07/03/2012 - 10:55

Ratings agencies under pressure on advice

07/03/2012 - 10:55

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Credit ratings agencies need a renewal of integrity.

Credit ratings agencies need a renewal of integrity.

WHILE the Labor Party’s leadership fight has dominated the news cycle in recent weeks, some critical economic news has been overlooked.

Major international credit ratings agency Moody’s downgraded three Australian banks, thereby showing real doubt exists about the economy.

While Moody’s admitted that this was not what it called the ‘central scenario’ for its 2012 outlook, a sharp deterioration in the eurozone crisis could whack Australia’s banking system hard.

Moody’s also placed Westfield Group on notice for a possible downgrade, and cut Qantas’ long-term unsecured rating from Baa2 to Baa3.

Baa3 puts Qantas one notch above ‘junk’ status.

Surreptitiously, credit agency ratings have increasingly influenced the investors’ universe, but little is known about how these firms actually operate.

In 1996, Pulitzer Prize winning author and journalist Thomas Friedman wrote:  “There are two superpowers in the world today in my opinion – there’s the United States and there’s Moody’s Bond Rating Service.”

“The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds.
“And believe me, it’s not clear sometimes who’s more powerful.”

Agencies’ history

Investment decisions in the early 20th century weren’t based on the same financial data that’s available today. 

Often, investors were forced to fly blind when searching out financially stable companies. 

Launching in 1900, self-taught American financial analyst and investor, John Moody, published the ‘Moody’s Manual of Industrial and Miscellaneous Securities’.
This manual provided information and statistics on stocks and bonds of financial institutions, government agencies, manufacturing, mining, utilities, and food companies.

Forced to sell following the 1907 stock market crash, Moody returned to the financial market two years later by emerging as the first financial analyst to assign letter grades to railroad bonds.

This trustworthy report gave investors an easier way to evaluate the rail companies’ debt levels.
By 1924, Moody’s ratings covered nearly the entire US bond market.
It was the beginning of one of the most powerful forces in modern capitalism. 

John Knowles Fitch founded the Fitch Publishing Company in 1913. 

He published financial statistics for use in the investment industry via ‘The Fitch Stock and Bond Manual’ and ‘The Fitch Bond Book’. 

In 1924, Fitch introduced the AAA-through-D rating system that’s gone on to become the basis for ratings throughout that sector.
Henry Varnum Poor first published the ‘History of Railroads and Canals in the United States’ in 1860, the forerunner of securities analysis and reporting to be developed over the next century. 

Poor’s Publishing (later Standard & Poor’s) started selling its bond ratings to investors in 1916.

Standard Statistics merged with Poor’s Publishing in 1941 to form Standard and Poor’s (S&P), and was acquired by McGraw-Hill, in 1966.
S&P has become best known by indexes such as the S&P 500, a stock market index that is both a tool for investor analysis and decision making, and a US economic indicator.

In the 1930s, federal regulators began using these private ratings to evaluate the safety of banks’ holdings.

However, the importance of the agencies waned following WWII as bond defaults became rare.

The economic turbulence of the 1970s raised their profile again. 

In 1975, the US Securities and Exchange Commission deemed certain firms as ‘nationally recognised statistical ratings organisations’, making a sign-off from a ratings agency a necessity for anyone involved in selling debt. 

But ratings also became a stamp of actuarial approval that often let investors and regulators skimp on their own due diligence.

Meanwhile, the agencies’ business model switched from one whereby investors paid for ratings to one compensated by their clients – the bond issuers. 

This generated more revenue, but it also created the potential for a massive conflict of interest, something that has been cited in the current sub-prime mortgage mess. 

In 2006, the SEC took regulatory authority over the agencies, in part because of their failure to ring more alarm bells concerning companies such as Enron. 

The agencies have since suffered massive credibility issues, being exposed during the GFC and appearing to have been captured by the financial system in relation to the AAA credit ratings they granted to trillions of dollars of highly complex derivatives.

In August 2011, William J Harrington, a former senior ratings agency analyst, went public by submitting a 78-page comment to the SEC’s proposed rules about rating agency reform.

The firm that once employed this ‘insider’ is paid by the banks and companies whose securities it is supposed to objectively rate.

While Mr Harrington’s story at times reads like score-settling, he claimed the conflict of interest was so pervasive that the ratings issued were “useless at best and harmful at worst”.

Mr Harrington alleged that the internal corruption was manifest in simply giving the ‘issuers’ (banks and companies) what they wanted.

Actions that helped make the agency’s clients happy were rewarded, whereas actions that hurt their firm were punished.

Past v future

Another problem ratings agencies face is that they base their assumptions on the past, whereas investors make assumptions about the future. 

For this reason the credit agencies are always playing catch-up with the market, making their ratings look outdated.

A gem that’s carried in a report from one ratings house from as recently as December 2009 is entitled, ‘Investor fears over Greek government liquidity misplaced’.
Six months later, Athens received a $147bn rescue package.

In response to the European financial crisis, S&P recently downgraded the credit ratings of 12 European countries, including France and Spain. 

But the market didn’t flinch.
Instead it rejected S&P’s evaluation out-of-hand by buying up European government debt bondholders.

Long-term French bond yields hardly moved and borrowing costs fell at the country’s sale of €8.59 billion ($A10.65bn) in bills.
Spain, whose rating was cut to an A, sold debt at half the interest rate of a month earlier.

The US, which had lost its AAA-credit rating last August, followed suit, yet US treasuries have continued to outperform AAA-rated corporate bonds. 

In the wake of the GFC, many Europeans have lobbied to have the credit rating agencies banned, while others want regulators to strangle them with regulation.

Since January 1 2010, the Australian Securities and Investments Commission (ASIC) made credit rating agencies liable for their ratings.

If these agencies give consent to having a rating put in a prospectus here in Australia, they are legally exposed should they have been shown to be in error.

Between the Europeans wanting to outlaw the credit agencies, and everyone else starting to ignore them, their survival after the GFC proves their determination to stay alive. 

Perhaps the cheapest and most obvious solution for the credit rating agencies is that they return to their original charter, and make a renewed commitment to corporate integrity.
Investors’ portfolios cannot afford anything less.

Steve Blizard is an authorised representative of Roxburgh Securities.


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