Monday, June 4, 2012

Of Credit Rating

(This article appears in the latest issue of Moneylife. I also confess that I have worked for CRISIL and admire the organisation even today. I learnt so much there) FAITH ACCOMPLI Credit Rating has become a controversial topic. No one seems to like credit ratings. This dislike comes from investors who attribute credit ratings as the cause for the Lehman crisis, sovereigns that have had their egos bruised by rating downgrades and companies that generally get ratings lower than their own expectations. In a world without credit ratings, the investment universe would perhaps shrink dramatically. Investors would be forced to do their own analyses of companies across the globe ( or at least in terms of where they can invest) or fall back on ‘name’ recognition. Sitting in Mumbai, a fund manager may not know enough of an issuer in Coimbatore or in Ludhiana. He has to perforce undertake the full analyses himself. Of course he can always fall back on a ‘sell side’ broker report. And this broker would be someone who is also earning some fee from the issuer. And no issuer is obliged to share the future with a broking firm or with a journalist. In case he does so, it would be voluntary and only project what he wants to be seen as. There is no one to pay the Devil’s Advocate. And of course, in the absence of credit ratings, interest rates would be driven by perceptions. An issue from a known stable or group would get snapped up easily and an unknown issuer with better credit would end up paying up higher costs. Without ratings, the investment universe would be a smaller and inefficient place. I believe that credit ratings serve a very useful purpose. To my knowledge, the fact that the issuer pays a fee to get his issue rated has not so far been a reason for any bias. Fees are uniform across the issuer universe. Yes, it is possible that some late entrants or those with lesser market acceptance may use fees as a tool to attract some business. Or they may promise some issuer a higher rating. This cannot last for long. It would be short lived and ultimately, the market place knows how to differentiate. Whilst we have five ‘recognised’ credit rating agencies, the investors do make a distinction in pricing, depending on which rating agency has assigned the rating. The rating agencies that compromise on ethics and standards survive only because there are pools of money belonging to governments and provident funds, which go by the rule book. They don’t care which agency. As long as a ‘recognised’ agency gives its ‘chop’, they are okay. This lets the not so creditable agencies get business. I will not name them but every player in the market knows the names. I was shocked to hear about a company going to court and blocking the likely ‘downgrade’ of its credit rating. And the court, surprisingly, issued a stay! This means that the company was virtually sure of its downgrade! And the names were in the press, so would investors not react? More shocking was the stay granted by the court. After all, credit ratings are opinions. They are not a recommendation of any sort. Tomorrow, can a movie producer get a stay on a review by a critic? I am a solid supporter of plain vanilla credit ratings on bonds. However, when it comes to fancy stuff like securitisation or the IPO grading, I hold a different point of view. Securitisation is a complex exercise and the basic flaw is in assigning highest ratings on par with vanilla bond ratings. Securitisation ratings are mere statistical exercises based on past behaviour, whilst credit rating is a forward looking opinion. The past statistics are based on a set of circumstances which keep changing from day to day. To this extent, there will be huge errors of judgement. So far, globally, securitisation has been a mere eye wash and there has never been a true sale. What happens here is that an originator (say a bank or a finance company) sells a bundle of loans (could be home loans or vehicle loans etc) to a Special Purpose Vehicle (SPV) which is typically a Trust. This Trust issues papers representing undivided shares in the pool of loans to investors. However, in reality, this Trust is a paper entity and all the action continues to be done by the lender. Securitisation is a mere window dressing exercise designed to help lenders to borrow beyond prudent limits. Similarly, IPO grading has been an addition that has not worked out too well. The problem with IPO grading is the lack of co-relationship between a grading and the issue price. Most users of IPO grading will assume that a high grading would mean a great issue in terms of returns on the offer price. The truth is that higher the perceived quality or strength of an issuer, the higher is the pricing likely to be. And IPO pricing today has generally been on the excess. So, an IPO grading at best can talk about the likelihood of the company being around for some time. Here also, the pitch is queered by the quality of credit rating agencies around in India, not all of whom do a honest job. My fear is that the IPO grading would not even help us to detect ‘vanishing’ companies. Also, unlike credit rating on bond issues, the IPO grading is a onetime exercise and rating agencies can easily be taken for a ride by a smart promoter. The other vexed issue is one of ‘general’ ratings. Here, I do not find much in to it. It just becomes like equity research with no real use for this rating. The other worrying thing to me is that the nationalised banks (which are generally slack in credit appraisals) are passing the buck by forcing companies and SMEs to go in for credit ratings. It is difficult for me to digest the credit rating yardsticks being applied to SMEs that are one man shows and are in unorganised sectors when they kick off. The only persons to benefit would be ‘consultants’ who promise to assist these SMEs to get the process completed. However, the rating agencies have marketed themselves very cleverly and ‘rate’ everything from hospitals to buildings. Perhaps there is a scope for extending their expertise to restaurants and compete with the Michelin Guide. I only hope that it provides some value to the consumer. If one has to use credit ratings, do not look beyond plain vanilla debt ratings on either bonds or fixed deposits. Commercial Paper or short term ratings are no indicator of company strength since it focuses on the short term. A company with a high Single A rating could have the highest short term rating. Remember that credit rating is an opinion and merely helps you with an additional input. It does not absolve you of your homework. And also remember that there are differences between ‘recognised’ credit rating agencies. And the truth is that globally, credit rating agencies are very powerful and the plural term is used because there are two of them who dominate the business. These global agencies used to assign ratings only on the global scale. In essence, it meant that if India has a rating of “BBB-“, no Indian company could get a higher rating. It was CRISIL that broke this system and assigned ratings on a domestic scale. This practice was pioneered by CRISIL and other agencies in the region followed. Ultimately, the American agencies had to accept this scale. Alas, they are snapping up regional agencies and to that extent, the duopoly is getting stronger. Maybe, China will take the lead and we can have a rating agency that competes with the American ones.

1 comment:

Anil Agashe said...

Agree about your views on IPO grading completely. As long as grading excludes pricing it is of no use to retail investors.
Rating agencies are responsible especially the international one's for the poor image. Moody's and S&P have escaped cheaply from 2008 fiasco blame for which they must share.
Why not bring Bank deposits under mandatory rating? This will be a good thing to do.
Also investors must pay part of the rating fees. For example while applying they should pay say Rs.50 up to an application of Rs. 10000, and so on.