Wag the Dog

Wag the Dog

In late December 2012, the Turkish Prime Minister stated that Standard & Poor’s undeservingly raised Greece’s rating from SD (selective default) to B-, meaning 6 steps up at once, and that in general, the agency’s activities were “completely politicized.” The question that comes up whenever new ratings are released is whether the global rating agencies do not actually reflect the economic situation, as much as they influence the international financial markets by what they themselves do. How fair is that statement?

Trust, but Verify

Naturally, the rating agencies themselves declare that their credit ratings are not recommendations to “buy”, “sell,” or “hold” any security. Credit ratings are just the opinion of an agency with respect to the quality of the issuer’s credit, based on information obtained from issuers, borrowers, underwriters, and other sources the agency considers reliable. These statements in particular allow the agency to take no responsibility for investment decisions.

For financial market participants, however, ratings are often a major component that is taken into account when making investment decisions.

Furthermore, government financial authorities also base their regulatory activities for credit and financial institutions, for example, on credit ratings assigned to issuers by the different agencies. It is important to note that in Russia and world-wide, international rating agencies Standard & Poor’s, Moody’s, and Fitch Ratings are the most influential, and not the national rating agencies. As a result, the financial markets in the majority of developing countries are dependent upon credit rating agencies based in the U.S. (in the case of Fitch Ratings, the U.S. and the UK), meaning upon analysts whose independence, and the full reliability of whose data, many are starting to doubt.

Let’s examine the credit rating changes of the infamous Enron Corporation from the “Big Three” (Standard & Poor’s, Moody’s, and Fitch Ratings), paying particular attention to the agencies’ actions from the end of October to November 2001.

At the end of October 2001, the rating for Enron was investment-grade according to all three agencies. At the beginning of November 2011, the agencies lowered the company’s rating: S&P and Moody’s by 1 step to BBB-/Baa3, and Fitch by 2 steps to BBB-.

On November 28, 2001 all three agencies seriously downgraded Enron to B-/B2/CC, but only Fitch decided to rate it as in a “pre-default state.” On November 30, 2011, Enron filed for bankruptcy.

Note that at the beginning of November 2011, the Enron Corporation’s rating according to S&P was the same as the Russian Federation’s current rating!

Can we really assume that the agency didn’t know about the deterioration of Enron’s financial condition? No. After all, if you look at the chart of stock prices (below), it is clear that the market price was in a decline beginning in March 2001. Clearly, the problems of any company last some time before it files for bankruptcy. And if you follow the quarterly reports, you can always observe the beginning trend of an issuer’s worsening credit. For the Enron Corporation, that was at least nine months, as can be seen from the graph.

Let’s take another example when the ratings assigned  by the agencies did not correspond to reality. This was an instance with structured financial products, the mortgage-backed securities (MBS), during the recent economic crisis.

Table 3 shows data on the ratings and the corresponding probability of default. The actual number of defaults in the Russian banking sector is significantly less than would be expected from the median credit ratings given to the banks. We can say that the rating of the Russian banking system for the period of review was lowered.

The validity of credit ratings is often questioned and the agencies have been heavily criticized for their excessively close relationship with the management of the companies being rated. After all, the technology requires personal meetings with the heads of the organizations being rated, which could open up opportunities for the issuing company to influence the rating agency’s opinion.

As a matter for discussion, we note how difficult it is for new participants to enter the rating services market and the lack of transparency in the methodology of several rating types, particularly for public debt.

The method by which rating agencies collect their fees is also a topic for discussion. The issuer pays for the assignment and maintenance of a rating and in order for the rating agency to keep the issuer as a client, it is possible that sometimes they have to be a little too loyal to the client.

Who Are the Judges?

Meanwhile, it should be noted that the need for independent assessments, such as ratings, will only increase in today’s world. In most cases, in order to obtain external financing, such as Eurobonds, it is mandatory to have credit ratings from international agencies.

Of course it is possible to organize debt financing on the domestic market without turning to these organizations. But at the end of the day, it will cost more. If an unrated company issues bonds on the Russian market, its cost for borrowing will be significantly higher (by 1% or more) than for the exact same quality of credit for a company that already has credit ratings. In addition, investors often don’t have time for a full analysis of a borrower’s financial condition, in which case they rely on third-party opinions.

Agencies can also influence the decisions of state agencies. For example, Standard & Poor’s revision of Croatia’s rating from an investment grade of BBB- to a speculative grade of BB+ led the government to abandon plans to sell government bonds set for early 2013. And this decision is tied to the higher cost of borrowing on the market for Croatia, which is inevitably due to the downgrade of the country’s rating.

Measuring the Impact of Ratings on Bond Yields

Obviously, the higher the credit rating of the issuer, the lower its borrowing costs. The table below shows the bond yields of Russian corporate and municipal issuers, depending on credit rating.

The Russian market has practically no bond issues with ratings higher than BBB+/Baa1. There are also almost no issues with ratings lower than B-/B3 since it would be pointless to enter the market with such low ratings – the market demands too high a yield.

The data in the last column illustrates how much higher the yields of bonds are with the ratings shown on the same row, than the yields of bonds with ratings from the previous row.

We can conclude from the figures shown here that the lower the rating, the larger the difference is in the required yield with each successive step down. However, this observed trend is not visible on every row, which could be explained by a lack of liquidity from certain bond issues that are in a particular group.

The Rating Agency “Market”

Experts estimate that the market share of the “Big Three” is about 95%. Approximately 40% of the market is claimed by Standard & Poor’s, and Moody’s and about 15% by Fitch Ratings.

These rating agencies account for 95% of credit ratings worldwide  – 95% of the ratings on which investment decisions in the global bond market are based!

On this basis alone, it can be said without hesitation that the Big Three dictate where global capital currently flows and where it will flow in the future. This is, in fact, global control of the modern world.

Attempts to “dilute” the Big Three by other national rating agencies occurred long ago. There are a number of such agencies in practically every country and professional agency associations have even been created in different regions.

For example, the Association of Credit Rating Agencies in Asia (ACRAA) has been around since 2001, beginning with 15 agencies from 10 countries, but now with nearly twice the members. At present, the association’s members include five rating agencies from China, including China Chengix International Credit Rating Co., Ltd. (CCXI), Dagong Global Credit Rating Co., Ltd (Dagong), five from India, four from Korea, and agencies from Bangladesh, Japan, Malaysia, and other countries, even two from Pakistan.

The European Association of Credit Rating Agencies (EACRA) was organized in 2009 and currently already has 12 agencies from 8 European countries, including the well-known Russian agency, RusRating.

However, we can say that the situation is currently changing and the influence of the national rating agencies is growing stronger.

Just recently, the Central Bank of Russia began introducing documents regulating bank activities that reference ratings assigned by national rating agencies. But for now, these are just alternative estimates to those of the international agencies, S&P, Fitch, and Moody’s.

The Bloomberg news agency now is not only reflecting opinions from S&P, Fitch, and Moody’s on its home page, but also those of the Chinese agency Dagong.

The table below presents data on a number of ratings assigned to Russian banks by foreign and domestic rating agencies, and there is a clear trend showing the increased share of Russian agencies on this market.

Do the Ratings Coincide?

The table below shows the ratings of some of countries assigned by the Big Three, China’s Dagong rating agency, as well as the Russian National Rating Agency (NRA).

It is clear from the table that the United States continues to get higher credit ratings from Moody’s and Fitch. S&P, if you’ll recall, downgraded the U.S. by one step, after which it came under pressure. We also note that the Dagong agency assesses U.S. credit quality at the level A, which is five steps lower than the highest credit rating of AAA.

As for Russia, the Chinese agency really stands out here, giving the country an A rating, which is two steps higher than the ratings from the NRA and Moody’s and three steps higher than ratings from S&P and Fitch.

Note also the ratings for the United Kingdom. The country’s ratings from the three international agencies are at the highest step, while the NRA assesses the UK’s credit quality at AA and Dagong at only an A+.

It becomes obvious that in studying issuer credit quality, one must take into account not only the opinions of the three main players, but also the national agencies working in the country of the issuer. Of course, ideally one should form one’s own opinion based on an independent analysis of the issuer’s financial condition, as the ultimate basis for making investment decisions.

Text: Natalia Suleimanova

Mihaly Galosfai, Commercial Counsellor at Hungarian Trade Mission, Moscow:
«Credit rating agencies (CRA) undoubtedly play an important role in the business environment. Their verdicts are keenly monitored and taken into consideration by governments, investors and other market players alike. The three largest credit rating agencies have a significant combined effect on the markets.
We all know that downgrades and upgrades seriously affect the evaluation of a country’s economy and influence the decision making of investors in terms of what to target and where to settle – an enormous power and responsibility to undertake.
During the last few years and especially in recent months there were shocking miscalculations made by the CRAs, not to mention the Lehman Bros case and the 2008 crisis. There were no adequate warnings or forecasts on the possible or even imminent risks.
Skeptics may also argue that in many cases the founders of the agencies are the same companies that are to be evaluated, resulting in rather close ties with the management of their clients; the implications are of course to question the agencies’ impartiality.
It is known that the evaluation itself involves political measures which can be assessed differently by CRAs and investors; another reason why the „evaluator team” should be widened.
Thus it is not a wonder that there are skeptics who question the infallibility of the rating agencies.
The risk of getting it wrong is higher if the evaluation is made by a „single” agency, even if it is a public one. A possible solution to getting closer to reality could be the creation of a UN based rating entity, with an emphasis placed on investor confidence, especially in relation to specific countries».

Steve H. Hanke, Professor of Applied Economics at The Johns Hopkins University:
«I have a lot of problems with the credit rating agencies. And the first point is that they made a big mistake prior to the crisis of 2008-2009. But, there are also two big problems in the structure of industry.
One. The industry only has three big suppliers of credit ratings, and they are regulated more-or-less by the government. Since there are only a small number of credit rating agencies, the industry is not very competitive. If you don’t have competition, you can make big mistakes. So, they make mistakes.
The lack of competition is one problem in the industry’s structure. Another problem is the source of payment for the ratings. The institutions that issue bonds are the ones who pay the credit rating agencies to rate the bonds that the institutions issue. Therefore, there is a big potential for conflict of interest. So, I don’t have really much good to say about credit rating agencies».

Rob Pefferly, the Head of Research in Novalytica OU:
«You cannot trust rating agencies. For example, they do create some mathematical models based upon objective input. Revenue, assets, balance sheet data, etc. But when it comes to scoring IPR or market potential or management expertise or… It is totally subjective and open for manipulation.
Since the funding scheme is such that the companies are getting evaluated are also usually the ones paying the bills to the rating agencies, this is a serious conflict of interests in that the sales team wants the sales, and thus pressures the analysis team to inflate the grades. It is moral hazard.
So do draw an analogy. Rating agencies are like beauty contests (or credit scoring agencies). They are mostly subjective decisions made behind a facade of objectivity.
To make a long story short, rating agencies attempt to be objective and state that they are, but in reality, grades are subjective and easily open for manipulation via economy, policy».

Maxim Bychkov, partner at Ernst & Young, Advisory for Financial Services Leader:
«To answer the question about the fundamental confidence in rating agencies, let’s try to figure out exactly what they do. Rating agencies assess the likelihood of repaying debt obligations to a specific issuer based on complex analysis in accordance with methodologies that are, as a rule, open to the public on their websites and which differ little from other methodologies used in credit risk assessment. That means that the rating agencies function as an external credit analyst and, like all analysts, give a future outlook that can more or less be trusted. Going back to the ratings given by rating agencies before the 2008 crisis, and for which the agencies have been subject to severe criticism, it is fair to say that the accuracy of their forecasts does not differ much from other market analysts».
«A more serious area for criticizing rating agencies is the blame imputed to them for deliberate distortion of their forecasts in the favor of issuers. In this regard, a number of market participants believe that the agencies should be subject to government regulation.»

Oleg Dushin, Senior Analyst, Zerich Capital Management:
«International agencies twice, in 1998 and 2008, ‘skated on thin ice’ with their assessments. The first time was during the Asian crisis and the second time was about the mortgage defaults in the U.S. Since then, there have been important changes, the most important of which was strengthened control over the banks by the central banks (especially in the U.S. and the eurozone). This facilitated the work of the rating agencies in terms of unpleasant surprises. The agencies became bolder about lowering sovereign ratings, and the S&P even lowered the U.S. rating. But the central tenet of the Big Three (S&P, Fitch, and Moody’s) remains intact. At the head of the global financial system is the United States. In so far as this is true, statements from the rating agencies can be trusted.»