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Should big rating agencies get away like their banking counterparts?

Feb 4, 2015

In this issue:
» An entire industry available cheaper than Pfizer or Facebook
» An incentive for small savers
» Are German bonds going the Japan way?
» ....and more!

It took them 6 years to admit the truth! Yet, the manner in which the big rating agencies are being let go for orchestrating one of the biggest financial crisis in recent history is funny. You would recall that ever since the big banks were bailed out after the subprime crisis in 2008, our biggest grudge has been against rating agencies. For they were not less guilty in conniving with the banks for creating the massive housing bubble. And yet there were hardly any fingers pointed at them! Anywhere.

It seems after lengthy legal lawsuits over all these years, world's largest rating agency S&P has admitted some guilt. It has admitted that its ratings decisions were affected by the impact they would have on its own bottomline. To put it more specifically, S&P awarded top grades on bonds built out of risky subprime mortgages that investors thought were as safe as debt from the US government. And all of this was to please its clients and win more business. When housing prices fell, the bonds defaulted, helping freeze credit markets and trigger the worst recession since the 1930s.

What is the outcome of this admission of wrong doing? Well, the rating agency walks away after making the US central and state governments richer by US$ 1.5 billion! So now every time banks and rating agencies do something wrong, the government can hope to fill its coffers! Meanwhile the poor small businesses and investors who relied on the ratings and invested in the bonds have to keep waiting for the next bubble. The US courts believe that the settlement will allow the world's biggest ratings company move beyond a bruising legal battle over the top grades it gave to subprime-mortgage bonds. However, one wonders if the very purpose of having a reliable and independent assessment of credit quality will ever be served!

In India too there is hardly any regulation for rating agencies and conflict of interest between their customers and users of the ratings is commonplace. Most such agencies even offer research on companies that are their clients for credit ratings. In such a complex scenario giving an independent view without compromising on business is understandably difficult!

We therefore urge investors to not look at credit ratings on companies as the only source of credible view on business fundamentals. Unless and until the business of rating agencies can become completely transparent and devoid of conflicts of interest, investors would be better off doing their own homework when it comes to assessing quality of bonds and stocks.

Do you think rating agencies that were responsible for the 2008 financial crisis should get away with a big penalty? Let us know your comments or share your views in the Equitymaster Club.

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The fact that India has one of the best savings to GDP ratio can be attributed to the central bank's care for small savers. In fact as the RBI governors have repeatedly reminded in their interviews, Monetary Policies are made in India keeping the interest of small savers. And hence the reluctance to cut rates too low in a phase of high inflation. For doing so would disincentivize savers.

All this while fixed deposit schemes in banks were treating big deposits, typically corporate or HNI deposits, differentially. Fixed depositors earn differential rates of interest based on the size of deposit. Deposits above Rs 1 crore earn a higher rate of interest. Additionally deposits up to Rs 1 crore can be withdrawn prematurely, resulting in asset-liability (ALM) mismatch. To correct this anomaly, the RBI has allowed banks to offer deposit schemes up to Rs 1 crore which cannot be broken prematurely. There are so-called non-callable deposits which would attract different (higher) rates of interest. Since the money would remain with the bank for a fixed and longer tenure it would avoid AM mismatches. This opens the prospect of retail depositors, who opt for such deposits, to earn a slightly better rate of interest than on a callable deposit. We believe schemes like this will go a long way in not just incentivizing small savers but also help in financial inclusion.

While savers in India may be getting incentivized, it seems that the long term bond investors in Germany may start looking at other alternatives considering that yields of 10 year bonds have fallen to 0.304% yesterday. This is lower than Japan's yields of 0.358%, a situation that has occurred for the first time in history.

A key reason behind this fall has been the disinflationary environment - with the latest data showing a price decline of 0.6%, matching the biggest decline in prices in the history of the single currency.

Since early 2013, Japan has been struggling to attain its goal of increasing inflation thereby only goes to indicate the difficulties of breaking out a disinflationary trap. We refer to this point because EU itself has expanded upon its QE program recently.

So, is Germany going the Japan way? Well... at least going by this stat it does seem so.However, an area where there is stark difference is the fact that German Debt to GDP stands at about 0.8x as compared to Japan's figure of 2.26x. However, with yields on German bonds having dipped from a little over 1.5% levels in early 2014 to they are currently only indicates of the slow growth and disinflationary environment expectations of the region, thereby making the possible situation of a 'Japan like situation' quite possible.

What is also interesting to note is that for the first time, corporate bond yields of one year bonds went into the negative zone as well. As reported on Bloomberg, Nestle's euro-denominated bond fell into the negative territory, with the ask yield at -0.034%. In comparison, yields of UK and US bonds are at levels of 1.44% and 1.7% respectively.

 Chart of the day
Today's chart of the day is an interesting one which we came across on the internet. It was presented by Tim Price, who is the Director at PFP Wealth Management. In his interview he mentioned that the theory of efficient market hypothesis - as per which markets cannot be beaten over the long term - can be proved wrong. And to prove the shortcoming of this theory, one of the slides he spoke of showed the way the market is currently valuing the gold mining industry.

As can be seen from the chart below, the market capitalisation of the entire gold mining index companies (combined) is lower than that of some of the top companies by market capitalisation. Imagine buying an entire industry in exchange for one company.

Another indication of US stocks being overpriced?
* Market cap of Arca Gold Miners Index (GDM); indicative figure

Given that gold has largely been an unpopular commodity in recent years, its miners have been battered as well. At the same time, the valuations that some of major corporations seem to be sky rocketing; and as per many, not justified - especially some the consumer stocks as the growth expectations are minimal to zero. If that is the case, valuations do seem to be the higher side. For instance, Johnson and Johnson (J&J) is currently trading at about 18x its earnings; or Unilever for that matter is trading at about 21.2 times.

However, a reason as to why investors may be flocking to these companies would be the higher dividend yields as compared to the government bonds. But this itself is an anomaly as any sign of the US government increasing rates would only move money out of stocks, a clear indication that hot money is chasing stock markets. Stocks in the US are currently believed to be trading at one of their highest valuation levels in a century, which only makes matters all the more scary.

The Indian stock markets hovered around the dotted line for most part of the day, before falling into the red during the final hour. The benchmark BSE Sensex closed lower by about 115 points (-0.4%). Stocks from the capital goods and banking spaces were the biggest losers today. Most of the Asian equity markets ended the day on a firm note; while stocks in Europe were trading weak.

Today's investing mantra
"Even the intelligent investor is likely to need considerable willpower to keep from following the crowd". - Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee and Devanshu Sampat.

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Equitymaster requests your view! Post a comment on "Should big rating agencies get away like their banking counterparts?". Click here!

2 Responses to "Should big rating agencies get away like their banking counterparts?"

Financial Vigilante

Feb 5, 2015

Besides this, even the regulators are culpable since they have made it mandatory for corporates to obtain ratings for papoers in whioch banks can invest. And now the Basle III regulatiosn even provide for credit risk weights based upon the ratings. These ratings have acted as proxy for risk assessment by banks / insurance companies / investors. Had these ratings been not in place, these investors woudlhave applied greater rigour, due dilligence before splurgign with the money.

S&P and others have taken a defence in US Courts of Ist Amendment which guarantees Freedom of Speech. Can anything be more farcical than this ? Regulators place reliance on utterances of an entity which believs that its output is nothing but Freedom of Speech. How different is this defence from that used by Larry Flynt, who published risque magazine Hustler and won the case in US Supreme Court on grounds of Freedom of Speech. ( The People V/s Larry Flynt is the landmark case)


Manish Shah

Feb 4, 2015

Rating agencies are 100% responsible for 2008 financial crisis and they can no longer be trusted. For that matter from the way governments have behaved , even they cannot be trusted. As you have rightly pointed out,all investors should do their own home work before making any investments in bonds/deposits.

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