Credit Rating Agencies: Dyeing Muddy Waters

By devan daniel.

Published on January 12, 2015 with No Comments

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Credit ratings have implications beyond risk pricing in the capital market. They are used in regulating banks and the capital market, so their accuracy has far reaching implications

Companies have issued a record number of bonds by value this year taking advantage of low interest rates. Because risk free rates are suddenly paltry, everyone managing pension funds, mutual funds and insurance pools are suddenly hyper sensitive about alpha. With bond markets now booming, businesses are in a go-go mood, issuing paper to finance acquisitions and plugging decades long capital
shortages.

Credit rating agencies – which estimate the ability of an organisation to fulfill its financial commitments when they fall due (basically the ability to repay debt) –have also seen a reversal of their fortunes. These are profitable times for credit rating agencies because bond issuers are queuing up to have their paper rated.

Bond market booms generally benefit credit rating agencies and competition between the two largest ones
here; Fitch Ratings Lanka, a unit of a multinational and Lanka Rating Agency (LRA), a firm that was controlled by Malaysia’s RAM but now owned by Sri Lankan investors, has intensified in the last couple of years since interest rates started declining.

If the race for credit rating market share is won by awarding overgenerous ratings instead of value for money type competition it could lead to portfolio investors depending on rating to misprice risk and over time erode rating agency credibility. LRA has become the credit rating agency of choice for firms that can’t stomach a Fitch Ratings Lanka downgrade or its ‘negative ratings watch’ classification, an indication a downgrade could be around the corner. At LRA, firms that dump Fitch are awarded a rating one to three notches higher than the one withdrawn by Fitch Ratings Lanka. Clearly LRA – which has an identical ratings scale to Fitch and other global agencies Moody’s and Standard & Poor’s –consistently concludes firms have better debt repaying capability than does Fitch. LRA argues, being a Sri Lankan firm, it understands local economic and business nuances better than a multinational with a straightjacket approach. Its critics argue the firm is simply overrating to sign up lucrative contracts.

Firms are naturally apprehensive about relying entirely on banks, which are famous for withdrawing credit lines during economic downturns. Now that interest rates are low, firms are issuing bonds to fix their cost of capital for the next five years. Because the system is Agenda flush with cash it isn’t difficult to find bond buyers now, but issuers clearly anticipate things will change.

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In October 2014 Lanka Rating Agency (LRA) assigned a credit A- rating to diversified Softlogic Holdings. It said,‘the rating was upheld by its well-diversified business interests, moderated by high borrowings’. The gearing ratio was 2.36 times. LRA rating came on the back of the company removing Fitch Ratings Lanka. Fitch had downgraded Softlogic Holdings to ‘BBB-’, just above the junk bond waterline, two notches from ‘BBB+’. “The two notch downgrade reflects the aggressive investments and capital structure and the weakness in its liquidity profile and financial metrics which are not considered appropriate for the previous BBB+ rating,’ Fitch said announcing the downgrade.

While LRA said the acquisition of up market fashion retailer Odel was beneficial to maintain Softlogic’s A- rating, Fitch said the acquisition put further pressure on already high debt. Softlogic Holdings has businesses in healthcare, retail, financial services, IT, automobile and hotels.Leveraging low rates for acquisitions and locking in long-term financing at an attractive interest rate makes good business sense. Businesses here taking higher risks by leveraging can’t also be hung-up over the respectability of investment grade credit ratings. Junk ratings are not an indictment of corporate strategy but only highlight the relative challenges a company may face in meeting its future obligations to creditors. Shareholders pay premiums not for companies that are risk averse but for ones that can generate alpha.

Inconsistency can be considered a challenge that need not alarm ordinary people, and something debt issuers and portfolio investors need to workout for themselves. If credit ratings agencies acquire a reputation for being overgenerous, they will simply lose credibility with portfolio investors – who will stop
relying on their opinion.

However overzealous ratings don’t only merely undermine the credit rating agencies’ own business model but has far reaching consequences on savings, pension funds and financial sector regulation, all of which directly impact ordinary people. Most ordinary people don’t understand credit ratings and won’t know how mispriced risk impacts their bank savings or future pension returns. This is why it’s important to appreciate
how ratings influence regulation.

Firstly credit ratings can impact accessibility of those securities to the public, which then impacts demand and pricing. For instance the Colombo Stock Exchange doesn’t allow junk bonds (those with an issue ratings below BBB on ratings scales of Fitch and LRA) to be listed. A firm with a junk bond issue rating could opt for an agency that may have a better opinion of its ability to service its debts and obtain an investment grade rating instead.

Secondly risk based regulating has allowed banks to have lower capital buffers on loans to clients with good investment-grade ratings. If repayment capacity of borrowers on average is weaker than their credit ratings denote it would mean the banks would need the largest capital buffers to maintain the loans to these overrated entities. So the underlying risks of the financial sector are probably much higher then the regulator and the banks themselves imagine requiring a larger capital buffer than the one currently available.

Thirdly state controlled pension funds are piling on to corporate debt. Unlike private portfolio managers the managers of the EPF and the ETF will rely more on ratings to determine their buying of these securities and the pricing. State controlled pension funds only invest in investment grade debt issues. For instance a company like Vallibel Finance, which was last Fitch rated BB- with a negative outlook (junk grade) before it was withdrawn obtained from LRA an entity rating three notches higher which also elevated it to investment grade. An entity that receives a similar boost for an issue rating will find that its bonds can now be listed on the CSE, subscribed for by state controlled pension funds and also receive better pricing because investors believe the risk is now lower.

Fourthly the usefulness of entity credit ratings which are mandatory for financial institutions to obtain and publish, so that the public can be aware of the comparative risks in them, becomes less meaningful. Perceived conflicts of interest can also erode credibility. For example, the Deputy Chairman of Commercial Bank of Ceylon Preethi Jayawardena is also Chairman of Lanka Rating Agency, which has awarded the bank a AA+ rating, one notch higher than the rating from Fitch Ratings Lanka.

Because issuers rather than investors pay for ratings companies, issuing bonds have a lot to gain in terms of lower borrowing costs by getting them rated. Industry critics have always argued that allowing issuers to pay for ratings incentivizes agencies to inflate them to please clients. The danger is that a small group of people at ratings agencies will put the financial wellbeing of their firms ahead of their obligation to the public and markets. Sri Lanka needs to build trust in the public markets and protect the bank deposits and future pensions of ordinary citizens. This may be challenging if ordinary people cannot be protected from a duopoly of ratings agencies controlling commercial information (the third ratings agency ICRA Lanka rates eight issues). Even financial experts – leave alone ordinary people – will be hard pressed to price risk under when risk opinions from ratings agencies vary significantly. Freedom for commercial information is useless when it’s incredibly flawed.

A utopian solution is to have investors pay for ratings instead of the issuers. In response to the 2008 global financial crisis where overrated financial instruments figured prominently, regulators have tried to reduce ratings agency influence and kept a keen eye on their conduct. In the European Union a whole new regulator, the European Securities and Markets Authority is doing this job while across the pond in the US the Dodd-Frank act required the capital market regulator there, the SEC, and the Federal Reserve, the American central bank, to tighten regulation of ratings firms. At the time of writing, The Securities and Exchange Commission was in the process of deliberating on the matter. “Nothing concrete has been discussed yet but we want to be able to reconcile the credit ratings of Lanka Rating Agency and Fitch Ratings Lanka. We may have to look at their methodologies” said an official of the SEC not wanting to be named.

Perhaps it’s critical for Sri Lankan credit ratings firms to consider the implications of regulators intervening in their affairs and stamp out conflicts of interest and win confidence of market about the usefulness of ratings in pricing risk. The impact of mispriced risk on ordinary people – who don’t know that such a thing as a credit rating exists – can be catastrophic. Its time LRA and Fitch worked on clearing the muddied water rather than throwing dye in to it.

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