If you have suddenly found the investors fidgety or moody don’t blame them for the rating standards have become poor!
Never before has any single industry come under the scanner as in recent times with financials institutions falling nine pins. The consecutive failure of the giants only indicates that more is to come in the next couple days, weeks and months. The news reports based on the data released by the Federal Deposit Insurance Corporation indicating the banks and savings institutions on the ‘problem list’ grew to 117 in the second quarter of the calendar year 2008 against 90 in the first quarter. A 30% increase in the number of potential delinquents. The information evidently is not going to go down too well in the banking and financial community not to speak of the investors or the average layman who may just be wondering as where on earth he could keep his savings. It sounds literally like the nursery rhyme written “Ringa Ringa Rosie” with every conceivable financial entity falling!
Investors, be it the institutional financial investors or the retail investors, have always derived comfort from the any external assurance like professional audit and credit rating agencies. The turn of events over the last week has dealt a body blow on the confidence levels. One definitely is intrigued by the fact that the entire international rating agencies had assigned a credit rating of AA to AIG till May 2008 and suddenly down graded it just the night before the company was taken over the federal government under the bailout package. Even the down grading was to an investment grade which raises the basic question as how could a company on verge of significant credit default and bankruptcy has an investment grade rating?!
If investors in the failed companies are still looking at heaven to obtain plausible explanations, the failed giants namely AIG, Lehman and others to follow themselves, with all their financial acumen, appear to have been done by their trust on credit-rating agencies. The main credit raters — Moody's and Standard & Poor's, Fitch had assigned AAA and AA ratings to all sorts of exotic mortgage securities and other financial without evidently understanding or communicating to layman the underlying risks involved. An average investor would be last person to know how and understand the risks in the context of a collateralized loan obligation or commercial-mortgage-backed securities.
In hindsight it appears even sophisticated investors took Moody's and S&P's assessment of companies & instruments at face value and it turned out that the agencies sailing in the same boat as that of investors - clueless! A survey, a couple of years back, of the Association for Financial Professionals revealed that about 30% of finance managers perceived the credit ratings of their own organizations to be inaccurate; about 40% perceived rating changes to be untimely.
The role of credit rating agencies has been under the scanner ever since the sub-prime crisis started making its rounds in the international financial markets. The credit rating agencies have had to put up a strong defense to deny the accusation that they gave inflated ratings to sub-prime mortgage debt and other discredited bonds in order to attract more Wall Street investment banks that have now failed. This has happened not too long back and was about the same time last year.
Going back to the case of AIG, one wonders if the rating agencies had factored into the rating assignment the key issues of the leverage that is ratio of borrowings to capital. It was the highest in comparison to its peers at 11 to 1. This has to be viewed in the context of its exposure to the credit default swaps coverage that it had extended. The entire risk management mechanism of the company evidently was skewed and this, in retrospect, did not meet the eye rating agencies. The only aspect that raises an alarm is that all the agencies have accorded the same rating. The question that begs answer is if there is a cartel on rating or the rating mechanism shallow and fundamentally flawed! Harsh questions but definitely would be crossing the minds of every affected person.
Warren Buffet the sage from Omaha and financial expert had in an interview just after the Enron saga had said that derivates like futures, options and swaps were developed to allow investors hedge risks in financial markets - in effect buy insurance against market movements - but have quickly become a means of investment in their own right. He had warned that derivatives can push companies onto a "spiral that can lead to a corporate meltdown", like the demise of the notorious hedge fund Long-Term Capital Management in 1998. The words sound likes that of Nostradamus.
The credit default swaps (CDS) one of the many weapons of mass destruction that caused the current market meltdown has evidently not been brought under the scanner by the rating companies in their assessment. How else would one account for the madness of a virtual financial time bomb? According to industry, The International Swaps and Derivatives Association, estimates in USA the CDS market has exploded over the past decade to more than roughly $58 trillion.. That is many times over the size of the U.S. stock market and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market. Pardon me for my lack of mathematically knowledge - I would be happy if someone got a fixation on the number of zeros attached to these numbers! Maybe we should take the zero has no value, beyond the decimals, but in this case once the market is decimated!!
One of the allegations that surfaced in the review of the credit rating agencies conducted by the Securities Exchange Commission USA was that certain of the larger credit rating agencies abused their dominant market position by engaging in certain aggressive competitive practices. Fitch complained that S&P and Moody's were attempting to squeeze it out of certain structured finance markets by engaging in the practice of "notching" — lowering their ratings on, or refusing to rate, securities issued by certain asset pools (e.g., collateralized debt obligations), unless a substantial portion of the assets within those pools were also rated by them.
A US government staff report in the context of the failure of Enron had the following to say. “In the case of Enron, the credit rating agencies failed tus used their legally sanctioned power and access to the public’s benefit, instead displaying lack of due diligence in their coverage and assessment in their coverage and assessment of Enron. Credit rating agencies did not ask sufficiently probing questions in formulating their ratings, and in many cases merely accepted at face value what they were told by Enron officials, Rating agencies apparently ignored or glossed over warning signs, and despite their mission to make long term credit assessments, failed to sufficiently consider factors affecting the long term health of Enron, particularly accounting irregularities and overly complex financing structures” This Para would aptly summarize that nothing has really changed over the over the couple of years!
The intent is not to discredit the agencies or cast aspersions on the agencies as much to say that the process has not been addressed over the years the problems of the 2001 Enron episode have reared their ugly face yet again.
A major issue that the users have been grappling is relatively less regulatory role on the rating industry and process. The rating process has become a virtual financial black-box with little or no clarity on the methodology used in the process. The lack of transparency is something that the industry needs to desperately work on. All other independent professional assessment or assurance has clearly laid out standards, guidelines and reviews. Increased disclosure about rating processes and decision outcomes would also improve transparency in the rating process. Again the ratings have to be simplified in terms of communication rather than list of alphabets from A to Z with multiple combinations of AAA to CCC with positive and negative signs being added to compound to users woes.
It is not just a lesson for the credit rating process but for all independent professionals to get back to introspection mode and examine as to how the faith of the investing community can be restored.
Never before has any single industry come under the scanner as in recent times with financials institutions falling nine pins. The consecutive failure of the giants only indicates that more is to come in the next couple days, weeks and months. The news reports based on the data released by the Federal Deposit Insurance Corporation indicating the banks and savings institutions on the ‘problem list’ grew to 117 in the second quarter of the calendar year 2008 against 90 in the first quarter. A 30% increase in the number of potential delinquents. The information evidently is not going to go down too well in the banking and financial community not to speak of the investors or the average layman who may just be wondering as where on earth he could keep his savings. It sounds literally like the nursery rhyme written “Ringa Ringa Rosie” with every conceivable financial entity falling!
Investors, be it the institutional financial investors or the retail investors, have always derived comfort from the any external assurance like professional audit and credit rating agencies. The turn of events over the last week has dealt a body blow on the confidence levels. One definitely is intrigued by the fact that the entire international rating agencies had assigned a credit rating of AA to AIG till May 2008 and suddenly down graded it just the night before the company was taken over the federal government under the bailout package. Even the down grading was to an investment grade which raises the basic question as how could a company on verge of significant credit default and bankruptcy has an investment grade rating?!
If investors in the failed companies are still looking at heaven to obtain plausible explanations, the failed giants namely AIG, Lehman and others to follow themselves, with all their financial acumen, appear to have been done by their trust on credit-rating agencies. The main credit raters — Moody's and Standard & Poor's, Fitch had assigned AAA and AA ratings to all sorts of exotic mortgage securities and other financial without evidently understanding or communicating to layman the underlying risks involved. An average investor would be last person to know how and understand the risks in the context of a collateralized loan obligation or commercial-mortgage-backed securities.
In hindsight it appears even sophisticated investors took Moody's and S&P's assessment of companies & instruments at face value and it turned out that the agencies sailing in the same boat as that of investors - clueless! A survey, a couple of years back, of the Association for Financial Professionals revealed that about 30% of finance managers perceived the credit ratings of their own organizations to be inaccurate; about 40% perceived rating changes to be untimely.
The role of credit rating agencies has been under the scanner ever since the sub-prime crisis started making its rounds in the international financial markets. The credit rating agencies have had to put up a strong defense to deny the accusation that they gave inflated ratings to sub-prime mortgage debt and other discredited bonds in order to attract more Wall Street investment banks that have now failed. This has happened not too long back and was about the same time last year.
Going back to the case of AIG, one wonders if the rating agencies had factored into the rating assignment the key issues of the leverage that is ratio of borrowings to capital. It was the highest in comparison to its peers at 11 to 1. This has to be viewed in the context of its exposure to the credit default swaps coverage that it had extended. The entire risk management mechanism of the company evidently was skewed and this, in retrospect, did not meet the eye rating agencies. The only aspect that raises an alarm is that all the agencies have accorded the same rating. The question that begs answer is if there is a cartel on rating or the rating mechanism shallow and fundamentally flawed! Harsh questions but definitely would be crossing the minds of every affected person.
Warren Buffet the sage from Omaha and financial expert had in an interview just after the Enron saga had said that derivates like futures, options and swaps were developed to allow investors hedge risks in financial markets - in effect buy insurance against market movements - but have quickly become a means of investment in their own right. He had warned that derivatives can push companies onto a "spiral that can lead to a corporate meltdown", like the demise of the notorious hedge fund Long-Term Capital Management in 1998. The words sound likes that of Nostradamus.
The credit default swaps (CDS) one of the many weapons of mass destruction that caused the current market meltdown has evidently not been brought under the scanner by the rating companies in their assessment. How else would one account for the madness of a virtual financial time bomb? According to industry, The International Swaps and Derivatives Association, estimates in USA the CDS market has exploded over the past decade to more than roughly $58 trillion.. That is many times over the size of the U.S. stock market and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market. Pardon me for my lack of mathematically knowledge - I would be happy if someone got a fixation on the number of zeros attached to these numbers! Maybe we should take the zero has no value, beyond the decimals, but in this case once the market is decimated!!
One of the allegations that surfaced in the review of the credit rating agencies conducted by the Securities Exchange Commission USA was that certain of the larger credit rating agencies abused their dominant market position by engaging in certain aggressive competitive practices. Fitch complained that S&P and Moody's were attempting to squeeze it out of certain structured finance markets by engaging in the practice of "notching" — lowering their ratings on, or refusing to rate, securities issued by certain asset pools (e.g., collateralized debt obligations), unless a substantial portion of the assets within those pools were also rated by them.
A US government staff report in the context of the failure of Enron had the following to say. “In the case of Enron, the credit rating agencies failed tus used their legally sanctioned power and access to the public’s benefit, instead displaying lack of due diligence in their coverage and assessment in their coverage and assessment of Enron. Credit rating agencies did not ask sufficiently probing questions in formulating their ratings, and in many cases merely accepted at face value what they were told by Enron officials, Rating agencies apparently ignored or glossed over warning signs, and despite their mission to make long term credit assessments, failed to sufficiently consider factors affecting the long term health of Enron, particularly accounting irregularities and overly complex financing structures” This Para would aptly summarize that nothing has really changed over the over the couple of years!
The intent is not to discredit the agencies or cast aspersions on the agencies as much to say that the process has not been addressed over the years the problems of the 2001 Enron episode have reared their ugly face yet again.
A major issue that the users have been grappling is relatively less regulatory role on the rating industry and process. The rating process has become a virtual financial black-box with little or no clarity on the methodology used in the process. The lack of transparency is something that the industry needs to desperately work on. All other independent professional assessment or assurance has clearly laid out standards, guidelines and reviews. Increased disclosure about rating processes and decision outcomes would also improve transparency in the rating process. Again the ratings have to be simplified in terms of communication rather than list of alphabets from A to Z with multiple combinations of AAA to CCC with positive and negative signs being added to compound to users woes.
It is not just a lesson for the credit rating process but for all independent professionals to get back to introspection mode and examine as to how the faith of the investing community can be restored.
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