Ratings Agencies – Roles and Criticisms

By Tey Zhi Ren

Rating agencies, or more specifically credit rating agencies (CRA), are companies that assign credit ratings for certain debt instruments as

well as the issuers of the debt obligations themselves. The process in which their ratings are derived begins with the gathering and analysing of a wide range of financial, industrial, and economic information. This information is then synthesized before being published to offer an independent and credible source of assessment for creditworthiness.

Through the provision of the rating services, CRAs receive rating fees that are g

enerally paid for by the issuers. To a lesser extent,fee-based rating services may also

be received from subscribers of the CRAs. CRAs are considered useful due to their ability to increase a particular security’s pool of potential investors through the mitigation of information asymmetries between the issuers and potential buyers, hence improving their pricing and liquidity. Concurrently, ratings can be considered as a form of

motivational yardstick to oversee the management’s behaviour, as the risks of downgrading will limit their ability to shift risks.

CRAs and their ratings play a key role in the capital markets and are highly relied upon in facilitating contracting by important market participants. Ratings form a starting point for most investors in classifying certain securities and their associated risks.

Institutional investors such as mutual funds, pension funds, and insurance companies often use ratings to aid them in their investment process; and may even use them in entirety over self-analysis. Ratings are considered to be essential to the issuers as they underline the biggest measure of their credibility and affect the interest rates applied to their issued securities. Lastly, ratings can also be used by regulators to ensure compliance on the part of sell-side market participants. An example is the Rule 2a-7 of

the Investment Company Act that limits money market funds to only invest in commercial paper that are of a sufficiently high ratings.

Despite their immensely wide use, CRAs came under intense scrutiny and criticisms during the period following the sub-prime crisis. In light of their

ratings’ values being questioned, CRAs defended themselves by holding onto the stance that their ratings are just a published opinion on the creditworthiness of firms and securities, and should not serve as a strict recommendation in the buying or selling of the rated securities.

CRAs, and especially their credit ratings, are

criticised for not containing information relating to systematic risk exposure. Their ratings are derived based only on the cash flow risk, which measures the probability of default and expected recovery values, and is insufficient to enable accurate pricing of the securities as it does not account for payoff amounts that co-vary with economic states. This had contributed to the existence of distinctly differing yields am

ong classes of securities that may have similar given ratings.

The pronounced judgmental errors in CRAs ratings for structured products – with specific reference to the high default or downgrade ra

tes of AAA-rated structured products, is anoth

er highly debated issue. The proliferation of new AAA-rated securities in the period leading up to the sub-prime crisis was aided by the process of pooling and tranching countless underlying debt agreements. Tranches are prioritized to allow losses from the underlying portfolio be absorbed such that their ca

sh flows and credit ratings can have a significant difference from their underlying portfolio. Efficient pooling and tr

anching of suitable debts of a lower rating, say BBB, can allow for the manufacture of AAA-rated tranches. Such structuring allow for an upward-biased misrepresentation of the underlying debt pools, where

the perceived default probability of rated tranches from high yield CDOs are mistakenly biased downward, gifting a sense of over-confidence to potential investors who seek low-risk securities or products.

The lack of transparency in the ratings process, especially so during the investigation of Enron’s collapse, is another glaring viewpoint against CRAs. It was argued that should transparency in the ratings process be increased, a higher level of public scrutiny of the Enron’s activities can be allowed. That will help in reducing the potential conflicts of interests and continual use of fraudulent accounting. Opponents also pointed out the slow downgrade of Enron’s ratings prior to their bankruptcy, where they managed to maintain an investment grade rating just four days prior to its collapse.

Another ringing criticism is the conflicts of interest CRAs face that arises due the receipt of rating service fees from the issuer, rather than from the investors. By working hand-in-hand with the issuers, rating agencies essentially undertakes an overly prominent role in the creation of securities that leads to huge conflicts and is disadvantageous to the investors. CRAs might thus not be able to provide accurate and honest ratings.

At the same time, vicious cycles may be created through the lowering of ratings by CRAs. In the event that an under-performing firm’s score is downgraded, it will face rising interest rates and expenses as its contracts with other financial institutions are adversely affected as well. Decreases in its credit worthiness may also trigger clauses in certain loan agreements for full repayment of loans, which will contribute to further liquidity problems for the firm and lead to further downgrades of ratings by CRAs in a ‘death spiral’.

In conclusion, even though it appears that the existing market structure have a heavy reliance on rating agencies, they are still plagued with numerous criticisms and perceived structural weaknesses in their roles. It is clear that the reputations of the CRAs took a significant hit following the allegations that culminated during the sub-prime crisis. Thus, the key challenge for rating agencies remains in overcoming these criticisms, where they might have to consider a change their approach to ensure that their credibility can once again be reinstated.