Saturday, April 28, 2012

A short introduction to Rating Agencies

Rating Agencies

Let’s go back to late 19th century when the US railway was starting to emerge.  It was considered an extremely profitable venture so naturally it attracted hundreds of investors from all across the country. Before giving out their money to companies and individuals, investors wanted to know their credit worthiness i.e. a numerical assessment that a certain company or individual will (not) be able to repay its debts (this is called credit rating). Many railway companies had gone bankrupt; dozens of investors had lost millions in bankruptcies and frauds.

Henry Varnum Poor (one of the fathers of Standard and Poor’s) met this demand of information by analyzing and publishing the financials of various railroad companies. John Moody (1868 – 1958) founder of Moody’s Investor Service, launched a similar publication in 1900s called Moody's Manual of Industrial and Miscellaneous Securities (other names: Moody's Manual of Railroads and Corporation Securities, Moody's Analyses of Investments). Fitch Ratings founder John Knowles Fitch claims to be the first to start the alphabetical rankings of sovereign debt in 1924.

The rating agencies then moved from US Railways to analyzing the credit worthiness of foreign companies, treasury bonds and sovereign debt etc. Basically anything that could be rated was rated. More and more rating agencies emerged but S&P, Moody’s and Fitch remained global leaders.

Credit rating primarily depends on 4 things
1. History of borrowing
2. History of repayment
3. Availability of assets
4. Extent of liabilities

AAA Rating

The AAA rating is the gold medal of ratings. If a country’s bond has an ‘AAA’ rating then this means that an investor will face very little risk of losing their money. Since, this is the safest investment therefore it involves lowest interest rate. The rating agencies are quick to point out the difference between ‘very little risk’ and ‘no risk’. They have pointed out that their rating lies within "within a universe of credit risk", accompany or a country can default because of hundreds of reasons that lie outside the “credit universe”.

It should also be noted that there is no “standard-AAA” rating instead different agencies use different rating methodologies.

Criticism on ratings

You would probably know that a Debtor is a person/company/country who owes money to others and a Creditor is a person/company/country who lends money to others. Most countries would normally owe billions in debt to other countries and at the same time they would have lent billions to other countries. To calculate whether a country is a net debtor or a net creditor we would do the following:

Money Lent to others on credit – Money taken from others as debt = If +ve answer (net creditor)
                                                                                                           If –ve answer (net debtor)
This isn’t difficult to comprehend, it’s no rocket science.

The rating agencies have managed to make this ten times more complex than rocket science.  The result is that Japan, which is a net creditor, has an AA- rating (Fourth highest rating by S&P’s) while US, which is the world’s biggest net debtor, has a much higher credit rating of AA+.

China, which is the world’s second biggest (after US) and the fastest growing economy couldn’t get the ‘AAA’ gold medal either. Why? Because S&P’s thinks that the Chinese banking sector possibly has “contingent liabilities” which could bring its economy down. In other words, S&P don’t want to give a AAA to China, it’s their medal and they can give it to whoever they want.  So if you thought that rating is pure science, fair and unbiased, then you were wrong.

Are ratings reliable?

If you thought that ratings are reliable then you were wrong again. Anything that is unfair and biased cannot be reliable. Up until 2009, Greece’s rating was A, which was then downgraded to ‘A-‘.  Three years later, the country is on the verge of bankruptcy.

Does anyone remember the role of these agencies before the global financial crisis? Several books have been written on answering this question.

Recommended Readings 
1. The Rating Agencies and Their Credit Ratings: What They Are, How They Work, and Why They are Relevant (The Wiley Finance Series)
2. Ratings, Rating Agencies and the Global Financial System
3. The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness (Cornell Studies in Political Economy)

You might remember the terms ‘subprime mortgages’, ‘collateral debt obligations’ (CDOs) and mortgage backed securities (MBSs). These are fancy names for different financial instruments that were created by banks (and other financial institutions) and played a major role in bringing the financial crisis to our door steps.

These rating agencies were one of the primary causes for the financial crisis because they provided strong ratings to these risky instruments. If they would give an impressive rating to a security/financial instrument, naturally people would invest in that security.

Why? Because they use words like “Triple-A”, “Double-A”, “long term”, “reward”, “extremely strong capacity” to lure investors towards investment and most importantly because people trust them. It was their job to provide a fair and unbiased numerical assessment of these instrument's creditworthiness within a universe of credit risk.

These agencies gave strong credit ratings, investors rushed to invest, then they would rapidly downgrade the rating and people would end up losing millions.

So the short answer is ‘No’, they are not reliable, you’re probably better off doing research yourself (if you know a thing or two about Financial Accounting and Macro Economics) than relying on their analysis.

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