»5 Minute Wrap Up by Equitymaster

On This Day - 18 SEPTEMBER 2015
Time to downgrade the rating agencies?

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

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