateral must be reviewed; estimates of cash flows, defaults and recoveries modeled; and the legal structure of the obligations assessed. In addition, these securities often are broken into different tranches, with available cash flow going first to the senior-most tranche – and once that obligation is met, flowing to the lower level tranches. Because of their structural complexity, once some asset-backed securities encountered trouble, investors fled en masse from the whole field, even from the most senior tranches, which, in most cases were still adequately backed with collateral and cash flow. With lots of sellers and not many buyers, the prices on the asset-backed securities were driven down drastically, often to levels implying high probabilities of default and low recovery values not seen since the Great Depression.
Avoiding conflicts of interest between agencies and the companies that pay them….
The ratings agencies separated their ratings operations from their business operations several years ago. The people who assign the ratings have little or no knowledge of what fees are charged to the companies being rated, and the fees charged have absolutely no bearing on the rating assigned. Additionally, strict rules are in place prohibiting analysts from investing in the debt or equity of the companies they rate. I worked with and observed ratings agencies for more than 25 years, and never saw one case where a supposed “conflict” was shown to affect a rating. It’s also interesting that active participants in the market – the investors, the borrowers, and the investment bankers with whom I’ve spoken – don’t see this as a fundamental issue.
If you look at the extent to which ratings impact corporate behavior, it’s clear that any influence is traveling in only one direction – from the agency to the debt issuer. Issuers commonly undertake significant actions in response to agency concerns – they might, for example, reduce dividends and expenditures or possibly divest assets in an effort to maintain an investment-grade rating with Moody’s and S&P.
Why credit ratings are critical, and how agencies arrive at them….
Credit ratings determine a debt issuer’s cost of debt as well as its access to funds. Companies with stronger credit ratings enjoy lower borrowing costs and greater access to debt markets. But ratings agencies look at a wide variety of factors before issuing a determination.
When analyzing a company’s creditworthiness, ratings agencies try to look through the business cycle. This means that in addition to detailed, often confidential, financial information provided by the debt issuer, ratings agencies evaluate the company’s strengths and weaknesses in the context of both the overall economy and within specific industry sectors. Because of this approach, credit ratings tend not to change much with fluctuations in business cycles. This is why a rating may be lower than financial ratios would suggest at the top of a cycle, or higher than those ratios would indicate at the trough.
The debt rating process involves frequent discussions among the issuer’s representatives and the rating analysts, who scrutinize the issuer’s financial and business information to assess its credibility. The process is ongoing, and past projections and results are considered along with outlooks for the future and the likelihood of various possible scenarios’ unfolding. Finally, after considering both business and financial factors among the criteria, the credit committee – never just a single analyst – determines an issuer’s credit rating. ■
From Analysis Group Forum (Spring/Summer 2009)