ACR Grads

Archive for the ‘Credit Ratings’ Category

By, Shah Gilani

Contributing Editor

Money Morning

Underlying the credit crisis gripping the U.S. and world economies is a crisis of confidence. Blame has been laid at the feet of the U.S. Federal Reserve, and an investment bankers’ brew of toxic financial products. Ultimately, however, it was the supposedly trustworthy rating agencies that got everyone to drink the poisoned Kool-Aid.

The sheer fraud and greed of rating agency analysts and executives is staggering. That no one has gone to jail, and none of the agencies have been shut down is a travesty of justice on an infinitely larger scale than Bernie Madoff’s Ponzi scheme. Until depositors, bankers and investors regain confidence in the quality of ratings we rely upon to measure financial stability and creditworthiness, the tremors that underlie the credit crisis will drag on indefinitely.

Letter and number ratings – such as AAA, Aa1, BBB and Caa1 – are financial shorthand for the due diligence supposedly done by rating agencies after they’ve examined an issuer or a security’s financial structure, and evaluated the likelihood of its being able to pay interest and principal at maturity. Investors rely on the objectivity and fiduciary responsibility of the rating agencies to publish fair, accurate and uncompromised assessments.

By law, certain investors must rely on the ratings of a handful of Securities and Exchange Commission designated “Nationally Recognized Statistical Rating Organizations” (NRSROs). For example, most state insurance regulators require that only assets rated in the top four ratings categories by NRSROs are eligible investments. Similarly, money market funds can only invest in securities with the highest NRSRO ratings. In fact, innumerable institutions – public and private, and domestic and international – mandate asset quality levels predicated on the major rating agencies’ due diligence.

Standard & Poor’s Ratings Services, Moody’s Investors Service (MCO) and Fitch Ratings Inc. are all SEC-designated NRSROs. They are the largest, best-known and most-profitable ratings firms in the tiny, $5 billion-a-year universe of ratings firms. S&P is a part of The McGraw-Hill Cos. Inc. (MHP), while Fitch is a subsidiary of France’s Fimalac SA.

Moody’s was spun out of financial publisher Dun & Bradstreet Corp. (DNB) as a public company in 2000. Warren Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK.B), apparently having spotted a diamond in the rough, bought into D&B before the divestiture, and ended up with a hefty 19% stake in Moody’s after the spin-off was completed.

The problem with the business of rating the issuers of securities, and rating the securities they issue – such as mortgage-backed securities and collateralized mortgage-backed obligations – is that the rating agencies are paid by the issuers to rate them. Objectivity aside, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. It’s like all the contestants in the Miss World pageant paying the judges with country funds … who’s not going to be judged beautiful?

What was even more problematic in the scheme of the ratings business model was that analysts didn’t understand how to analyze and rate the very complex cash flow structures of these new collateralized mortgage-backed securities. Not wanting to lose business to their competitors, who were all in the same boat, they used the same rating model structures that they used to rate corporate bonds, though the two different securities had nothing in common.

It was like asking your local car mechanic to certify your Citation V jet – just before you take off for a transatlantic flight to London. God help you if there’s a problem.

And there were problems. Lots of them. According to a Feb. 15 “Review & Outlook” piece in The Wall Street Journal, Joseph Mason, professor of finance at Drexel University, studied collateralized debt obligations rated “Baa” by Moody’s and determined that they were 10 times more likely to default than equivalently rated corporate bonds. The article went on to say that an S&P spokesperson, when asked if they actually examined the underlying mortgages in the pools, answered: “We are not auditors; we are not accounting firms.”

While S&P – and to a lesser degree, Fitch – were just playing the game, Moody’s actually ran away with the ball. An eye-popping and brilliant April 11 Journal article by Aaron Lucchetti exposed the unseemly underbelly of Moody’s greed. What stood out the most in the article was Moody’s willingness – under the direction of Brian Clarkson, who joined the firm in 1991 and became president and chief operating officer – to bend over backwards to accommodate issuers of mortgage-backed and structured finance paper. Clarkson was willing to switch analysts if clients complained, which several did, including Credit Suisse Group AG (ADR: CS), UBS AG (UBS), and Goldman Sachs Group Inc. (GS).

Under Clarkson, Moody’s expanded and grabbed a huge piece of the deal-ratings-market pie. By 2006, the company was rating $9 out of every $10 raised in mortgage securities. For all of that year, the firm’s structured finance group generated more than $881 million in revenue, about 43% of Moody’s revenue. And in 2007 it was estimated that the firm rated 94% of the approximately $190 billion in mortgage and structured-finance CDOs floated during the year.

But there was some concern, including some from insiders. Former Moody’s analyst Mark Froeba told The Journal that “there was never an explicit directive to subordinate rating quality to market share. There was, rather, a palpable erosion of institutional support for rating analysis that threatened market share.” In the same article, former Moody’s executive Paul Stevenson was quoted as saying that “the most recent problem is that the rating process became a negotiation.”

Clarkson, the Moody’s president and COO, didn’t do too badly negotiating his compensation, either. In 2006 he made $3.8 million, while the firm’s chief executive officer, Raymond McDaniel, made $8.2 million. Clarkson “retired” under pressure this past May and McDaniel, the CEO, added the title of president to his mantle.

Eventually, the always-late-to-the-dance SEC awoke to the realization that it was supposed to be watching the watchers – the ratings agencies. While hundreds of billions of dollars around the world was invested in Wall Street’s pay-to-play version of Illinois gubernatorial politics, many heartbroken and flat-out-broke investors discovered that what the rating agencies had determined to be “AAA” rated securities were not the princely investment-grade securities those three letters said they were, but were toxic Amazon frogs instead. Of course, that calls for an investigation. And so it was.

A 10-month “examination” by the SEC, concluded in July, uncovered, believe it or not, “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.” Brilliant!

According to the report, which included as exhibits several e-mail exchanges between analysts at unnamed ratings firms, there was an obvious degree of knowledge and complicity in playing the ratings game. In one exchange, an analyst said that their ratings model didn’t capture “half” of the deal’s risk but that “it could be structured by cows and we would rate it.” And in another even more famous exchange dated Dec. 15, 2006, a manager wrote that the firms continued to create an “even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Have any heads rolled? No. Have any fines been levied or any firms closed down? No. The SEC apparently went back to sleep, having since been intermittently aroused by the failure of The Bear Stearns Cos., the bankruptcy of Lehman Brothers Holdings Inc. (OTC: LEHMQ), the nationalization of American International Group Inc.(AIG), and a few other minor nap-interrupting events, including the bailout of Citigroup Inc. (C). I’m only sorry that the Commission’s disjointed hibernation should once again be interrupted by the petty crime of a simple Ponzi scheme artist. Well, maybe now they can finally get some rest. For the sake of our future, someone please disband this band of sleeping fools.

Shortly after the July examination was made public, in an acknowledgement that it might be under unwarranted attack, S&P announced that it was considering ways to take volatility and stability into account in its ratings. But, in a simultaneous burst of clarity, S&P suggested that it feared that a more disciplined and functional ratings model would make it harder for issuers to raise capital. Only days later, in fact, S&P went on the offensive, calling SEC proposals to boost disclosure and mitigate internal conflicts of interest too costly for the ratings businesses. Among the proposals that were pushed back was one to require a separate ratings structure and ranking system for structured products.

Fast-forward to Dec. 3, and the unveiling of the SEC’s latest proposed rules changes. While the toothless wonder folded up like a pup tent once again on all substantive changes that would have created a more transparent and honest playing field, it did manage to sneak in some suggestions, including those that said:

The rating agencies can’t rate debt they help structure.

Analysts can’t participate in fee negotiations.

Analysts can’t be given gifts worth more than $25.

Analysts must disclose a random 10% sampling of their ratings within six months.

The ratings agencies must maintain a history of complaints against analysts.

And that the agencies must record when an analyst’s rating for structured debt differs from a quantitative model.

Calling these proposed rules changes baby steps is like calling the Grand Canyon a ditch.

Because Wall Street didn’t like the idea, what got dropped from the proposed changes were rules to create different structures for rating different products. And the most egregious of the dropped rules was a proposal that ratings firms make public all underlying information they use in making their ratings. Which is exactly the transparency needed.

There is an overwhelming heaviness to the credit crisis that bears on our economic future. It is the inordinate weight of established, self-serving power brokers driving dump trucks full of ill-gotten gains over any clarion call for transparency. The underlying currency of capital markets must be clearly and objectively rated instruments, whose value is determined by free markets. Until confidence is restored in the producers, products and the purveyors of financial services, thirsty investors are unlikely to partake of any new punch.

[Editor’s Note: Uncertainty will continue to be the watchword for at least the first part of the New Year. Little wonder, as the global financial crisis continues to whipsaw the U.S. financial markets in a manner that hasn’t been seen since the Great Depression. It’s almost enough to make you surrender. But what if you knew, ahead of time, what marketplace changes to expect? Then you’d be in the driver’s seat – right? You’d know what to anticipate, could craft a profit strategy to follow, and could then just sit back, watching and waiting – and finally profiting from – the very marketplace events you anticipated.

R. Shah Gilani – a retired hedge fund manager and a nationally known expert on the U.S. credit crisis – has predicted five key financial crisis “aftershocks” that he says will create substantial profit opportunities for investors who know just what these aftershocks are, and how to play them. In the Trigger Event Strategist, trigger events,” as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the trigger-event profit strategy they feed into, check out our latest report.]

To read more Click here

Investment news

Credit Rating Agencies (CRAs) – Need for Reform

1. Crisis – Spotlight on CRAs

“Credit-rating agencies use their control of information to fool investors into believing that a pig is a cow and a rotten egg is a roasted chicken. Collusion and misrepresentation are not elements of a genuinely free market ” – US Congressman Gary Ackerman

The smooth functioning of global financial markets depends in part upon reliable assessments of investment risks, and CRAs play a significant role in boosting investor confidence in those markets.

The above rhetoric although harsh beckons us to focus our lens on the functioning of credit rating agencies. Recent debacles as enunciated below make it all the more important to scrutinize the claim of CRAs as fair assessors.

i) Sub-Prime Crisis: In the recent sub-prime crisis, CRAs have come under increasing fire for their covert collusion in favorably rating junk CDOs in the sub-prime mortgage business, a crisis which is currently having world-wide implications. To give some background, loan originators were guilty of packaging sub-prime mortgages as securitizations, and marketing them as collateralized debt obligations on the secondary mortgage market. CRAs failed in their duty to warn the financial world of this malpractice through a fair and transparent assessment. Shockingly, they gave favorable ratings to the CDOs for reasons that need to be examined.

ii) Enron and WorldCom: These companies were rated investment grade by Moody’s and Standard & Poor’s three days before they went bankrupt. CRAs were alleged to have favorably rated risky products, and in some instances put these risky products together for a fat fee.

There may be other over-rated Enron’s and WorldComs waiting to go bust. CRAs need to be reformed to enable them pin-point such cancer well-in-advance thereby increasing security in the financial markets.

2. Credit Ratings and CRAs

i) Credit rating: is a structured methodology to rank the creditworthiness of, broadly speaking an entity, or a credit commitment (e.g. a product), or a debt or debt-like security as also of an Issuer of an obligation.

ii) Credit Rating Agency (CRA): is an institution specialized in the job of rating the above. Ratings by CRAs are not recommendations to purchase or sell any security but just an indicator.

Ratings can further be divided into

i) Solicited Rating: where the rating is based on a request say of a bank or company and which also participates in the rating process.

ii) Unsolicited Rating: where rating agencies claim to rate an organisation in the public interest.

CRAs help to achieve economies of scale as they help avoid investments in internal tools and credit analysis. It thereby enables market intermediaries and end investors to focus on their core competencies leaving the complex rating jobs to dependable specialized agencies.

3. CRAs of note

Agencies that assign credit ratings for corporations include

A. M. Best (U.S.)

Baycorp Advantage (Australia)

Dominion Bond Rating Service (Canada)

Fitch Ratings (U.S.)

Moody’s (U.S.)

Standard & Poor’s (U.S.)

Pacific Credit Rating (Peru)

4. CRAs – Power and Influence

Various market participants that use and/or are affected by credit ratings are as follows

a) Issuers: A good credit rating improves the marketability of issuers as also pricing which in turn satisfies investors, lenders or other interested counterparties.

b) Buy-Side Firms : Buy side firms such as mutual funds, pension funds and insurance companies use credit ratings as one of several important inputs to their own internal credit assessments and investment analysis which helps them identify pricing discrepancies, the riskiness of the security, regulatory compliance requiring them to park funds in investment grade assets etc. Many restrict their funds to higher ratings which makes them more attractive to risk-averse investors.

c) Sell-Side Firms : Like buy-side firms many sell side firms like broker-dealers use ratings for risk management and trading purposes.

d) Regulators: Regulators mandate usage of credit ratings in various forms for e.g. The Basel Committee on banking supervision allowed banks to use external credit ratings to determine capital allocation. Or to quote another example, restrictions are placed on civil service or public employee pension funds by local or national governments.

e) Tax Payers and Investors: Depending on the direction of the change in value, credit rating changes can benefit or harm investors in securities through erosion of value and it also affects taxpayers through the cost of government debt.

f) Private Contracts: Ratings have known to significantly affect the balance of power between contracting parties as the rating is inadvertently applied to the organisation as a whole and not just to its debts.

Rating downgrade – A Death spiral:

A rating downgrade can be a vicious cycle. Let us visualise this in steps. First a rating downgrade happens. Banks now want full repayment anticipating bankruptcy. Company may not be in a position to pay leading to a further rating downgrade. This initiates a death spiral leading to the companys’ ultimate collapse and closure.

Enron faced this spiral where a loan clause stipulated full repayment in the event of a downgrade. When downgrade did take place, this clause added to the financial woes of Enron pushing it into deep financial trouble.

Pacific Gas and Electric Company is another case in point which was pressurised by aggrieved counterparties and lenders demanding repayment thanks to a rating downgrade. PG&E was unable to raise funds to repay its short term obligations which aggravated its slide into the death spiral.

5. CRAs as victims

CRAs face the following challenges

a) Inadequate Information: One complaint which CRAs have is their inability to access accurate and reliable information from issuers. CRAs cry that issuers deliberately withhold information not found in the public domain for instance undisclosed contingencies which may adversely affect the issuers’ liquidity.

b) System of compensation: CRAs act on behalf of investors but they are in most cases paid by the issuers. There lies a potential for conflict of interest. As rating agencies are paid by those they rate and not by the investor, the market view is that they are under pressure to give their clients a favourable rating – else the client will move to another obliging agency. CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. There are conflicting noises with some CRAs admitting that if they depend on investors for compensation, they would go out of business. Others strongly deny conflicts of interest defending that fees received from individual issuers are a very small percentage of their total revenues so that no single issuer has any material influence with a rating agency.

c) Market Pressure : Allegations that ratings are expediency and not logic-based and that they would resort to unfair practices due to the inherent conflict of interest are dismissed by CRAs as malicious because the rating business is reputation based and incorrect ratings may lower the standing of the agency in the market. In short reputational concerns are sufficient to ensure that they exercise appropriate levels of diligence in the ratings process.

d) Ratings over-emphasised: Allegations float that CRAs actively promote an over-emphasis of their ratings and encourage corporations to do like-wise. CRAs counter saying that credit ratings are used out of context through no fault of their own. They are applied to the organizations per se and not just the organizations’ debts. A favourable credit rating is unfortunately used by companies as seals of approval for marketing purposes of unrelated products. A user needs to bear in mind that the rating was provided against the stricter scope of the investment being rated.

6. CRAs as Perpetrators

a) Arbitrary adjustments without accountability or transparency: CRAs can downgrade and upgrade and can cite lack of information from the rated party, or on the product as a possible defence. Unclear reasons for downgrade may adversely affect the issuer, as the market would assume that the agency is privy to certain information which is not in the public domain. This may render the issuers security volatile due to speculation.

Sometimes eextraneous considerations determine when an adjustment would occur. Credit rating agencies do not downgrade companies when they ought to. For example, Enron’s rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company’s problems for months.

b) Due diligence not performed: There are certain glaring inconsistencies which CRAs are reluctant to resolve due to the conflicts of interest as mentioned above. For instance if we focus on Moody’s ratings we find the following inconsistencies.

All three of the above have the same capital allocation forcing banks to move towards riskier investments.

c) Cozying up to management: Business logic has compelled CRAs to develop close bonds with the management of companies being rated and allowing this relationship to affect the rating process. They were found to act as advisors to companies’ pre-rating activities and suggesting measures which would have beneficial effects on the companys’ rating. Exactly on the other extreme are agencies which are accused of unilaterally adjusting the ratings while denying a company an opportunity to explain its actions.

e) Creating High Barriers to entry : Agencies are sometimes accused of being oligopolists, because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). All agencies consistently reap high profits (Moody’s for instance is greater than 50% gross margin), which indicate monopolistic pricing.

f) Promoting Ancillary Businesses: CRAs have developed ancillary businesses like pre-rating assessment and corporate consulting services to complement their core ratings business. Issuers may be forced to purchase the ancillary service in lieu of a favorable rating. To compound it all, except for Moody’s all other CRAs are privately held and their financial results do not separate revenues from their ancillary businesses.

7. Some Recommendations

a) Public Disclosures: The extent and the quality of the disclosures in the financial statements and the balance sheets need to be improved. More importantly the management discussion and analysis should require disclosure of off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments. Shortening the time period between the end of issuers’ quarter or fiscal year and the date of submission of the quarterly or annual report will enable CRAs to obtain information early. These measures will improve the ability of CRAs to rate issuers. If CRAs conclude that important information is unavailable, or an issuer is less than forthcoming, the agency may lower a rating, refuse to issue a rating or even withdraw an existing rating.

b) Due Diligence and competency of CRAs Analysts: Analysts should not rely solely on the words of the management but also perform their own due diligence by scrutinising various public filings, probing opaque disclosures, reviewing proxy statements etc. There needs to be a tighter (or broader) qualification to be a rating agency employee.

c) Abolition of Barriers to Entry: Increase in the number of players may not completely curtail the oligopolistic powers of the well-entrenched few but at best it would keep them on their toes by subjecting them to some level of competition and allowing market forces to determine which rating truly reflects the financial market best.

d) Rating Cost: As far as possible, the rating cost needs to be published. If revealing such sensitive information raises issues of commercial confidence, then the agencies must at least be subject to intense financial regulation. The analyst compensation should be merit-based based on the demonstrated accuracy of their ratings and not on issuer fees.

e) Transparent rating Process: The agencies must make public the basis for their ratings including performance measurement statistics historical downgrades and default rates. This will protect investors and enhance the reliability of credit ratings. The regulators should oblige CRAs to disclose their procedures and methodologies for assigning ratings. The rating agencies should conduct an internal audit of their rating methodologies.

f) Ancillary Business to be independent: Although the ancillary business is a small part of the total revenue, CRAs still need to establish extensive policies and procedures to firewall ratings from the ancillary business. Separate staff and not the rating analysts should be employed for marketing the ancillary business.

g) Risk Disclosure: Rating agencies should disclose material risks they uncover during the risk rating process or any risk that seems to be inadequately addressed in public disclosures, to the concerned regulatory authority for further action. CRAs need to be more proactive and conduct formal audits of issuer information to search for fraud not just restricting their role to assessing credit-worthiness of issuers. Rating triggers (for instance full loan repayment in the event of a downgrade) should be discouraged wherever possible and should be disclosed if it exists.

These measures if implemented can improve market confidence in CRAs, and their ratings may become a key tool for boosting investor confidence by enhancing the security of the financial markets in the broadest sense.

List of resources

i) http://www.zyen.com/Knowledge/Articles/assessing_credit_rating_agencies.htm

ii) http://www.chasecooper.com/News-Regulatory-Basel-II-2007-10-01.php

iii) http://www.blackwell-synergy.com/doi/abs/10.1111/j.1468-0491.2005.00284.x?cookieSet=1&journalCode=gove

iv) http://www.house.gov/apps/list/speech/ny05_ackerman/WGS_092707.html

v) http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2373869.ece

vi) http://www.cfo.com/article.cfm/9861731/c_9866478?f=home_todayinfinance

vii) http://en.wikipedia.org/wiki/Credit_rating_agency

A study by Australia’s biggest credit report provider has shown many Australian consumers are worried about their ability to pay the bills.

The Veda Advantage study has indicated that making repayments is a major cause of concern for three quarters of Aussies in debt.

Rising prices, with some commentators expecting inflation to reach 4.6 per cent in 2008, is causing more than half of those questioned in the study the greatest concern about their ability to meet their bills. This was followed closely by rising interest rates, which is making it harder for many Australians to repay their mortgages.

Other factors giving Australians a headache when it comes to repaying their bills are increased transport and petrol prices, the cost of food, and health costs.

The study, carried out for Veda Advantage by pollsters Galaxy Research, also found the level of new debt taken on by consumers had dropped slightly to 15 per cent. But rising mortgage payments, due to higher interest rates, was given as a reason by a quarter of consumers who owed more money. Buying a car, a property or an unexpectedly large bill was also given as a key reason for being further in debt by many of those who found they were deeper in debt.

A Veda Advantage spokesperson said that while 62 per cent of Aussies had said they could still meet their repayments, despite being worried, 16 per cent admitted debts took up most of their budget. A staggering 91,000 people said they were unsure how they were going to pay their next bill.

A separate survey carried out by credit ratings firm, Dun and Bradstreet has shown a growing number of Aussies expect to face financial hardship. The survey, conducted by Newspoll, showed one in five people expect to pay for something they can’t afford on their credit card.

Young people are the most likely to turn to their plastic to cover costs, with women between the age of 18 and 24 being the most likely to resort to this tactic. Mature people, the-over-50s, are less likely than any other group to use their credit card to cover expenses they cannot afford, according to the study.

Debt problems are not confined to those on low incomes. Aussies who earn $30,000 to $70,000 expect to face problems with credit card use, with one-in-four in this band expecting to use their credit card to pay for items they cannot afford, the study said.

The Veda Advantage debt study has backed up Dun and Bradstreet findings, which showed that 1 in 4 Australians expect to be in more debt.

Worryingly, 1 in 5 low income Aussies said they didn’t expect to pay more than the required minimum monthly repayment on their credit cards, which is double the national average. Eighty per cent of those earning more than $70,000, on the other hand, believed they would make payments greater than the required minimum.

Credit file provider, Veda Advantage, has renewed its call for the government to act to protect Australians from becoming further debt stressed, by changing the law to allow more credit information to be shared.