Rating the raters

After the credit crisis of 2008-09, credit rating agencies have become a laughing stock. It was surprising that rating agencies could not decipher the fact that the mortgage loans (which were more like gifts) in the US that triggered the crisis were potential landmines.

These agencies rate a large number of financial products including debt instruments, commercial paper, bonds and deposits. They also have access to the management of a company and are generally informed of major developments in the company.

Yet, they invariably downgrade ratings only after the news of the trigger for the downgrading is public. Over the past few years, India has had opportunities to question the ratings given by these agencies.

The downgrades JP Morgan AMC was forced to restrict redemptions from two investment plans following a rating agency’s decision to suspend the rating of Amtek Auto. Another credit assessor lowered the company’s rating by 12 notches in a day. Investors in the debt securities of Amtek Auto saw the value of their investments evaporate.

Earlier, the same rating agency downgraded Jaiprakash Associates by six notches from a rating of BB to D-, a rating that reflects a default in the debt security. Non-convertible debentures of Bhushan Steel also saw their rating drop by six notches. Punj Lloyd, Monnet Ispat and Energy, Bhushan Power and Steel, 20 Microns and Shree Renuka Sugars are the other companies that have seen significant rating downgrades.

A few years ago, a rating agency awarded AA and A1+ ratings to various instruments of Deccan Chronicle Holdings (DCHL). An AA rating signifies high degree of safety regarding timely servicing of financial obligations. An A1+ rating is the highest for short-term debt instruments and carries the lowest credit risk. The ratings were altered a week after DCHL first defaulted on a payment.

Rating of financial instruments usually involves two stages — an initial rating when the instrument is issued and regular ratings (normally annually). The initial rating should not cause much of an issue because a company that is on the wrong side of public esteem will not venture to issue any instruments.

It is the check-up ratings that are a cause for concern. Can a rating agency predict a default by deep-diving into financial statements? No. Can a rating agency predict a possible default? Yes — the financial statements, management attitude and a host of other intangible factors could give them an inclination of possible defaults.

A rating fund In such situations the credibility of the rating agency is tested; they should have the gumption to say it as they feel it is. In the case of Amtek, there were enough triggers for the rating agency to consider a downgrade.

But why don’t the rating agencies do so? Because the ratee pays the rater fees both for the initial rating as well as the annual rating true-up checks. There could a point here because rating agencies are dependent on client fees for their sustenance. One way to solve this problem is for the government to create a ‘rating fund’ with an initial corpus from the government and contributions from the ratees. The fund would pay the fees of rating agencies.

For the investor, investor emptor (investor beware) could well be the new mantra. The ratings should be considered alphabetical permutations and combinations that can alter overnight.

The writer is a chartered accountant

COMMENT NOW