Rating agencies

(CRA) – Need for Reform

1. Crisis – Spotlight on the rating agencies

“The rating agencies use their control of information for investors to believe that the pig a cow and a rotten egg is a chicken fried fool conspiracy and false statements are not elements of a truly free market.” – U.S. Congress Gary Ackerman

The smooth functioning of global financial markets depends in part on reliable estimates of investment risk and the rating agencies play an important role in improving investor confidence in those markets.

Rhetoric above, although difficult invites us to focus our lens on the functioning of credit rating agencies. Current debacle as described below make it even more important to consider the application of rating agencies as assessor fair.

i) sub-prime crisis: In the recent subprime crisis, rating agencies came under increasing fire for their collusion in favor CDO junk rating in the subprime crisis that is currently with global consequences. To provide clarification loan originators were guilty packaged subprime mortgages securitization, and market them as asset-backed bonds in the secondary mortgage market. Rating agencies do not their duty to warn the world of finance carry a fair and transparent assessment. Surprisingly, they were favorable ratings to the CDO, for reasons that must be considered.

ii) the Enron and WorldCom: The companies were investment-grade rating by Moody’s and Standard & Poor’s three days before bankruptcy. Rating agencies have a positive effect on the assessed risk products and in some cases, these risk products, and for costs of fat.

There may be other over-rated Enron and WorldCom bankruptcy proceedings pending. Rating agencies must be reformed so that they cancer point where in advance so that the increased financial security pin.

2. Ratings and rating agencies

i) The credit rating agencies: a structured methodology, the creditworthiness of some of an entity or loan commitment (eg a product), or a debt or claim as such as a transmitter of a commitment Rank

ii) Credit Rating Agency (CRA) is a specialized agency of the work of the rating above. Ratings from rating agencies are not recommendations to buy or sell securities, but only one indicator.

Notes can be divided into
i) Required Note: If the rating to a request to a bank or a company that is based involved in the rating process say
.
ii) without further notice: If the rating agencies in the amount of an organization in the public interest

claim.
Rating agencies help to achieve economies of scale, because they avoid investments in tools and help internal credit check. It allows market intermediaries and investors focus on their core competencies to an end leaving the job evaluation of complex reliable agencies.

3. The rating agencies note

Agencies that assign credit ratings to companies include

A. Mr Best
(U.S.)
Baycorp Advantage (Australia)
Dominion Bond Rating Service (Canada)
Fitch Ratings (Germany)
Moody’s
(U.S.)
Standard & Poor’s
(U.S.)
Creditworthiness of the Pacific (Peru)

4. Rating agencies – the power and influence />
Various market participants to use and / or affected by credit ratings are as follows

a transmitter): A good credit rating improves the ability of issuers and market prices, which in turn, to satisfy investors, lenders and other counterparties involved.
b) Business Buy-Side: buy-side firms such as mutual funds, pension funds and insurance companies use credit scores to help as one of several important factors, their own internal credit ratings and analysis of investment, the price differences to identify the level of security risks, compliance to them require funds in the asset quality park, etc. Many restrict their funds to higher assessments, which makes them more attractive to conservative investors.
c) Business Sell-Side: I buy-side firms for many companies sell side broker-dealers to use the assessment and risk management for commercial purposes.
d) Regulation: the use of the regulatory order of ratings in various forms, for example, has the Basel Committee on Banking allows banks to use external ratings to determine capital allocation. Or take another example, restrictions on the public service or public pension funds from local or national governments are imposed.
e) the tax payers and investors: Under the direction of the gain or changes in credit benefit or harm investors in securities issued by the erosion of value and it also affects taxpayers through the cost of public debt.
f) private contracts: Opinions are known to significantly affect the balance of power between the parties that the spelling inadvertently applied to the organization as a whole and not just its debt.

Rating downgrade – A death spiral:

A rating downgrade can be a vicious circle. Let us view this in stages. The first step is the rating downgrade. Banks now want bankruptcy expect a full refund. Society can not be led in a position to pay an additional discount. This begins a spiral of death led to the collapse of the company’s ultimate closure.
Enron engaged in this vicious circle where a clause provides for the full repayment of the loan in the event of a downgrade. If decommissioning has occurred, the clause to the financial problems of Enron by pulling in serious financial difficulties.
Pacific Gas and Electric Company is another example that has been damaged by the business partner and creditor repayment set by a rating downgrade pressure. PG & E was not mobilize resources to meet his slip to repay short-term be composed into the death spiral.

5. Rating agencies as victims

Rating agencies have to face the challenges following

a) Lack of information: a statement that credit rating agencies to access their inability to provide accurate and reliable information about issuers. Cry of the rating agencies, issuers deliberately withheld information not in the public for such a risk not disclosed, which may adversely affect the liquidity of the issuer.

b) compensation system: the rating agencies act on behalf of investors, but they are in most cases paid by the issuer. There is a possible conflict of interest. Since the rating agencies by the records themselves and not by the investor point of view of the market are paid, they are under pressure to provide their customers with a positive note – the other client will move to another location helpful. Rating agencies of conflicts of interest that plagued it from the exact and honest assessment could prevent. There are conflicting reports with some rating agencies recognize that if it on the compensation of investors, they would go bankrupt. Others strongly deny conflict of interest that the defense costs of individual emitters was a very small percentage of their turnover, so no significant influence issuers with a rating agency.

c) the pressure of the market: The allegations that the ratings opportunistic and not based on logic and that they are unfair practices because of the inherent conflict of interest resorts by the rating agencies refused to be harmful because the ratings established reputation and misconceptions can lower status agency market. Short reputation are sufficient to ensure that they appropriate degree of accuracy in the rating process.

d) Results exaggerated allegations to be done to promote credit rating agencies active swimmers too much emphasis on their ratings and to encourage companies like-wise. Rating agencies disadvantages, the ratings are used out of context, without the fault of their own. They are used in organizations themselves, not only the debts of the company. A favorable credit rating is unfortunately used by companies as a seal of approval for the marketing of products independently. A user must remember that the note was delivered to more strictly to keep the level of investment to be evaluated.

6. Rating agencies as authors

a) Corrections arbitrarily without any accountability or transparency, the rating agencies to downgrade and upgrade and point to the lack of information in the nominal part or on the product as a possible defense. some reason downgrade may affect the issuer, the market assumes that the agency deliberately not some information in the public domain. This may be due to volatile security issuers speculation.
Sometimes eextraneous consider whether an adjustment would be made. The rating agencies do not downgrade companies when they should. For example, many Enron at investment grade four days remained before the company went bankrupt, despite the fact that the rating agencies had been aware of social problems for months.

b) Due diligence is not enough: there are some glaring contradictions, the rating agencies are reluctant, because conflicts of interest are referred to resolve. For example, when we refer to the ratings of Moody’s focus, we find the following inconsistencies.

The three above have the same distribution of capital forced banks to move into riskier assets.

c) licks Management: The business logic has forced rating agencies to assess a close relationship with the management, development and thus influence the relationship with the rating process. They proved to propose themselves as consultants on the pre-assessment activities and measures that act to the positive impact on business rating. Just the other extreme are institutions that fit the one-sided opinions being accused, while the refusal of a company the opportunity to explain his actions.

e) creation of barriers to entry: Agencies are sometimes accused of being an oligopoly, because the entry barriers and high-paying corporate rating agency is itself based on reputation (and the financial sector much attention to a note that is not recognized). All agencies routinely make large profits (Moody’s, for example over 50% gross margin) to view the monopoly prices.

f) promotion of support services: credit rating agencies have developed activities such as the pre-assessment and consulting services business to complement its core business evaluations. Issuers may be forced to support services instead of purchasing a favorable rating. For all compounds, except for all the rating agencies Moody’s and others are private companies and their financial results are not yet back to part with their activities.

7. Some recommendations

Information) Objective: The extent and quality of information in the financial statements and balance sheets must be improved provided. Even more important is the management report and analysis, the disclosure of off-balance sheet, contractual obligations and commitments and contingent liabilities. Shorten the time between the end of the quarter of the issuer or of the year and date of submission of the quarterly or annual report will rating agencies to obtain information quickly. These measures will improve the ability of rating agencies to rate issuers. If the rating agencies, to include the essential information to is not available, or made less of an issuer, the Agency may refuse to lower class to give an opinion or even remove an existing rating.

b) Due diligence and competence of analysts, rating agencies, analysts should not solely on the words of management, but also lead their own due diligence in other public records to transfer probe opaque, examination of proxy statements, etc. There should be stricter (or higher qualification) to be an employee of the credit rating agency.

c) eliminating barriers to entry: to increase the number of players can not completely reduce the powers of entrenched oligopolistic years, but it would be best to keep them up to speed by up to a certain level of competition and thus market forces determine what really is the best rating reflects the financial market crisis.

d) costs Note: Wherever possible, have published the cost estimates. If revealing such sensitive information raises issues of commercial confidence, then agencies must at least the subject of intense regulation of financial markets. Analyst compensation on the basis of merit based on the accuracy of their ratings and found not at the expense of the issuer.

e) the credit rating process transparent: The public agencies should make the basis for their ratings, default rates, including statistics for measuring performance issues and historical. This will protect investors and improve the reliability of the ratings. Regulations should rating agencies to disclose their procedures and methods of rating products open. Rating agencies should review their internal audit rating methodologies.

f) In addition to independent stores, although the second activity is a small part of total revenues, the rating agencies have yet to policies and procedures to set up firewall reviews auxiliary enterprises. separate staff and not the rating analysts should be used for marketing activities.

g) Risk Disclosure: Explore CRAs significant risks, it seems insufficient to be addressed in public communications, should disclose to the relevant authority regulations for further action during the process of risk assessment or risk. Rating agencies must be more proactive and conduct formal reviews of issuer information to the fraud not only their role should evaluate the credit quality of issuers. Note Trigger (repayment of the loan, such as full in the event of a downgrade) is discouraged wherever possible and should be mentioned, if it exists.

These measures could be implemented to improve if the market’s confidence in rating agencies and their assessments can be an important tool to promote investor confidence by improving the security of financial markets in general.

Resource List

i)
http://www.zyen.com/Knowledge/Articles/assessing_credit_rating_agencies.htm
ii)
http://www.chasecooper.com/News-Regulatory-Basel-II-2007-10-01.php
iii) http://www.blackwell-synergy.com/doi/abs/10.1111/j.1468-0491.2005.00284.x?cookieSet=1&journalCode=gove
iv)
http://www.house.gov/apps/list/speech/ny05_ackerman/WGS_092707.html
v)
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2373869.ece
vi)
http://www.cfo.com/article.cfm/9861731/c_9866478?f=home_todayinfinance
vii)

http://en.wikipedia.org/wiki/Credit_rating_agency

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