Why price and disclosure should make rating agencies redundant

If one accepts the reasons for the existence of credit rating agencies, it is hard to argue against the expansion of their activities into the realms of equity analysis and ratings.

What does a credit rating agency do? It assesses an entity's ability to meet its obligations in full and on time. Ratings are graded, and historically the gradings can be shown to approximate to the probability of the default (the inability to meet debt obligations in full and on time). Fitch and S&P base their ratings on the risk of default but Moody's ratings assess overall credit risk which includes the likelihood of default and any financial loss suffered in the event of a default. (Emphasis added)

Apart from a rating, the agencies usually provide a written analysis to justify their decisions. In the case of a typical corporate or financial institution issuer, it is hard not to regard these analyses as little more than advertorials, as they are paid for, and invariably reviewed, by the issuer.

Rating agencies came into existence because of the demand for credit by borrowers who sought to raise money directly from investors rather than through the banks. This process of disintermediation is the foundation of western financial services and the so-called "Anglo-Saxon" way of doing business. In much of the rest of the world, bank lending to borrowers remains the most important source of debt finance.

After several credit blow-ups in the USA in the C20th, the SEC decided it would formally recognise certain credit rating agencies and then require issuers to obtain ratings. Even where ratings were not obligatory, investors soon adopted, or had imposed on them by supervisory bodies, various rating requirements for the assets in their portfolios. The result of this was the indirect regulation of the bondmarket by the SEC, under the guise of the approved rating agencies. [Unfortunately, these unaccountable credit ratings are now being enshrined into future bank regulation and capital requirements under Basel 2 so even if disintermediation takes a breather, the agencies will keep their place in the world]

If the raison d'etre for rating agencies was the concern that investors needed help in deciding which debt instrument was "money good", why was a similar scheme not established for investment in equities? After all, equity is the riskiest part of the capital structure. It absorbs the first losses so that creditors can be paid but unlike most debt, it is perpetual and unlikely to be returned. It also differs from plain vanilla debt - in that there is no regular coupon, although equity investors in established companies will expect some dividend paid out of earnings and annual cash flow. Whether an investor buys debt or equity, he does not intend to lose money.

Why are so many investors happy to (or even allowed to) buy and sell ownership interests in companies without guidance from a financial analyst? Any recommendation on the equity of these companies will come from analysts at investment banks, brokers or perhaps independent research houses. These are unlikely to be directly paid for by the company and any positions or conflicts of interest will be declared on the research publication. But if I want to lend money to the company, the borrower has to pay for a rubber stamp rating.

Quite simply the market for equity is sufficiently transparent in terms of price and issuer information (as required by the relevant stock exchange regulations). This generates trading liquidity and the overall availability of information more than offsets the risk of the ultimate subordination that my investment incurs in the legal priority of claims against the business.
Information on an entity's operating performance, it's financial condition and the price of its securities count for far more than its credit rating.

In the current crisis, credit rating agencies have been rendered ineffective. Credit losses are decided by the market. Traders will conduct the price discovery to find the level at which sellers and buyers of impaired assets are satisfied. The credit rating agencies are no more involved in the process than any other investor who is monitoring the situation.

The only time the rating agencies could possibly claim to have better knowledge of the issuer, than the market as a whole, is at the time of bond issuance. This would certainly be the case for structured credits, but not for stockmarket listed businesses. In any case, within a matter of days – the market’s knowledge of any issuer is on a par with, or better than, that of the agencies.

To a certain extent, rating agencies recognise their deficiencies apparent even in the regular ratings of plain vanilla bonds. Rating agencies are frequently criticised for being slow to act. Their excuse for being slow stems from their claims to act only on fact and not speculation. So they will try and glean from the issuer the facts behind any story before taking any action. Few CFOs will give the agencies inside information, particularly if there is bad news ahead, so in spite of their supposed relationship with the issuer, the agencies are no better informed than the capital market as a whole.

Meanwhile, the equity market will be flagging up problems, as it did at Enron, Worldcom and more recently with Northern Rock, well before the credit rating agencies lurch into action. The rating agencies are well aware of the information derivable from equity and asset prices. There are accounting-based algorithms such as the Altman Z score that highlight potential distress as equity market capitalisation decreases. Models such as KMV, based on option theory, derive expectations of default by considering the stage at which the equity holders put what remains of the company to its creditors.

KMV was deemed so good (or potentially a threat to classic, fundamental credit analysis) that Moody’s acquired it. Variances between fundamental ratings and equity volatility derived, accounting linked, bond implied and market (CDS) implied ratings are monitored by the agencies but the information is limited to subscribers and is not a public good.

What the examples of equity-driven credit rating research confirm is that with the transparent prices and business and financial disclosures that stock exchanges require, a separate rating agency activity is not needed.

The biggest risk of loss in any investment situation arises where trading activity of the security is infrequent and trading volumes low e.g. structured finance bonds. If investors punt in debt securities with limited information and rely on a price worked backwards from the rating then they are deluding themselves. Loss has everything to do with liquidity and exit routes and relatively little to do with credit ratings.

Sporting behaviour

Having benefitted from the EU's savings directive and the grief that measure has caused the private banking industry in Switzerland, it's good to see Singapore, in the form of GIC and a near USD10bn equity injection, come to the rescue of UBS. Hopefully Singapore can maintain banking secrecy indefinitely but one expects the EU to pressure Singapore to disclose european client details to EU tax authorities at some stage. Until then, Singapore can get a bit closer to the gnomes and cement its position as the leading AAA haven for fast money.