Ratings in rough weather

MOHAN R. LAVI | Updated on August 16, 2011

Rating agencies must be independent and not get carried away by pecuniaryconsiderations.

Expecting a perfect rating report which will stand the test of time is akin to asking an auditor or management if there is any expectation of fraud in an entity in the years to come.

The trouble with weather forecasting is that it's right too often for us to ignore it and wrong too often for us to rely on it: Patrick Young. Reports by credit rating agencies have often been compared to weather forecasts. Yet, the downgrading of the sovereign credit rating of the United States by Standard and Poor's from AAA to AA+ has aggravated the gloomy global atmosphere further.

Justifying the downgrade, S & P states that it believes that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicated that further near-term progress on containing the growth in public spending — especially on entitlements or on reaching an agreement on raising revenues is less likely than it had previously assumed and will remain a contentious and fitful process.

A rising public debt burden and greater policy making uncertainty confirmed their thoughts. A colossal error in the assumptions was accepted by S&P but did not alter its stand on the rating. As a concession, it removed both short-term and long-term ratings from credit-watch negative though it warned of further downgrades if the improvements it seeks are not seen.

Critics state that the downgrade has come too late as it was common knowledge that the US economy was crippled for quite some time and healing an injured elephant takes time. The US is too significant to every nation for different reasons to let fail. The downgrade is not expected to have too much of an impact save for the initial tremors being witnessed, for the world trade and business must go on. The impact, if any, would be at best psychological.

Rating the raters

Criticism is not new to rating agencies. Just after Lehman Brothers derailed, credit rating agencies were ridiculed for precipitating the credit crisis. Collaterised Debt Obligations (CDOs) were the stand-out amount in Lehman Brothers balance-sheet, but they were also the weakest in terms of reliability. These exotic instruments were given top-notch ratings, prompting comments that the expansion of P in S&P reflected the quality of their ratings, while the instruments rated by Moodys lived up to the name.

Rating agencies were chastised in Congressional hearings and lawsuits for miscalculating the risks associated with mortgage-related securities. They were accused of creating complex models to calculate the probability of default for individual mortgages, and also for the securitised products these mortgages made up.

Raters failed to judge the likelihood of the decline in housing prices and their effect on loan defaults. These inflated ratings also failed to account for the greater systemic risks associated with downgrading structured products, as opposed to simpler securities such as corporate and sovereign bonds. Rating agencies also came under fire for allegedly sacrificing quality ratings to win a bigger share of the booming structured products business.

Lehman Brothers apart, Bear Stearns, Wachovia, Freddie Mac and Fannie May, AIG and Kaupthing Bank were all examples of undeserved good ratings. Legislation had to follow and the Dodd-Frank Act created an Office of Credit Ratings in the Securities and Exchange Commission (SEC). Rating agencies abroad seem to have got it all wrong in too many bell-weather cases.

Credit rating in India

Rating agencies in India have not been so much under the scanner. Initially, the Securities and Exchange Board of India (SEBI) mandated ratings for corporate bonds and debt instruments. Public issues by fly-by-night operators prompted a move to grade IPOs with five levels of grading. The IPO grading process is expected to take into account a plethora of facts.

Rating agencies have backed the wrong horse on a few occasions illustrated by a 4 rating (above-average fundamentals) to the public issue of a power company which priced the issue at a huge premium. As the stock kept heading southward, the management attempted to appease unhappy investors with a bonus issue.

To be fair to the rating agencies, expecting a perfect rating report which will stand the test of time is akin to asking an auditor or management if there is any expectation of fraud in an entity in the years to come. The final rating depends on a large number of assumptions and crystal-gazing into the future. Two diametrically opposite views on India's rating from S&P and Goldman Sachs (though not a rating agency) confirm the view that at best a rating report is only an opinion, and not a statement of fact. Rating agencies need to be intensely independent and must not get carried away by pecuniary and other considerations. If there are too many instances of erroneous ratings, another wisecrack about the weather could be applied to rating agencies — Climate is what you expect, weather is what you get.

(The author is a Bangalore-based chartered accountant.)

Published on August 11, 2011

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