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Ratings Demystified — Part I

I have a confession to make. Although I generally knew that financial instruments issued by companies and countries are “rated” by one of the three independent agencies (Moody’s, Standard and Poor and Fitch), I did not know much more. Oh yes, I also knew that certain ratings made an instrument “investment grade” while other ratings made them “speculative grade”. So I decided to do some reading and, in the next two articles, I will share with you (in as simple English as possible) what I learnt.

But first some background. I was attending the Eurofinance conference in Vienna in spring last year as a speaker. One of the sessions that I attended as a member of the audience was a session where all the three rating agencies were on the stage and were being grilled by the audience on their rationale for giving high investment grade ratings to several mortgage backed securities. To their credit, they defended their position strongly and denied any wrong doing.

Martin Winn of S&P summed up the industry’s position in the following words in an article in the February 2009 ACCA magazine for which he was interviewed “a rating is an opinion of the relative probability of a security defaulting, not about its market value or its suitability as an investment”. He further said “The performance of many of our ratings on the US sub-prime-related securities has been worse than has been the case historically, but the bigger problem has been the sharp fall in their market values and mark to market write downs by banks and investors.” Winn pointed out that as at mid-November 2008, less than two per cent of the $3 trillion worth of housing related securities rated by S&P since 2005 have gone into default.

To me, Winn is merely squirming. A conclusion of ACCA’s September 2008 policy paper, “Climbing out of the Credit Crunch”, was that many investors placed strong reliance on ratings supplied by agencies such as Moody’s and S&P and they did so “with little or no further due diligence or consideration of risk”. Readers, do remember that Arthur Anderson went out of business for the Enron fiasco — a much smaller offence.

I think Warrant Buffett (he owns 20 per cent of Moody’s and therefore he should know!!) summed it up eloquently in his 2008 report to Berkshire shareholders when he said “Back-tested” models of many kinds are susceptible to this sort of error. Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.) Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognise this all-important fact. Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.

Okay, so what is a credit rating? Ratings are evaluation of credit risk — i.e. the relative ability of an issuer to meet its financial obligation in full and on time, as well as the credit quality of the specific issue and the relative likelihood that it may default.

Ratings are not buy or sell recommendations, guarantees of credit quality, or exact measures of the probability of default. It is merely a rating agency’s opinion of relative creditworthiness, from strongest to weakest, within a universe of credit risk. So a higher rated bond is less likely to default compared to a bond with a lower rating.

A rating can be assigned to an individual issue or to an issuer. Let as look at individual issues. These could be one series of bonds, or short term or long term debt obligations, loans, structured finance instruments or even preferred stock. Ratings could be assigned to issuers such as a corporation, municipality or even a sovereign government. In the next article we will look at how bonds and issuers are rated and what those funny alphabets assigned by the agencies mean.

Views expressed by the author are his own and do not reflect the 
newspaper’s policy.