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**Crisis – Spotlight on Credit Rating Agencies**

*“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 **Credit Rating Agencies** 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 Credit Rating Agencies as fair assessors.

**i) Sub-Prime Crisis:**
In the recent sub-prime crisis, Credit Rating Agencies 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. The agencies 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. Credit Rating Agencies 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 WorldCom’s waiting to go bust. The agencies need to be reformed, to enable them pin-point such cancer well-in-advance, thereby increasing security in the financial markets.

**Credit Ratings and Credit Rating Agencies**

**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 Credit Rating Agencies 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.

Credit Rating Agencies 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.

**Credit Rating Agencies 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.)
– Moody’s (U.S.)
– Standard & Poor’s (U.S.)
– Pacific Credit Rating (Peru)

**Credit Rating Agencies – 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 example, 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.

**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 organization as a whole and not just to its debts.

**Rating downgrade – A Death spiral:**

A rating downgrade can be a vicious cycle. Let us visualize this in steps. First, a rating downgrade acts as a trigger. Banks now want full repayment, anticipating bankruptcy. The company may not be in a position to pay, leading to a further rating downgrade. This initiates a death spiral leading to the company’s 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 pressured 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.

**Credit Rating Agencies as victims**

Credit Rating Agencies face the following challenges

**a) Inadequate Information:**
One complaint which Credit Rating Agencies have is their inability to access accurate and reliable information from issuers. Credit Rating Agencies cry that issuers deliberately withhold information not found in the public domain, for instance undisclosed contingencies, which may adversely affect the issuer’s liquidity.

**b) System of compensation:**
Credit Rating Agencies 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 favorable rating – else the client will move to another obliging agency. Credit Rating Agencies are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. Some Credit Rating Agencies admit 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 Credit Rating Agencies 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 overemphasized:**
Allegations float that Credit Rating Agencies actively promote an over-emphasis of their ratings and encourage corporations to do the same. Credit Rating Agencies 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 favorable 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.

**Credit Rating Agencies as Perpetrators**

**a) Arbitrary adjustments without accountability or transparency:**
Credit Rating Agencies can downgrade and upgrade and can cite a lack of information from the rated party or on the product as a possible defense. 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 issuer’s security volatile due to speculation. Sometimes, extraneous 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 Credit Rating Agencies are reluctant to resolve due…
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Ihab Salloum