|»5 Minute Wrap Up by Equitymaster|
On This Day - 18 SEPTEMBER 2015
Time to downgrade the rating agencies?
In this issue:
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.
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.
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.
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...
Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement
Disclosure & Disclaimer: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. The Author does not hold any shares in the company/ies discussed in this document. Equitymaster may hold shares in the company/ies discussed in this document under any of its other services.
This document is confidential and is supplied to you for information purposes only. It should not (directly or indirectly) be reproduced, further distributed to any person or published, in whole or in part, for any purpose whatsoever, without the consent of Equitymaster.
This document is not directed to, or intended for display, downloading, printing, reproducing or for distribution to or use by, any person or entity, who is a citizen or resident or located in any locality, state, country or other jurisdiction, where such distribution, publication, reproduction, availability or use would be contrary to law or regulation or what would subject Equitymaster or its affiliates to any registration or licensing requirement within such jurisdiction. If this document is sent or has reached any individual in such country, especially, USA, Canada or the European Union countries, the same may be ignored.
This document does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Our research recommendations are general in nature and available electronically to all kind of subscribers irrespective of subscribers' investment objectives and financial situation/risk profile. Before acting on any recommendation in this document, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. The price and value of the securities referred to in this material and the income from them may go down as well as up, and subscribers may realize losses on any investments. Past performance is not a guide for future performance, future returns are not guaranteed and a loss of original capital may occur. Information herein is believed to be reliable but Equitymaster and its affiliates do not warrant its completeness or accuracy. The views/opinions expressed are our current opinions as of the date appearing in the material and may be subject to change from time to time without notice. This document should not be construed as an offer to sell or solicitation of an offer to buy any security or asset in any jurisdiction. Equitymaster and its affiliates, its directors, analyst and employees will not be responsible for any loss or liability incurred to any person as a consequence of his or any other person on his behalf taking any decisions based on this document.
As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.
Equitymaster Agora Research Private Limited (Research Analyst) 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: email@example.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407