Time to fix it raters

Credit rating agencies in India have so far escaped the wrath of investors. But that should not stop them from putting in place simple rules that regulators may have overlooked

The world financial markets follow three credit rating agencies. We track five. One such agency has rated an institution bond as ‘BBB plus’     while another has placed a separate debt by the same institution three notches higher at ‘AA minus’. Take your pick. A fund manager in an insurance firm, where internal rules restrict investments below double A papers, chooses the second rating. The institution which has floated the bonds may have shopped around to find an agency that is willing to give a double A stamp. The agency may even be willing to charge a lower fee to hand out the rating. No one complains. Life goes on.

USER TO PAY? FORGET IT
The fund manager who uses the rating to take the investment call doesn’t pay the agency — making ‘rating’ the only product in the world where the buyer (the bond issuer) and the user (the fund manager) are two different sets of people. But it’s a small cosy world where the firm raises the money, the investment banker syndicates the deal and a few large investors like banks, mutual funds, insurance companies and provident funds may have a quick chat to figure out what’s best for all. Once that’s settled, it will be a matter of a few days, may be even hours, before the money gets credited to the issuer’s bank account.

    
Changing the model to make users pay is easier said than done, even though it hasn’t stopped people from giving funny suggestions. Nobody since John Moody — the founder of the world’s second-biggest rating agency Moody’s — ever tried that. In the predepression days of Wall Street, Moody’s Manual of Railroads and Corporation Securities reached only those investors who paid for it. But after a big default and a near-collapse of the US commercial paper market, Moody had to change his business model to issuer-pay, as more firms wanted their bonds to be rated. By then, it had captured the investor imagination that a bond with a higher rating had a smaller probability of default. Things haven’t changed much since.

UNDER THE GLARE
Chances are that this basic model will stay unchanged. But the debate on rating agencies, sparked by Lehman’s collapse and widespread defaults, will rage. Angry investors have often felt that the debacle has been catalysed by the mistakes of rating agencies. Some are beginning to distrust ratings; instead, preferring that investments should be driven by the good old judgement on the merit of a security and its issuer.
    
These ripples have touched the shores of India — a market that’s devoid of complex structured products — whose ratings in the West were an outcome of equally-complex methodologies, understood and spewed out by the computer; a market, where rating agencies were fortunate enough not to rate such securities and could thus preserve their reputation (at least, till so far).
    
But, given the harsh media glare on overseas markets and banks — which dominated the front pages and covers of business publications for a good part of 2008 and 2009 — the government and regulators feel that something must be done. So, here we have two sets of reports telling the agencies what more they need to do to stay credible.

(Interested, but impatient, readers may Google to quickly scan the last chapters of the two reports where the recommendations have been spelt out).

TRICKY TRADE, SIMPLE RULES
Even the most sceptic trader or bond salesman takes ratings as a hygiene factor, and a regulator’s decision to revisit the old rules to discuss what more needs to be fixed is welcome. More so, because despite the outrage among many investors across markets, tighter regulations have made rating agencies more indispensable. Not only do banks, insurance firms, pension and mutual funds prefer rated bonds, agencies are rating even loans, thanks to the global capital norms for banks. There can’t be a better time to ponder over a few points which the recent reports seem to have missed out.

• Why did no rating agency spot Satyam? The simplest reply, of course, would be that Satyam had no bonds in the market. Fair enough, but in all likelihood, the fraud would have slipped the rating radar even if there were Satyam securities floating in the market. An insider, who blew the whistle, had alerted an independent director who possibly did nothing. But if there is another Satyam — another firm which has outstanding bonds — what are the chances that such an insider will approach the rating agency. Is there a number the person can call? Or, a mail ID where the beans can be spilled? Besides auditors, agencies may be tapping other channels like bankers, suppliers and even trade unions to fish out more information. But, providing a particular telephone number or a mail address on the agency website could be a clever way to keep the door open to get that information they thought never existed. In six out of seven cases, it could be a wild goose chase; but it could also give a lead that would protect the agency’s reputation and investors’ money.

• Agencies have to battle allegations of waferthin Chinese walls that seemingly separate the rating business from other divisions like advisory, consultancy and software development. The lure of business from these non-rating activities, runs the allegation and clouds the rating committee’s judgement. Given the relationships that agencies develop with corporates, it’s natural that they would explore multiple revenue options to keep alive the interest on their stocks. If auditors and banks can pursue consultancy and investment banking, rating agencies perhaps have a point. But what’s stopping agencies from disclosing other business relationship with the company its rating? The regular press communiqués on an upgrade (or even downgrade) can mention whether the agency has advised the company on, say risk management. It may not be a huge leap in corporate governance. But certainly there’s no harm.

• Methodologies differ between agencies, and they should. The mix of informal sources, the degree of dependence on company auditors, feedback (mostly verbal) from lenders, vary among agencies. But what shouldn’t is the format. For instance, some agencies give the ‘rating outlook’, while others don’t. The former claims it’s incremental information to the investor, the latter argues it’s a job half-done — ‘either upgrade or downgrade when you think the time’s right, but don’t keep it hanging’.
    
Just like investment banks or auditors, fees charged by rating agencies vary. And, just like any other business, a rating agency may be tempted to promise ‘superior quality’, ‘faster delivery’ and ‘lower price’ — dangerous terms in a tricky trade like rating. It may be easier to resist the temptation since Basel capital norms and greater regulations are bringing in more and more business. But it could be a challenge if the business begins to dry up.
    
sugata.ghosh@timesgroup.com