What’s a Rating Agency Opinion Worth?
The financial industry relies heavily on the opinions of credit rating agencies, but are rating agencies providing the high quality analysis that everyone assumes? This article investigates and reaches some controversial conclusions.
What’s a Rating Agency Opinion Worth?
With the potential for a downgrade in the credit rating of Australia, and the recent downgrade of the United Kingdom
there’s been a spike in interest in credit rating opinions. Whilst many speak of the desire for Australia to retain the
coveted “AAA” ratin
g few understand what actually goes into a credit rating.
So what is a credit rating and is it worth
anything anyway? Should investors pay attention to these opinions particularly after the poor performance of rating
agencies in the financial crisis?
What
do rating agencies do well and do badly?
The basics of a credit rating
Credit ratings are an opinion of
the
financial strength
of a
debt
issuer. The letter combinations often cited (i.e. AAA or
BBB)
denotes
the
relative
ability of an issuer to repay its p
rincipal and interest on time. The table below from Standard
& Poor’s explains their view of financial strength.
Source: Standard and Poor’s
Credit ratings are a mix of qualitative and quantitative factors. The primary driver of a rating is a combination of
financial ratios such as debt/EBITDA for corporates or debt/GDP for governments. Analysts overlay a qualitative
adjustment
to the ratios which
can
result
in
a
slightly higher or slightly lower outcome than the ratios alone would
indicate. The entire process is subjective; what ratios are used, in what proportion they are weighted and the
qualitative adjustments are all components that issuers argue
about seeking to influence the ratings agencies to issue
a more pos
itive assessment of their debt
repayment prospects
.
What a rating say
s
about a debt issuer
The opinions of ratings agencies are seen as important by
investors
as a lower rating indicates a higher risk of pri
ncipal
and interest not being paid in full. The
chart
below shows that companies with lower ratings have an exponentially
higher probability of defaulting on their debts. As a result, debt issuers with lower ratings must pay a higher interest
rate in order
to attract buyers for their debt to offset the perception they have a higher risk of not paying their debts.
Source: Standard and Poor’s
Criticisms of Rating Agencies
Conflicts of i
nterest
The big three rating agencies
(Standard & Poor’s, Moody’s
and Fitch)
have attracted heavy criticism from governments,
regulators and investors as they charge both issuers and investors for their services. Issuers pay the rating agencies to
prepare a report and provide an opinion on their risk profile. This creat
es tension between issuers and rating agencies,
as the issuer can threaten not to pay the rating agency if the opinion is not optimistic enough for their liking. Investors
pay rating agencies to be able to access the detailed reports, though rating agencie
s do make the ratings publicly
available without charging. As a result of this conflict of interest independent credit research firms such as CreditSights
and Egan
-
Jones
have emerged that
are paid only by investors for
their analysis.
Ratings are not
fungible
One of the biggest misunderstandings of credit ratings is that the same risk rating for
d
ifferent type
s
of debt (e.g.
corporate, sovereign, financial institution) means they have equal likelihood of defaulting. As history has shown many
times, di
fferent types of debt have very different risk profiles for the same rating. It is reasonable to compare ratings
within the same debt type, but
erroneous
to compare ratings between debt types. This is explained further in the
following section on the merit
s of ratings for different deb
t
types.
Ratings changes
are delayed
Investors have long complained that rating agencies fail to downgrade ratings in a timely fashion. Many prefer credit
default swaps as a better measure of the real time probab
ility of def
ault, although
these have a tendency to overshoot
when negative information comes to light. Rating agencies often give the benefit of the doubt to debt issuers as
downgrading a rating is typically a controversial step that the issuer may publicly disagree
with. In the most fractious
cases, issuers stop paying the rating agency and ask for the opinion to be withdrawn.
Performance in the
f
inancial
c
risis
The poor track record of credit ratings during the financial crisis means that the big three credit
ratings agencies aren’t
trusted anywhere near as much as they used to be.
Lehman Brothers had
“A” ratings when it defaulted and many
other failing banks were similarly rated. Thousands of ratings and trillions of dollars of debt were downgraded across
mort
gage backed securities and collateralised debt obligations
from 2007 onwards. In the worst examples,
securities
went from AAA
to defaulting within a year
.
Investors who
failed to undertake their own due diligence suffered
substantial losses and many took legal action as a result.
The
M
erits of Ratings for Different Debt Types
Corporate
d
ebt
Ratings on corporate debt are the
bread and butter of rating agencies
and it is where they do their best work
.
Thousands of companies are publicly rated with Moody’s data set stretching back to 1920. The big three
rating
agencies
produce
annual
reports which show that lower rated corporate
s are far more likely to default than higher
rated corporates. On the whole, there are few examples of highly rated corporates defaulting with Enron and Parmalat
arguably the worst in recent decades. Both of these involved financial deception on the part o
f management. The main
criticism of corporate debt ratings is the slowness of downgrades as companies deteriorate
.
Investors can generally
expect corporate credit ratings to be an approximately fair reflection of
default
risk.
Sovereign
d
ebt
R
ating
agencies are almost always too optimistic on their ratings for developed nations. The standout example is Japan,
with the big three all seeing it in the “A” category. Most independent analysis of Japan has it unable to repay its debt
without printing money
. If the average interest rate on
its debt was to rise by 3%
all government revenues
would be
consumed by interest payments
with nothing left for
healthcare
,
education or defence spending
.
Many governments
in Europe and
the
US continue to receive high ratings even though they are running substantial budget deficits yea
r
after year and have
sizeable
unfunded pension obligations. Ratings for developing nations tend to be a fairer reflection
of their risk of defaulting.
Investors should treat sovereign debt rating
s with great caution.
Financial institutions debt
R
ating age
ncies tend to be
way
too optimistic in rating large banks and
somewhat less optimistic
in their opinions of
smaller banks. For large banks, credit ratings have a substantial impact on their ability to attract institutional funding
and to trade with their counterparties. A downgrade below investment
grade
(below BBB
-
) is effectively a death k
nell.
AIG and Lehman Brothers were examples of
hugely
optimistic ratings
during 2008.
Comparisons are
now
being made
between Lehman Brothers and
Deutsche Bank
, which
could see its funding and trading opportunities rapidly disappear
if it suffers further downgr
ades.
Several Italian banks are being talked about as needing government bailouts yet still
have credit ratings in the “B” and “BB” categories. Investors should treat credit ratings of
financial institutions
with
great caution.
Securitised
d
ebt
Rating agencies were rightly excoriated for their ratings of securitised debt such as mortgage backed securities and
collateralised debt obligations in the lead up to the financial crisis. As highlighted in the move The Big Short, rating
agencies gave infl
ated ratings to securitised debt in order to protect their market share and maximise revenues.
However, since the financial crisis the rating agencies have dramatically increased their analysis of securitised debt to
the point where the ratings are general
ly
pessimistic. In a reverse of the situation for other types of debt, rating
agencies are criticised for failing to upgrade ratings in a timely fashion when securitised transactions perform in line
or better than expected. Investors can generally
expect securitised debt credit ratings to be an approximately fair
reflection of default risk, but
need to bear in mind the diversity within securitised debt and the range of complex
assumptions required to produce a rating.
Conclusion
Credit ratings play an important part in the functioning of capital markets, but should always be treated as an opinion
not a definitive judgement. Issues with credit ratings include the conflicts of interest that the big three rating agencies
have, rating
s are not fungible between debt types and rating agencies tend to be slow to downgrade ratings in
response to new developments.
Credit r
atings for sovereign and financial institution debt tend
s
to be particularly
optimistic
but corporate debt and securitise
d debt are generally more reasonable assessments
. Investors should
always conduct their own financial analysis
and form their own judgement before investing
.
W
ritten by Jonathan Rochford for Narrow Road Capital on
Ju
ly 6
, 201
6
. Comments and criticisms ar
e welcomed and
can be sent to
info@narrowroadcapital.com
Disclosure
This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and
tailored financial
advice. It contains information derived and sourced from a broad list of third parties, and has been
prepared on the basis that this third party information is accurate. This article expresses the views of the author at a
point in time, and such views may
change in the future with no obligation on Narrow Road Capital or the author to
publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including
securities linked to the performance of various companies and
financial institutions.
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