Free Reports

Time to downgrade the rating agencies?

Sep 18, 2015

In this issue:
» The perils of a cheap money regime
» ARCs fail to solve the bad debt issue
» A round up on markets
» ....and more!

00:00
There is one and only one social responsibility of business - to use its resources and engage in activities designed to increase its profits.

The words of Mr Adam Smith may resonate in a world driven by capitalist forces. However, investors may find them an anathema where they concern one business: the business of rating agencies.

Globally, some of the biggest financial bubbles, and the crises that followed, were fuelled by rating agencies that played hand in glove with banks. The global economies are still paying the price. While some of the banks collapsed in the aftermath, the ratings agencies managed to go scot-free.

Back home, the rating agencies seem to have been badly influenced. The recent case in point is Amtek Auto. A sudden suspension in its ratings led to a crisis-like situation. Not only the debt investors suffered: shareholders' wealth too was wiped out in a matter of days.

The impact that a sharp change in ratings has on the stock price or bond yield highlights the gravity of the responsibility these rating agencies bear. But are they well geared to handle it? The number of cases of agencies lowering ratings two or three notches overnight does not suggest they are.

As highlighted in an article in Livemint, Amtek Auto is not an exceptional case. JaiPrakash Associates, Bhushan Power and Steel, and Punj Lloyd, to name a few, also witnessed sharp and sudden downgrades, catching investors unaware.

Sharp downgrades or suspensions by rating agencies are becoming a norm, which raises serious questions about the way credit ratings operate.

Why are aggressive ratings assigned to unworthy business in the first place? When the business shows sign of disintegration, why do the agencies wait until the last minute to officially announce the upcoming disaster? This is negligent, incompetent, and irresponsible.

The biggest concern is the agency's fee structure: The rating agencies are often paid by the companies they rate! If the client is pleased with the rating assigned, the rating agency is likely to get more business, and in turn higher market share in the ratings business. This is a clear case of conflict of interest.

Rating agencies are definitely not independent. And hardly reliable.

As ratings get downgraded sharply, it is not just debt securities that bear the brunt. A sharp downgrade sets a chain reaction that involves shareholders as well. Hence, one cannot overemphasize the need to design a robust mechanism of assigning and monitoring ratings. Regulation of rating agencies is another aspect that should be considered.

Indian companies are not just borrowing locally. The exposure to foreign debt is significant. This is made worse by the rupee's vulnerability to developments in China and speculation of a rate hike by the US Fed and unhedged exposure. The need for regulatory oversight on such companies, and the agencies that rate them, is higher than ever.

Instances like Amtek Auto, while unfortunate, have been an eye-opener. They highlight the loopholes and flaws in how the financial markets and regulators operate. A welcome change is that now the regulator is seeking the rationale of mutual funds' exposure to distressed corporate bonds. But it should also insist on regular disclosures by listed companies about their debt situation.

Meanwhile, investors would do themselves a service to not rely blindly on the views of rating agencies and do their own homework. One of the biggest risks in investing is a false sense of security.

Do you as an investor overly rely on credit agency ratings? Do you think there needs to be a major overhaul in the way rating agencies function? Let us know your comments or share your views in the Equitymaster Club.

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02:00
 Chart of the day
Fed held to status quo. Amid speculation and volatility, equity markets around the world heaved a sigh of relief after the decision to raise interest rates by the US Federal Reserve was deferred. On the surface, the fears may seem valid. The last time Fed raised interest rates were in 2006. And since then, foreign money has found way to emerging markets in search for higher returns. The end of the era of low interest rates can pull out hot money impacting stocks and currencies around the world. But this concern cannot mask a much deeper malaise ushered in by the cheap money regime. And the malaise that we are talking about is the mountain load of debt that has piled up in developed economies due to long periods of easy monetary policy post the financial crisis. This is highlighted in the Annual Report by the Bank for International Settlements. Since 2007, the indebtedness of the non-financial sector of advanced economies has shot up by 36% to 265% of the gross domestic product (GDP) in 2014. And the increase has been fuelled by the steep rise in government debt.

Emerging markets are relatively better placed with debt of the non-financial sector standing at 167% of GDP in 2014. But this is still higher by 50% as compared to the level seen in 2007. Amongst emerging economies, China has a huge debt to GDP ratio of 235%. However, India with its conservative monetary policies has managed to maintain a comparatively low debt to GDP ratio of 125% during this period.

But the bottomline is that the world has become more indebted than before. Unless major central banks refrain from short term measures of keeping interest rates artificially low to boost growth, the world may be find itself getting trapped in a vicious cycle of ballooning debt.

Debt build up amid low interest rates

03:30
The Reserve Bank of India (RBI) has been managing its state of affairs in a more pragmatic fashion as compared to the other central banks. But Indian banks, particularly the public sector banks, have been saddled with large amounts of bad loans due to inefficiency and lack of autonomy in their operations. Asset Reconstruction companies (ARCs), which buy these bad loans have not been able to play a significant role in bringing down the burden. Reserve Bank of India data suggests that at the end of March 2015, ARCs had assets to the tune of Rs 69.2 bn . This is a very small fraction of total gross non-performing assets (NPA) of more than Rs 3.3 trillion. ARCs are yet to play crucial role in mitigating bad debt issue. And the involvement so far has fetched them return on equity of less than 5%. One of the reasons for low returns is an increase in the acquisition cost of bad assets.

When an ARC buys an NPA at a discount to the book value, it pays only 15% of the agreed amount in cash and for the balance 85%, security receipts are created. But since there are hardly any takers for these security receipts, it ends up in the books of the banks selling the assets, as investments. The recovery rate of ARCs has been low at around 31%. And banks are not confident either. RBI's insistence on ARC's bearing more responsibility by subscribing to at least 15% of the security receipts has turn has pushed up their capital requirements. In short, neither ARCs not banks seem to be benefitting. Sale of bad loans to ARC's does not seem to be the panacea for the bad loan problem afflicting the banking system.

04:30
Barring Japan (down 2.0%), the major markets across Asia are trading higher today as the US Fed held off on raising interest rates. The Indian markets were trading firm with the BSE-Sensex trading higher by about 484 points or 1.9% at the time of writing. Most sectoral indices are in the green with stocks from the banking and pharma sectors leading the gains. The BSE midcap and smallcap indices also trading higher by 1.8% and 1.6% respectively. The European markets were however trading lower at the time of writing.

04:45
 Today's investing mantra
"Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future." - Warren Buffett

Publisher's Note: Vivek Kaul, the India Editor of the Daily Reckoning, just made a bold call - Real Estate prices are headed for a fall. Well, if you are someone who is looking to buy real estate, or is just interested in the space, I recommend you read Vivek's detailed views in his just published report "The (In)Complete Guide To Real Estate". To claim your copy of this Free Report, please click here...

This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst) and Madhu Gupta (Research Analyst).

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Equitymaster requests your view! Post a comment on "Time to downgrade the rating agencies?". Click here!

11 Responses to "Time to downgrade the rating agencies?"

gokul manjeshwar

Sep 19, 2015

If rating agencies and their remuneration is decided by the managements of companies they rate, there is conflict of interest. The following could ensure independence of rating agencies :
- wherever a company needs to get it's securities rated, it should apply to SEBI who should appoint one or the other agency on it's panel.
- SEBI should collect from all listing companies a fee which will defray expenses incurred by it on engaging rating agencies.
- the above will ensure rating companies are free of any company influence that impacts their ratings or downgrades.

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ARUN KUMAR ABROL

Sep 19, 2015

RATING AGENCIES ARE LIKE HUMAN RIGHTS COMMISSION WHICH ARE RATING THE COMPANIES/COUNTRIES AS PER THEIR WILL OR SELF MADE PARAMETRES WHICH IS PROVED TIME AND AGAIN

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ANAND

Sep 19, 2015

I think it is time that we have an authority to oversee the functioning of rating agencies. The fact is that they get away with everything and the history is there to prove on the incompetent and careless approach of rating agencies who are squarely responsible for not raising the red flag at the appropriate time. Their role doesnt end with pocketing the fees and dishing out ratings just to enable the rougue corporates raise money from money markets. They should have concurrent assessement mechanism such that there are adequate early warning signals. The AA company like amtek cannot become D within a matter of months. We need a watchdog to monitor rating agencies otherwise the entire markets will become a playground for unscrupulous corporates. pertinent to mention that the credibility of rating agencies and their style of functioning needs to be reviewed and questioned in the larger interest of protecting investor interests.

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Navendu Bajpai

Sep 18, 2015

Yes you're absolutely correct though I've few years of experience in the equity market. And in these few years I've been watching how foolishly these agencies work.

I think they have no proper system of upgrading and downgrading stocks but the worst part is that still many people follow them why i don't know. By following them blindly they help rating agencies in milking more money from the companies they rate.

There is a need of a regulator to design a mechanism of monitoring and assigning ratings. So that they cannot create panic in the market by downgrading a certain stock overnight, rather do that is a systematic manner so that shareholders wealth does not erode overnight

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SANKARAN VENKATARAMAN

Sep 18, 2015

Nobody's words whether Rating agency or Research organisations or Brkerage cos,Experts in Media, MF Fund Manager should be taken as Gospel of truth. Every recommendation/action must be independently checked before investing .
The sordid game played by rating agencies in 2008 financial crisis is wellknown and they got away scotfree.The entire Basel recommendations are mainly influenced by diktats of Rating Agencies and they are the prime beneficiaries.Financial crisis keep on happening whether it be Greece, Spain, Italy or China

Like 

Jitender Jain

Sep 18, 2015

i work in a rating agency.. the practice is to assign rating of Crisil/ICRA + 1 or +2 without understanding the risks at all..

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marwal

Sep 18, 2015

Their Ratings should be scrutinized threadbare before investing your money. All speak in different tones. So its your money & don't burn your fingers.
Even consulting agencies are suspect.
I still think Tatas should not have sold their blue chips like ACC, Tata Oil Mills on the advice of their consultants who indirectly helped their MNC friends to buy these blue chips with most valuable brands.Look today valuations of these sold companies.
Look where Tata Steel is due to Corus & Tata motors still reeling in India despite JLR, only TCS is their due to Indian Technocrats.
When Tatas can be misled so can ordinary investors.

Like 

Krishna

Sep 18, 2015

Being an important part of the financial eco system, on which both shareholders as well as lenders rely on, it is time that the Govt.brings rating agencies under regulation possibly by SEBI

Like 

P. K. Parhi

Sep 18, 2015

May be the only mouse who can bell a cat is itself a cat in mouse clothing. On a serious note, there will always be a string leading from the 'one who rates a business organisation' to 'the organisation which is rated'. This is an intrinsic feature of all our systems. Such strings show their true colour only when they are subjected to the right test. Ironically in most cases, the entity who tests to reveal the true colour of such strings is not an institution - private or government - but a market force.

Like 

R Tayal

Sep 18, 2015

While your lament about conflict of interest and knee jerk reactions by rating agencies is indeed justified, your advice to investors to do their own homework and not rely blindly on rating agencies is as hare brained as it gets. How is the average investor to know in which case the agency's advice is to be trusted or not? It is childish to imagine an investor can do a better job, and I expect Equitymaster to refrain from such meaningless pontification.

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