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How do you rate the ratings agencies?

February 28, 2019

 

ref:- "Tail Risk" by Kate Allen, The Financial Times, Companies and Markets

 

This short and not entirely complimentary piece by Kate Allen got us thinking more widely about credit rating agencies and the role that they play.

 

There are numerous agencies but essentially this "market" is controlled by the big three: Moody's, S & P Global and Fitch, who between them are responsible for assessing the credit-worthiness of 95% of the global debt. The issuers of this debt may range from comparatively small companies right up to the largest of sovereign nations, and the ratings that they are given go a long way to deciding the price of their debt and therefore the cost of their borrowing. That's why the agencies play such an important role, and why borrowers quite often run a little scared of them. The agencies wield enormous power, and it's a moot point as to whether that's such a good thing. A lower rating can do irreparable damage to the borrower in terms of share price, cost of borrowing etc. whether it's merited or not, and in that sense even if a poor rating is wrong it can be self-fulfilling.

 

We get the impression that Ms Allen is not a rating agency fan. With the explosion in global borrowing, and therefore in the number of bonds and other debt instruments to be assessed, the turnover and profits of these agencies are climbing sharply. You can hardly blame them for that, but Ms Allen's view is that the agencies are not telling any sensible investor what they don't already know... or at least what they should already know: "Stating the obvious has been the foundation of rating agencies' business model for years". The suggestion is that asset managers often seek out investments highly rated by the agencies not because they've suddenly been pointed towards some new investment-grade vehicle that they didn't know about, but because they both fit the parameters of the portfolios they are running and also because it means they can shift responsibility if things go wrong: "It's not my fault that XYZ Inc. has fallen off a cliff... they were Triple-A rated!"

 

A bit cynical? Maybe so... but the thing is that those who question the inherent value of the rating system have other ammunition to hand. The most obvious criticism is that the agencies can get it wrong... and spectacularly so, too. The agencies, quite correctly, point out that they get things right infinitely more often than they get it wrong. Quite so... but when you look at some of the examples of disasters that they didn't see coming, it's hardly surprising that some people are sceptical: The Asian Financial Crisis (1997), the Russian Financial Crisis (1998), the Long Term Capital Management collapse (1998), the Enron collapse (2001)... and of course the Sub-Prime Mortgage-led Financial Mega-Crisis of 2007/2008.

 

That last example opens up another awkward area for the agencies, which concerns how they earn their money. They actually get paid by the issuers of the debt... the borrowers. Now, if one was of a mind to think that way, that opens up a whole new can of worms. Remember "The Big Short", the film from Michael Lewis' book about the origins of the financial crisis in the sub-prime mortgage market? Both book and movie imply that the decision of the rating agencies to give AAA ratings to countless CDOs (collateralised debt obligations - newly devised investment vehicles into which worthless mortgage portfolios were dumped) right up to time that they all collapsed was influenced by the need to keep those selling the CDOs happy, and thereby to keep their business.

 

It's one view... but at the very least one has to say that the potential for some "conflict of interest" when a borrower is the one paying a third party to value their own debt is pretty obvious. Still, no doubt lessons have been learnt and processes tightened. Whatever the case, the rating agencies go marching on, integral to the workings of debt markets. Well... why not? They couldn't make the same sort of mistake again, could they?

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