1. Introduction
Events here in South Africa, over
the last two weeks, have left me with that feeling of déjà vu. I am referring
of course to local lender African Bank being taken into curatorship following
an announcement by the governor of the local central bank on Sunday, August 10th.
The week before African Bank’s share price nosedived in response to the
unsecured lender’s announcement that its CEO had quit and that the unsecured
lender had suffered a further deterioration in financial performance. The bank
would need to come to market to raise yet more capital; despite previous
reassurances to the contrary. Remembering the events which played out in
September of 2008 when Lehman collapsed, I remarked to a colleague prior to
that fateful weekend, that I couldn’t see how African Bank would last the
weekend.
And then it came. Like Lehman,
which was forced to file for Chapter 11 bankruptcy on a Sunday, the local
central bank duly made an announcement on the Sunday, although, unlike Lehman,
the central bank chose to step in and (mostly) rescue debt holders. Equity
holders were not so lucky; six years, 1 month and 4 days earlier, nor was Dick
Fuld1.
Lehman employees at the Canary
Wharf office in London receive the news of the bank's Chapter 11 filing on
Monday morning September 15th 2008.
The now infamous report by Morgan Stanley analysts which called on equity investors to reload on Lehman stock only months before its collapse.
While I think it is fair to say
that 2008 was the year of reckoning for many institutional and retail investors
globally, South African investors were, for the large part buffeted from those
events. The events of financial distress at that time were many and varied but
the poster-child for the period is no doubt the default of the investment bank
Lehman1. The crisis in essence stemmed from the fact that banks lent
too much money to people who were unable to repay their debt. That South
African banks emerged mostly unscathed was a source of great pride and the
local financial system was held up as a shining example of a well-regulated
industry with sensible lending practices. And then over the last 6 years as
scandal after scandal has emerged - Madoff2, LIBOR-fixing3,
dark pools4, high frequency trading5, commodity price
fixing6 and so the
list goes on, I daresay that South African's felt slightly smug.
Bernie
Maddoff in happier times
Any
delusions of grandeur South Africans may have had about superiority in the
appropriate regulation and safeguarding of the financial system were laid to
rest with the effective collapse of African Bank and the domino effect that
event has had on our banking, savings and investment industries. While, the
large South African banks will still feel a certain amount of smugness, the
failure of African Bank is, arguably, also an indictment on the lack of a
sufficiently responsive feedback loop between regulators and the private sector
so that perhaps the latter must shoulder some responsibility?
2. Lessons from African Bank
Lesson
1: "Credit worthiness is like virginity; it can be preserved but not
restored very easily"
Like
their global counterparts in 2008, South African pension funds, insurers and
individual investors have had 'golden circle' tickets to the greatest show in
town. If I were to attempt to distil all the lessons learnt over the last few
weeks then much like in 2008 it would be simply this: throw out everything you
thought you knew to be true, assume nothing and question everything. If I were
to apply this mantra to one feature of recent events it would be to consider
the central role that assessments of credit worthiness have played in this
latest crisis. I say this because, in the case of both Lehman and African Bank,
once it became clear that their lenders had lost faith in their ability to
successfully navigate their financial woes their sources of funding dried up
and their fate was sealed.
In late
2013, the US government was engaged in a dangerous game of chicken with its
lenders. The Treasury Department was fast reaching its borrowing limit (as set
by the US Congress) and needed an act of Congress to borrow beyond this limit.
Not raising the limit would have meant that the US Treasury would have been
unable to borrow money to meet upcoming commitments on its maturing debt
obligations. Warren Buffet noted that it would be ludicrous for the US to
contemplate defaulting7 on
its debt repayment obligations and said that "credit worthiness is like
virginity; it can be preserved but not restored very easily".
The lighter side of the debate on
the US debt ceiling debate
Lesson
2: To assume is to presume
If we
accept Warren Buffet’s comment as being an accurate reflection of the
importance of credit worthiness, then surely investors should be aiming to
ensure that the tools in place for measuring credit worthiness are robust and
as infallible as can be. After all, a significant deterioration of credit
worthiness could trigger a downward spiral in the financial fortunes of a
borrower, one that was difficult, if not impossible, to recover from, leaving
the lender vulnerable to not recovering the amount they have lent.
The
failure at African Bank has placed the spotlight firmly on those making these
assessments, including:
- equity fund
managers who chose to buy shares in African Bank and so were implicitly
making judgements about the safety of their client’s investments and the
likelihood of having their capital returned, let alone achieving an
acceptable return on their investment;
- money market and
fixed income fund managers who lent African Bank money by buying their
bonds and
- credit rating
agencies (CRA’s)8, professional firms in the business of
assessing making credit quality assessments.
Most of
the public attention has fallen on the equity and money market fund managers:
- equity fund
managers are being criticised because they have lost substantially all of their client’s
money that was invested in African Bank shares and
- money market
fund managers are being criticised because their money market funds were
sold as ultra-safe, something that was close to cash, yet for the first
time in history these funds have ‘broke the buck’ – investment speak for
saying that investors in money market funds can expect to lose some of
their initial investment.
But with
the recent credit rating downgrade of the Big Four South African banks
(ABSA/Barclays, FirstRand, Nedbank and Standard Bank), attention is turning to
the credit rating agencies, professional firms whose business model is premised
on making money from evaluating and then rating the credit worthiness of
borrowers. Professional money managers, investment advisers and clients place
their confidence and trust in these ratings and billions of Rand, Pounds and
Dollars are invested by reference to these ratings.
The main
criticism levelled against these purveyors of credit worthiness assessments is
that they have been slow to react. If all was really well at African Bank why
did these rating agencies continue to award African Bank a rating that only the
most credit worthy of institutions would have deserved (known as an ‘investment
grade’ rating9) right up to the point of African Bank going into
curatorship. It seems that while referencing a credit rating can be important
part of an investor’s due-diligence, it is by no means sufficient to fully
assess the credit quality of a borrower.
Given
what we have just said about credit worthiness, you may be forgiven for
thinking that the global financial services industry would have an established,
robust and commonly accepted system for consistently measuring the
creditworthiness of a company. It is probably not an exaggeration to say that today,
the complete opposite is true and that the most common global approach to
measuring credit worthiness, a credit rating issued by a recognised credit
rating agency, has embedded flaws.
So what,
I hear you say? Well,
- if the people
you trust to manage your money place an undue reliance on these ratings
then perhaps they are taking more risk with your money than is immediately
apparent and
- if the
regulators entrusted with protecting the financial system are slow to
regulate to prevent the unintended consequences from this flawed system of
credit ratings then perhaps investors need to be alert to the flaws of the
system and find alternate ways to manage their risk.
It
would be dangerous to assume that credit ratings are a panacea for assessing
credit worthiness of borrowers.
Lesson
3: Trust nothing; question everything; historical quirks have created deep
‘fault-lines’ in our financial system. It sometimes takes a seismic event for
the ‘fault-line’ to be noticed. Unfortunately such seismic events rarely occur
without leaving behind a trail of destruction in their wake.
One way
of gauging investor confidence in the financial fortunes of a company is the
company's share price. Another way is to consider that company's cost of
borrowing or the additional premium demanded by the company’s lenders versus
lending to the most secure of borrowers, typically seen as the government of
the country. There is, however, a third, and arguably even more influential
determinant of investor's perceptions of a company's credit worthiness and that
is a company's credit rating.
Background: the advent of credit
ratings?
Very simplistically, investors in
stocks and bonds are lenders of money to the companies they invest in. Ordinary
shareholders expect that in exchange for committing their capital to the
company, they will be rewarded through a pro-rata share of the company's future
(unknown) profits but also recognise that they are first in line to lose money
should things go wrong with the company's business. On the other hand, those
lending money to a company, for example, by buying their bonds (a form of
tradeable loan), expect to be paid a well-defined return on their investment (a
pre-specified rate of interest) and ultimately expect their loan to the company
to be repaid on time.
Many professional investors have
historically relied on credit rating agencies ("CRA's"). Modern day CRA's
date back to 1909 when American John Moody started offering credit ratings on
American railroad bonds in a book called ‘Analysis of Railroad Investments’.
Until then most bond investing was in the public (or sovereign) debt of
governments and investors (the bondholders) trusted those governments as being
willing and able to honour their obligations.
John Moody, founder of the modern credit rating agency
But in the early 1800's the American railroads were being built by privately owned railroad companies. The large amount of capital needed to finance the building of railroads in what were then 'frontier' regions meant that railroad companies turned to issuing bonds - effectively borrowing money from US and international investors against their future expected profits. Not only was this the beginning of the corporate bond market as we know it today but the development of this market eventually led John Moody to offer a service, rating the credit quality of these borrowers. Remember this was before the establishment of the US Securities and Exchange Commission (SEC), which was created in 1934 and required public companies to issue standard financial statements.
Shortly thereafter, in 1916, the
Poor company, started by Henry Varnum Poor, turned its attention from publishing
the Manual of the Railroads of the United States (a compendium of financial
information on the railroad companies) to rating railroad bonds. The company
merged with Standard Statistics in 1941 to form Standard & Poor's (S&P).
Today Moody's and S&P are the world's largest credit rating agencies.
So
powerful have the rating agencies become, as the definitive voice on a
borrower’s credit worthiness that Thomas Friedman, a television interviewer on
PBS, would say on 13 February 1996:
"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."
Rating
agencies are the strangest of hybrids; a seemingly split personality. Most
organisations with a regulatory role are non-profit organisations. Credit
rating agencies (CRA’s) on the other hand are profit-making companies
performing a regulatory role10. The conflict is problematic mostly
because of the manner in which the CRA’s are remunerated. When John Moody first
conceived his rating agency (or manual), in exchange for selling his rating
manual, Moody was remunerated by his investors who were end users of the
information he provided. In the 1970s, the concept of ‘issuer pays’ began to
take hold. Under ‘issuer pays’, the entity issuing bonds (borrowing money),
pays the CRA to rate their bonds. There have been many reasons put forward for
the change11. One of the quirkiest reasons is that the advent of
high-speed photocopying in the early 1970s meant that once a single investor
had bought and paid for a rating, it could be easily duplicated and passed on
free of charge to other investors. Whatever the reason, with the benefit of
hindsight, the conflict of interest in the ‘issuer pays’ model is clearly
apparent – it can be compared to a restaurant paying a food critic to evaluate
the quality of the dining experience on offer. More bluntly, the question
critics raise is around the temptation for a rating agency to massage up a
rating in order to prevent an issuer seeking a different (possibly higher)
rating from a competitor agency.
Regulators
have long recognised the Jekyll and Hyde nature of rating agencies and are now
setting about to change this, specifically by eliminating references to credit
ratings in new regulations governing financial stability. Globally, the
Financial Stability Board (FSB), chaired by the Governor of the Bank of
England, Mark Carney is leading the charge. In October 2012, the FSB, of which
South Africa is a member, published a roadmap for implementing its principles
for reducing reliance on credit rating agency ratings11. The roadmap
to removing the references to credit ratings embedded in regulations is being
implemented globally, including here in South Africa, and there is now
widespread acknowledgement that mechanical reliance on credit ratings to ensure
the credit-worthiness of an investment is no substitute for fundamental
due-diligence and analysis. Furthermore, baking into regulations a reliance on
credit ratings as a means for measuring financial strength may in fact be
compounding the problem of mechanical reliance and fails to recognise that the
credit rating business has embedded conflicts of interest.
Mark
Carney appears in front of the UK Treasury Select Committee in advance of his
confirmation as the first non-Brit to become Governor of the Bank of England.
Carney assumed the role on 26 November 2012
What is
not yet changing is the ‘issuer pays’ model and so while the split personality
is changing, the conflict of interest to investors relying on these ratings
will likely persist for some time. The winds of change will, to many, feel more
like a breeze but what this does highlight is the potential for latent conflicts
of interest in our financial system to pass undetected for long periods of
time. These conflicts of interest are, in of themselves, not necessarily
problematic. What is problematic is not taking being aware of the conflict when
using these ratings in ones assessment of credit risk. As we will illustrate in
our next point, whilst the current model may be imperfect, the rating agencies
themselves are transparent on these points so it should be the role of the
end-user to understand how best to use the output from the credit rating
agencies.
Lesson
4: There is no such thing as a free lunch; if something looks too good to be
true it probably is. A credit rating does not reflect all information about the
credit worthiness of a portfolio. If regulators are changing regulations to
remove references to ratings as a measure of credit worthiness perhaps
investors should, at the very least, try to broaden their approach to
controlling the credit quality of those they lend money to.
Rating
agencies have a long history of slow reaction to financial distress. This dates
back to the default of Penn-Central Railroad13 and First Executive Corporation but it
was the defaults of US companies Enron on 28 November 2001 and WorldCom on July
21 2002 that drew the ire of US politicians who reacted angrily to the fact
that the Big Three rating agencies maintained an ‘investment grade’ rating for
Enron’s bonds until five days before Enron declared bankruptcy.
The
lighter side of the Enron scandal
The delayed response by rating agencies was also prevalent when Lehman Brothers defaulted on Monday 15 September 2008. The Friday before (12 September), Lehman bonds held an investment grade rating. This phenomena, known as ‘jump-to-default’ – where a seemingly credit worthy institution can move, literally overnight, to being in default for many investors is seen as all too common an occurrence so perhaps we need to understand why these professional rating agencies seem unable to foresee impending trouble or have investors misunderstood the purpose of these ratings?
The key
lies in recognising that credit ratings are not necessarily designed to be a
forward predictor of deteriorating credit worthiness. Furthermore there are
many studies in finance literature which demonstrate that a borrower’s future
credit worthiness (or more aptly its lack thereof) may be better predicted by
a:
-
deterioration in its share price14;
-
an increase in its credit spread15 (the additional yield demanded by
lender’s to lend to a company rather than a safer borrower, say, the
government); and
-
an increase in the implied cost of insuring against a default by
the borrower16;
There are
many structural reasons that explain why, by design, credit rating changes may
lag actual changes to a company’s likelihood of default and hence why credit
ratings may not be the best predictor of future credit worthiness. We outline
some of these below.
1. There is evidence to suggest that
rating agencies adopt an approach known as a ‘through-the-cycle’
approach. This means that an assigned rating may not immediately change to
reflect adverse events unless those adverse events are expected to be long-term
and significant enough to cause a move to a lower category on their rating
scale. This means that rating changes by design take place quite gradually and
may not be as timely as investors may assume them to be. Rating agencies have
come in for a fair degree of criticism on this point from investors demanding a
more timely credit assessment. This criticism is too often levelled by those
with an insufficient understanding of the credit rating agencies methodologies
and their limitations.
2. Credit rating agencies use a rating
scale which has a limited number of categories17. As a result it is
possible that the credit worthiness of a company has deteriorated but that it
has not deteriorated to a sufficient extent to warrant a downgrade to a lower
rating category. [In technical jargon, credit ratings are a discrete variable
whilst the likelihood of default is a continuous variable.]
3. Credit ratings are not being
continuously updated yet, the likelihood of a company defaulting changes in
real time. Some lag in updating the rating is therefore inevitable.
There are a few implications that
arise from these observations:
-
Credit ratings are not meant to be a panacea and are no substitute
for a thorough bottom-up fundamental analysis.
-
Exposure limits set by bond investors for their fund managers
(e.g. no more than a certain percentage invested in bond instruments with a
particular minimum credit quality) are but one tool for controlling credit
risk. A simple mechanical rule for limiting exposure by credit-rating is
unlikely to be sufficient to control for credit risk.
-
It is entirely possible for, say, two fund managers to each
construct a debt portfolio with the same ‘average’ credit rating, yet offering
very different yields. Investors and their advisers should recognise that, all
else being equal, for a given average credit rating, the differences in yield
between these two portfolios should act as a flag about the true credit
worthiness of the two portfolios. This ‘flag’ with respect to the credit
quality would not be apparent by simply looking at an average credit rating.
-
Fund managers should not be adding securities to their money
market, income or other fixed income portfolios purely on the basis of the
comfort they are drawing from a credit rating about the borrower’s credit
worthiness
There are
good reasons for the reactive nature of credit ratings and it is the
responsibility of users of credit ratings to understand this, and other,
shortcomings of credit ratings. Again, the mechanical use of ratings as a
panacea for assessing credit quality is unfortunately far too common amongst
investors, including professional investors.
Credit
ratings have their shortcomings but they are still a useful tool if investors
take time to understand and compensate for their limitations. Credit ratings
cannot shoulder the blame for the follies of investors who use them without a
thorough understanding of their limitations; much like guns credit ratings are
only dangerous when used incorrectly and for the wrong purpose.
--------------------------------------------------------------------------------------------------------
Notes
(1) Dick
Fuld / Lehman default
Lehman Brothers was a US investment bank
that filed for bankruptcy on September 15th 2008. DicK Fuld was CEO of Lehman at
the time it filed for bankruptcy and is commonly thought to be the person whose
actions, more than any other, contributed to the demise of Lehman. Lehman was
the largest bankruptcy filing in US history, as measured by assets held at the
time of filing for bankruptcy. Lehman had $691bn of assets at that point. Until
Lehman WorldCom was the largest bankruptcy; when WorldCom filed for bankruptcy
it had $104bn of assets.
(2) Madoff
Bernie Madoff ran a pyramid scheme (also
known as a Ponzi scheme) out of his Manhattan office, promising investors
unusually large returns, using money from new investors to pay returns to older
investors. Madoff was caught in December 2008 when investors started demanding
returns. Madoff’s shenanigans shocked the already bruised global financial
system that was still reeling from the default of Lehman Brothers only 3 months
earlier.
(3) LIBOR-fixing
LIBOR (London Interbank Offer
Rate) is the average interest rate at which banks can borrow from one another.
London is mentioned in its name because the benchmark is set in that city. A
number of banks estimate how much interest they would pay to borrow money on a
short-term basis from other institutions. While the process is still overseen
by the British Bankers' Association, the calculations are now performed by
Thomson Reuters. Thomson Reuters discards the four highest and four lowest
submissions as outliers, and averages the remaining ones.
The data provider then publishes its calculations,
generally around 11:30 a.m. London time, along with each bank's submissions.
There are actually 150 different Libor rates published every day. They cover 10
currencies and 15 maturities.
Essentially, Libor is one of the main rates used to determine the borrowing
costs for trillions of dollars in loans. Interest rates on some mortgages,
student loans and credit card accounts rose or fall when Libor moves. Often the
rates are adjusted annually or quarterly, rather than every day. Interest rate
swaps may reference LIBOR if they reference a floating rate of interest.
In late June 2012 news broke of fines of close to $450m being imposed against
Barclays PLC. This was the first time that the public heard of the manipulation
of this key interest rate even though it would subsequently become clear that
the earliest evidence of LIBOR-fixing dated back at least 4-years prior.
(4) Dark
pools
Dark pools are a private trading
venue where details of trades are not made available to the public. The main
advantage of these trading venues is allowing their participants to conduct
trading activity without revealing their true investment intentions – the fear
being that if their investment intentions were made public, knowledge by the
wider public could adversely impact the performance of their intended
investment strategy.
As the name suggests, these private trading venues operate away from the public
exchanges like the London or New York Stock Exchanges. Instead they are
operated by large investment banks.
CBS News noted that: ‘The problem is that so much trading is now happening in
dark pools that it may be warping publicly quoted stock prices to the extent
that they no longer properly represent where the market is. For example, if a
lot of sell orders for stock in ABC123 Corp. are waiting to be fulfilled in a
dark pool, then buyers in the pool and elsewhere don't know that the price of
that stock should be lower than it is. Further, because dark pools base their
prices on the prices from the public exchanges, then the prices in the dark
pools will be wrong as well.
Also, dark pools have several characteristics in common with things that
contributed to the financial crisis: lack of transparency, under-regulation
and, because of the amount of trades they now handle, they have clear
systematic links to the rest of the financial system and the entire economy.’
(5) High
frequency trading
High-frequency trading (HFT) is
algorithmic trading that involves the very rapid placement of buy and/or sell
orders, in the realm of tiny fractions of a second. It is alleged that HFT
firms are often involved in front-running whereby the firms trade ahead of a
large order to buy or sell stocks based on non-public market information about
an imminent trade. Another criticism is that HFT has increased the level of
potential market systemic risk whereby shocks to a small number of active HFT
traders could then detrimentally affect the entire market. A related concern is
whether HFT could exacerbate market volatility. These concerns have percolated
since the “Flash Crash” of May 6, 2010, when the Dow Jones Industrial Average
(DJIA) fell by roughly 1,000 points in intraday trading—the largest one-day
decline in the history of the DJIA. The crash was analysed in an investigative
report by the SEC and CFTC which, among other factors, looked at the role that
HFT may have played and determined that it was not the cause, but may have
exacerbated the crash.
Regulators have been scrutinizing HFT practices for years, but public concern
about this form of trading intensified following the April 2014 publication of
a book by author Michael Lewis.
Source: High Frequency Trading: Background, Concerns and Regulatory
Developments; Gary Shorter and Rena S. Miller; 19 June 2014; Congressional
Research Service. http://fas.org/sgp/crs/misc/R43608.pdf
(6) Commodity
price fixing
Prices
for oil and other commodities are estimates based on either:
-
standardised contracts that trade transparently on regulated
exchanges or
-
data on bids, offers and deals as reported by unregulated
price-reporting agencies (PRA’s) which make money by gathering market
information and selling it to subscribers.
The European Commission and the US Commodity Futures Trading Commission (CTFC)
in 2013 started investigating possible market-rigging of commodity prices by
oil companies. Platts, the largest PRA was raided by the EU in 2013.
Source:TheEconomist http://www.economist.com/news/finance-and-economics/21595943european-union-wants-change-how-commodity-benchmarks-are-set-fixing-fix
(7) Has the US defaulted before?
Not really. There are three
examples in US history that come close to default, with the most recent
occurring in 1979. Then, the US Treasury inadvertently defaulted on $122m,
because of what it said was a word processing error. Although the error was
quickly fixed, and even though $122m was a tiny fraction of the $800bn in debt
that the Treasury had at the time, a study found that the mini-default raised
the cost of borrowing by 0.6%, or $6bn a year.
The other two instances, in 1933 and in 1790, both involve defaults akin to the
current situation in Greece, when creditors were forced to take less money than
what they were owed. Some economists have defined this as a default, but it's
murky territory.
(Source: BBC)
(8) Credit
rating agencies
A credit rating agency is a
professional firm which issues assessments on bonds that provide investors with
an opinion on the credit quality of the bond – i.e. an assessment of the
borrower’s ability to pay both interest and capital and the likelihood of
default. Bond markets existed for at least 60 years prior to advent of the
first credit rating agency in 1909. There are approximately 150 credit rating
agencies worldwide although just three agencies dominate; Moody’s, Standard
& Poor’s and Fitch. Of these S&P and Moody’s dominate.
The next largest rating agency after S&P and Moody’s is Fitch. Fitch
Publishing Company was founded in 1913 by John Knowles Fitch, a 33-year-old
entrepreneur who had just taken over his father’s printing business. Fitch had
a unique goal for his company: to publish financial statistics on stocks and
bonds. In 1924, Fitch expanded the services of his business by creating a
system for rating debt instruments based on the company’s ability to repay
their obligations. Fitch were first to introduce the now familiar
"AAA" to "D" ratings scale to meet the growing demand for
independent analysis of financial securities. Although Fitch’s rating system of
grading debt instruments became the standard for other credit rating agencies,
Fitch is now the smallest of the “big three” firms.
Source: Basel Committee on Banking Supervision, 2000; Langohr and Langohr,
2008, p.384
(9) African bank credit rating
Note that the rating was
investment grade on the national scale but sub-investment grade on a global
scale.
(10) Regulatory
role of credit rating agencies
The regulatory role of credit
rating agencies dates back to 1934 when US bank regulators decreed banks could
not invest in non-investment grade (low credit quality) bonds as determined by
a recognised rating agency (or manual as they were then). The only recognised
credit rating manuals at the time were those issued by Moody’s, Poor’s, Fitch
and Standard. With this, the credit assessments made by these third-party and
for-profit organisations attained force of law.
In the decades that followed, some insurance and pensions regulators followed
similar routes by linking what they deemed suitable bond investments to the
bond ratings issued by these rating agencies.
The SEC then finally cemented the regulatory role of rating agencies in 1975
with two acts:
-
the creation of the ‘nationally recognised statistical rating
organisation’ (NRSRO) and
-
the grandfathering of Standard & Poor’s, Moody’s and Fitch as
NRSRO’s,
by decreeing that only a rating
from an NRSRO could be used as a measure of the credit-riskiness of
broker-dealers (in 1975) and as a measure of the credit-riskiness of commercial
paper held by money-market funds (1990).
Between 1975 and 2000, the SEC designated only four additional firms as NRSROs:
Duff & Phelps in 1982; McCarthy, Crisanti & Maffei in 1983; IBCA in
1991; and Thomson BankWatch in 1992. Mergers among the entrants caused the
number of NRSROs to return to the original three by year-end 2000.
Source: Journal of Economic Perspectives – Volume 24, Number 2- Spring 2010 –
Pages 211-226. The Credit Rating Agencies by Lawrence J. White, Professor of
Economics, Stern School of Business, New York University, New York.
Lwhite@stern.nyu.edu.
(11) Reasons
for moving from ‘investor pays’ to ‘issuer pays’
Some of the reasons given include:
-
The advent of the high-speed photocopying machine meant that many
investors would have been able to simply photocopy the rating manual from other
investors thereby reducing the rating agencies’ revenue.
-
The bankruptcy of Penn-Central Railroad in 1970 was a catalyst for
bond issuers to have credit rating agencies vouch for them by rating their debt
and reassuring investors about their low risk status. This made bond issuers
more willing to pay for the rating.
-
Bond rating firms realised, somewhat belatedly, that regulations
had been passed in the US requiring some institutional investors to hold debt
with certain ratings. This observation would make issuers more willing to pay
for a rating to get their bonds into those portfolios.
(12) Press
Release: FSB publishes thematic peer review report on reducing reliance on
credit rating agency (CRA) ratings http://www.financialstabilityboard.org/press/pr_140512.htm
(13) Penn-Central
Railroad
In May 1970, Penn Central
Railroad, then on the verge of bankruptcy, appealed to the Federal Reserve for
aid on the grounds that it provided crucial national defence transportation
services. The Nixon administration and the Federal Reserve supported providing
financial assistance to Penn Central, but Congress refused to adopt the
measure. Penn Central declared bankruptcy on June 21, 1970, which freed the corporation from its commercial paper obligations. To counteract the
devastating ripple effects to the money market, the Federal Reserve Board told
commercial banks it would provide the reserves needed to allow them to meet the
credit needs of their customers. In 1971, the government provided $676.3
million in loan guarantees. In 1976, the federal government consolidated the
still struggling Penn Central with five other railroad companies that were also
failing to form Consolidated Rail, or Conrail. The government spent $19.7
billion, including roughly $7.7 billion for the initial investment, to keep Conrail
operating. By 1981, Conrail began to earn a profit. The government sold Conrail
in 1987 for $3.1 billion. In addition to the sale price, the Treasury received
a $579 million dividend from Conrail.
(14) Norden,
L. and Weber, M. (2004) Informational Efficiency of Credit Default Swaps and
Stock Markets: The Impact of Credit Rating Announcements. Journal of Banking
and Finance, 28, 2565-2573. http://dx.doi.org/10.1016/j.jbankfin.2004.06.011
(15) Hull,
J., Predescu, M. and White, A. (2004) The Relationship between Credit Default
Swap Spreads, Bond Yields, and Credit Rating Announcements. Journal of Banking
and Finance 28, 2789-2811. http://dx.doi.org/10.1016/j.jbankfin.2004.06.010
Note that in emerging markets (like South Africa), the usefulness of credit spreads can be more limited than in developed markets, due to the lack of a readily liquid secondary market. Furthermore some methodologies used by exchanges to mark corporate bonds to market require a minimum traded amount to be reached before prices (and hence credit spreads) are updated.
Note that in emerging markets (like South Africa), the usefulness of credit spreads can be more limited than in developed markets, due to the lack of a readily liquid secondary market. Furthermore some methodologies used by exchanges to mark corporate bonds to market require a minimum traded amount to be reached before prices (and hence credit spreads) are updated.
(16) Hull,
J., Predescu, M. and White, A. (2004) The Relationship between Credit Default
Swap Spreads, Bond Yields, and Credit Rating Announcements. Journal of Banking
and Finance 28, 2789-2811. http://dx.doi.org/10.1016/j.jbankfin.2004.06.010
(17) Response
of rating agencies to criticisms of their discrete scales
Moody’s and Standard &;
Poor’s have adopted refined rating categories by adding modifiers (e.g. “+” and
“−”, or “1”, “2”, and “3”) to the generic rating categories to indicate whether
a bond is on the upper, middle, or lower end of the rating category. The
refinement of the rating categories can be viewed as a step moving from a
discrete rating system toward a continuous spectrum. So refined ratings not
only reflect the default probability more precisely, they also may trigger a
rating change more quickly as rating agencies do not have to wait until the
financial positions of bond issuers to deteriorate (or improve) to the next
broader generic rating category to make rating changes.
Source: Do Credit Rating Agencies Sacrifice Timeliness by
Pursuing Rating Stability? Evidence from Equity Market Reactions to CreditWatch
Events Jenny Gu, Jeffrey S. Jones, Pu Liu, 13 May 2014
