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Wednesday, Jul 17, 2002

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Opinion - Credit Rating

The fall of rating agencies

K. Subramanian

FOR American investors, rating companies is like mother's milk. In the early years of American development, they played an important role in raising capital for railroads and westward expansion. Moody's gave its first rating in 1909, followed by S&P's in 1922 and Fitch in 1924. They provided accurate, impartial and independent information. American banking laws and regulations prevented banks from direct involvement in the promotion of companies. There were restrictions on inter-state lending and bonds and commercial paper became the major sources of financing rather than direct bank lending. These led to the growth of rating agencies and there are estimated to be 8,000 such firms in the US.

Of these, only three are effective players. They differ from rating companies in Germany and Japan, where banks are involved directly in financing companies/projects and manage their affairs by getting into their boards. During globalisation, borders got blurred and other countries imbibed more of America's standards and style.

There were two broad trends. As Dr Dieter Kerwer of Max Planck Project group puts it, the power of banks waned and their traditional role in allocating capital — intermediating between depositors and borrowers — was eliminated. With the expansion of financial markets since the 1980s, depositors preferred mutual funds to banks. "The concrete credit relationship between borrowers and banks is replaced by an abstract relationship between a multitude of issuers and buyers of securities". This shift took the rating agencies to the centrestage.

The other trend was globalisation. With the ascendancy of the Washington Consensus, there was greater reliance on private sources to finance the general withdrawal of the state from economic activities. Bilateral and multilateral sources of finance were drying up and developing countries were driven to tap the international capital market directly. This increased the dependence on rating agencies. Lenders, largely from the US, had to conform to rating thresholds. Borrowers, in their turn, sought the grading attractive to US investors. Thus, the process of global financial expansion and integration promoted the adoption of American methods and standards. In many instances, rating agencies got involved in direct dialogue with ministers and officials of developing countries.

In the years preceding the first Mexican default of October 1984, there was an unholy alliance between banks, borrowers and lending agencies and the rating agencies joined the chorus by providing comfortable "sovereign ratings". Even a few days before the default, the rating companies did not anticipate default and gave it a high rating. This situation came about because the rating companies ceased to remain `outsiders' to maintain objectivity and assess the developments independently. They had become a part of the team formed by fund managers, banks and financial institutions. There were conflicts of interests and they failed in the regulatory role. Was it due to the huge service fee attached to loan proposals?

When we review the years of East Asian development fed by bank loans, the credibility of rating agencies is further diminished. All of them failed to predict the financial crisis. As Ms Carmen Reinhart says: "The downgrades appear to materialise after and not before the crises in Asia." (Default, Currency Crises and Sovereign ratings, NBER Working Paper No. 8738, January 2002). He further explains how rating agencies failed to relate currency crises to defaults and to delve into the factors leading to currency crisis.

They were not alone. Even the IMF, with all the computerised data at its command, could not foresee the crises. Moreover, those were the years when the West was undergoing secular stagflation and its surplus funds were thirsting for investment outlets and East Asia seemed to provide an enduring haven. There was a collective euphoria and rating agencies were not left behind. Stray voices, such as those of Mr Paul Krugman, were heard, but not heeded.

The rating system has serious limitations when grafted on foreign bodies. In the assessment of risk or risk-related indicators, they tended to apply extraneous criteria and knowledge structures. They strayed far beyond credit-related elements and imported ideas such as privatisation, fiscal reduction, governance and deregulation. The failings of the rating agencies in these years did not worry the US public or the Congress as long as they occurred in foreign jurisdictions and promoted US interests. They were alerted only when those methods were re-exported to its homeland and brought about a major crisis — Enron.

The Enron crisis prompted the Chairman of Congress, Mr Joe Lieberman, to "ask why the credit raters continued to rate Enron as good risk up until four days before it declared bankruptcy". In a number of connected companies, the downgrade was given in a similar way. The stock market and financial analysts were aware of the `hollowness' of these players and anticipated their collapse. And yet, rating agencies came with their downgrades days after the collapse. The Enron crisis might have raised the debate to national and congressional levels. Even in the years preceding Enron, there was dissatisfaction over their performance among many economists.

Mr Lawrence White, Stern School of Business, doubted the efficacy of the agencies, which have come to wield so much power. In his view, though broadly there is correlation between ratings and default in that issues rated higher default less frequently, they do not provide extra or useful information beyond what is known to the market like interest spreads, etc. The Economist (February 14) reported that "a bond's rating tells you ever less and less about the price investors are willing to pay". There were variations between the ratings and credit spreads and in 2001 "credit spreads' standard deviation, a measure of dispersion, had risen more than six-fold".

Prof Jonathan R. Macey, Cornell Law School, explains: "Credit ratings do not provide useful or timely information about the credit-worthiness of companies in today's markets. Academic studies tend to show that information in credit ratings is of marginal value at best because... (it has) already been incorporated into share prices. One well-known study showed that the ratings provided by rating agencies lagged the information contained in securities prices by a full year.

In defence, rating agencies informed the Committee that Enron provided `deceptive' and `fraudulent' information to them. But they were told that the rating agencies had a "major obligation" and "duty" to get the truth on Enron's financial condition. Under law, rating agencies have special access and protection. They are allowed to look at a company's inside information to make assessments and are exempted from liability when they participate in securities offerings. And yet, they did not ask for the information. So, if they did not ask for more information, there was good reason for it. They were aware of the real state of affairs and were helping the company put through creative packages — collateralised debt obligations (CDOs) — to ward off the risk. Perhaps, based on Enron's connections, they were confident that the White House would come to the rescue as it did when LTCM suffered a similar crisis. Unfortunately, the situation was out of control and beyond the White House's reach. Rating work was dependent on sound accounting practices, transparency in the disclosure of assets and liabilities of a corporation. Such companies as Enron distorted the accounting practices. They shifted risk by shifting them to banks and insurance companies through the creation of CDOs. CDOs were shuffled between companies, banks, funds and insurance companies. Fictitious revenue streams were created and trading companies, in turn, created fictitious trading turnovers through round-tripping. The shuffling of CDOs was also to circumvent regulations. Amid the chaos, the rating agencies were expected to rate securities, which were backed by fictitious accounts, and hidden in CDOs whose ownership was unclear. As descried by The Economist (May 16) they had to rate the "asset managers as much as cold assessors of the underlying assets".

It is easy to demolish the rating agencies. It is not as easy to establish a new structure in their place. This is partly because there has so been much reliance for over three decades on private agencies to perform a `public' role. The inadequacies of such reliance have become clear. Regulators the world-over would need to rate securities and fix thresholds for various purposes. In the US and EU, where deregulation philosophy is dominant, there is reluctance to establish statutory agencies to undertake the role.

Ultimately, it may be unavoidable. The reluctance is based on the view that these agencies would not be able to fill the bill and it would impose additional costs on banks and institutions. The former is a prejudice; the latter a fallacy if the overall savings in social costs and interests of pension funds, etc, are considered. Old habits die hard. So where reason fails, necessity must drive.


(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)

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