Thursday, July 12, 2012

Credit Rating Agencies & Sovereign Rating

Why do countries(or for that matter anyone) resort to debt?

(click on picture to expand)

As evident from picture above, for its functioning, govt., chalks out various policies, programs for which it presents the budget every year, which mentions the expenditure which it will incur. Then there are day to day admin and other expenses. To meet all these expenses, the first capital access it has is the revenue it collects from its citizens and corporates(operating within its territories). However, they are not sufficient to cover all its expenses. So to meet the shortfall it resorts to debts. 

However, debts are either not free or they are also not easily available. one has to have good creditworthiness for the debt provider to issue you debt. 

Remember the GDP formula of GDP = Govt Expenses + Investments + Consumption + (Exports - Imports)

So, govt. expenses we spoke above. Now about the investments and thereby consumption. 

Apart from investment by Indian corporates, the country also depends on investments by foreign investors(who have bigger stock of cash with them). These foreign investors can make investments into a country in two ways - FIIs or FDI. Now, unless a country is in good credit steadying in eyes of these investors, they will NOT put in their hard earned money in that country. So having good credit rating and thereby attracting foreign investors is important. 

Hence we realise the importance of credit rating for any country. The same can be applied to any company who is looking for debt to fund its growth or expansion plans. 

What is Credit Rating & Who are Credit Rating Agencies (CRAs)?

A credit rating is an opinion on the creditworthiness of a "debt instrument" or its issuer. 

It is the Credit Rating Agencies which issue this credit rating and can rate anything, but primarily they rate bonds (and other securities) and central govt. across the world. 

What are types of Credit Rating?

So as you see from above picture, credit rating can be for "debt issuer"(who issues debts) or "debts instruments itself" !! 

What is the scale on which credit rating is given?

As you see from picture above, that India is on borderline of investment grade and speculative grade(also called "junk bond" status). Hence recently S&P warned that India could be the 1st BRIC nation to lose its investment grade status. 

Credit Rating Vs Outlook: 

Many times, the CRAs rather than changing the credit rating of a "bond/debt" OR a "bond/debt issuer", they issue something called an outlook. This is NOT credit rating, but an assessment of what may happen in next 6 months - 2 yrs time.

Outlook can be Positive OR Stable OR Negative . 

So if the outlook changes from Stable --> Negative, then its a signal to watch out, because there may be an issue and you may face a "downgrade" of your credit rating.

See where different countries in the world stand on credit rating

Observe that all "peripheral nations" of European Union(i.e. in periphery of EU e.g. Portugal, Greece, Ireland etc) are in trouble and their credit rating is in speculative grade. Recently Greece received a credit rating of "CCC" from S&P.
[Note: This picture is from 2011, so rating for many EU nations were downgraded since then and hence may not reflect the current scenario. This picture is just to help you understand the overall world scenario on credit rating. Observe in EU, Germany has a very good credit rating, which is same till today. One can ask why? One main reason(among many others) for this is that Germans have a very good habit of savings. Unlike the people in US/UK(who mainly survive on credit), Germans use debit cards more often than they use credit cards. Hence they are well prepared for any unexpected credit crisis. They also believe in investment which adds fillip to the nation's growth. Savings in short run may slow down the economy, but have lasting advantages in long run. No wonder, this intrinsic "savings" mentality is guiding the "austerity" drive suggestion of Ms Angela Merkel ]

Who are major CRAs of the world ?

1. Standard & Poor's (S&P) 

2. Moody's 
(together, the above two companies occupy around ~50% of credit rating market worldwide.) 

3. Fitch - 15% market share

These three CRAs issue their own credit rating for corporates, sovereign or debt instruments.

Major Indian based credit rating agencies are:

1. CRISIL - Standard & Poor's company

2. ICRA India - Moody's company

What are revenue sources of CRAs?

As you see from picture above, the "bread and butter" for the CRAs comes from rating the corporate bonds/debt. Sovereign ratings(given to countries worldwide) do not draw any revenue and are conducted mainly for "public relations" and marketing purposes.

How are Sovereign Rating for Countries prepared?

CRAs also do credit rating of countries across world, and its called Sovereign Rating. This rating indicates the ability of a country to pay back its debt. Several factors are considered by CRAs before they decide on the rating. Though the exact variables are not known, but they key things which CRAs look are:

As we see from picture above, credit rating for any country are of two types : Foreign Currency Rating and Local Currency rating, which tells the creditworthiness of country to pay debt which is in foreign currency and local currency respectively. Since, the chances of paying local currency is always higher than foreign currency, hence the local currency rating is always >= foreign currency rating. 

[Note: Ultimately debt owned by govt. are paid back from tax payer's money. Hence political decision, stability of govt., tax reforms etc also affect the creditworthiness of the govt.]

What are the impacts of Credit Rating Downgrade?

IMPACT 1. Cost of capital for bond issuer, who wants to sell bonds and collect debt increases. So if India's credit rating is downgraded, investors who are 'risk averse' will not want to buy bonds from India. As a result, India may have to offer higher returns than it usually offers and as a result its cost of raising capital goes up. 

Bonds: I have explained above why do countries or any company go for debt. So issuing bonds is a type of debt collection mechanism, in which the debt issuer, collects money from its investors and promises to pay back after some time(maturity). Until maturity, the bond issuer pays interests(also called coupons). 

Bonds can be issued by governments (both state and centre) as well as individual companies. The aim of bonds is to collect money from market. 

Look into below picture: 

To explain further, lets assume the face value/nominal value of bond is Rs. 100. Also, suppose the above example is for a fixed rate bond. 

The above picture shows a bond, which will:

Provide to its holder a coupon of Rs. 7.49(becoz the rate is fixed) every 6 months (In India its halfyearly) till 2020, and then will provide Rs. 100 (nominal value) in the end of maturity period. 
It also says that currently the bond is trading in the market at Rs. 118.93 (which changes every min or hour) and the expected yield for the investor for this bond is 8.44%

Remember, market price of the bond is helpful in determining the yield of the bond. Investors always gets back the nominal or face value of the bond. In this case its Rs. 100 for each bond. So higher the price, lower is the yield, because the difference b/w market price and face/nominal value increases and hence yield decreases. 

So how is credit rating and bonds related? 

Good credit rating for any company or government which issues bonds, increases the demand for its bonds. This increase in demand of bonds will increase the price of bond. This ways the bond issuer can command a coupon rate for its bonds. It can offer lower coupon rate than what its currently offering, since its bonds have been rated high and are considered safe

So the bond issuer always has a motive to rate its bonds higher. Therefore, bond issuer getting its bonds rated by CRAs is actually conflict of interest !!! 

In the same respect if any govt. has got poor soverign rating, demand for its bonds decreases and to sell them(and borrow money from market), it may have to provide higher coupon rate to its investor. So its debt servicing obligation increases.So you may have read things like "increasing cost of capital", which means exactly this. The govt. with a bad rating will have to pay more to borrow and hence its cost of capital increases.

In above example, if currently suppose, govt. is paying 7.49% coupon rate for each bond, tomorrow if the credit rating of that govt. is downgraded, the investors would show less interest in buying the bond. As a result govt., inorder to raise money, will offer investors more coupon rate and try to attract them. So this way govt. is paying more due to lower rating !!! Hence good rating helps govt. who wants to raise money from market.

Credit Default Swaps (CDS):

It is cost of insuring against default by a bond issuer. So if the rating of the bond or the bond issuer is bad, its CDS will increase as low rating would mean more chances of default. 

This concept was popularized in the 2008 Credit Crisis in US when investment banks(Lehman Bros etc) clubbed different risk types of mortgage backed securities (risky, safe, medium risky) into one bunch, called then Collateralized Debt Obligation (CDO), got it rated with Credit Rating Agencies as "AAA" rated securities. Since its "AAA", the Credit Default Swaps (CDS) value will be less, so they insured these securities for less and sold it to investors. This was one of the main reasons for credit crisis, where risky mortgages(sub-prime mortgage) were clubbed along with safe mortgages (prime mortgages) and sold together. 

IMPACT 2. Investment climate in the country goes down. 

Remember the GDP = G + I + C + (X-M) formula ?? The I here is the investments. So countries needs to boost the investment momentum to fuel economic growth. 

Recently PM Manmohan Singh met with key infrastructure ministers and secretaries and Planning Commission to set targets for Infrastructure for 2012-13. He said and I quote

"The needs of the infrastructure sector are vast – estimated at over $ 1 trillion in the next five years. The government alone cannot invest such huge amounts and therefore it is important that we involve the private sector in our efforts, through Public Private Partnerships." - PIB 6th June 2012

So, there PPPs are FIIs or FDIs flowing into our country. If credit rating is downgraded, the investors will turn away from our country and govt. in itself or the indian corporates do not have that much money to invest. Hence credit rating downgrade is a matter of concern. 

IMPACT 3. Overall Impact on Economy

All the boxes, highlighted in "Pink" are affected due to low credit rating. 

1. Click on picture to expand

2. Think of reasons, why I marked certain boxes in pink and lets discuss why some are marked pink whilst others not  ]

What are the issues with Credit Rating Agencies?

Problem 1: Poor track record - failure to predict crisis in past 

(i) The CRAs continued to give an investment grade rating to Lehman Brothers’ debt until the day it filed for bankruptcy.

(ii) The CRAs are accused of ignoring the structural problems of peripheral Europe for almost a decade. As recently as December 2009, Greece—whose bonds today are considered ‘junk’—had an ‘A’ rating. (See rating scale above)

(iii) Asian Credit Crisis in 1997 - Through 1996 and the first half of 1997, not a single Asian sovereign’s credit rating was downgraded barring Moody’s downgrade of Thailand in April 1997. By September, Asia was in depth of a full-blown crisis.

(iv) In February 2001, the Turkish Lira crashed by more than 30%. CRAs predicted it late. 

It has been argued that the 'financial model' which CRAs uses to come up with credit rating is very superficial and checks only the most obvious things and not underlying currents. Take for example the Asian credit crisis of 1997. At that time CRAs included items like GDP growth, GDP per capita, external debt, default history, inflation experience and level of economic development to come up with Sovereign Credit Rating. However, crucial variables such as capital inflows, foreign exchange reserves and strength of the financial system were excluded. Hence the CRAs were not able to foresee the Asian crisis in which the reversal of short-term capital flows and a weak financial system played a critical role. In February 2001, the Turkish lira crashed by more than 30%. The triggers of the issues were in a weak banking system and over-reliance on ‘hot money’ flows. So, we can say that the roots of the crisis lay in a deteriorating financial sector, not in broader macroeconomic imbalances. 

Apart from this, as we know currency and debt crises are closely linked. Researches have shown that CRAs do not lay much emphasis on variables linked to currency. 

Much of this failure of sovereign credit ratings to predict debt crises is due to the fact that the CRAs rely entirely on ‘public information’ and therefore fail to detect the changes in the environment that often work hidden and yet play a major role in precipitating crises. 

Problem 2: Conflict of Interest - Bond issuer getting themselves or their bonds rated

As you must have seen from the holding structure of CRAs, they are not govt. companies. It has been alleged that during 2008 credit crisis, CRAs colluded with investment banks and got their securities rated "AAA" to sell them to investors. 

So this business model of bonds issuer paying has been heavily debated. It has been said that CRAs are softer on corporates primarily because they earn revenue from them, whereas CRAs have been very critical and harsh on countries as its for FREE. 

Problem 3: Problem of Identity - Power without Accountability

There are problems related to identity and legal standing of CRAs. Technically, a credit rating is simply anopinion on the creditworthiness of a debt issue or issuer. Rating agencies argue that an opinion is NOT arecommendation to buy or sell and thus does not constitute financial advice. This semantic distinction between ‘opinion’ and ‘advice’ has saved CRAs from litigation till now. It has also kept them outside the purview of regulatory oversight unlike say banks or brokerages whose research divisions provide explicit recommendations (and hence advice). In US CRAs enjoy the legal status of financial journalists, protected by the freedom of the press provided in its constitution.

Problem 4: Growing clout of Credit Rating Agencies

For long now, regulators have relied on credit ratings to set norms for for capital markets. Banking regulators set prudential norms for banks based on external ratings. Similarly other regulated financial institutions are also bound by ratings in structuring their portfolios. 
For example, Provident funds in India are not permitted to invest in securities that fall below a certain rating grade. 

So this regulatory outsourcing has de facto made the rating agencies regulatory agencies themselves whose ‘opinion’ sets regulatory benchmarks. Credit ratings have become virtually mandatory for every bond issue, be it a simple coupon bearing bond or a complex engineered synthetic instrument. Thus, in a sense, regulators have ‘outsourced’ regulation to the CRAs who have become gatekeepers of the debt capital markets. This 'king maker' position of CRAs have led them to malpractices as was seen in recent credit crisis.

So what is the way forward?

1. CRAs should improvise upon the methodology they currently employ to provide credit rating.

2. Appropriate business model for CRAs should be devised. Current business model raises a lot of question on their integrity.

3. There should be some sort of regulatory body for CRAs, who can held them responsible when CRAs fail to predict any crisis or waves a red flag when there is an obvious conflict of interest between investors and rated agencies or when ratings appear to be influenced by extraneous factors. 

4. The quality of analysts at these CRAs also have to be re-looked. Failure to predict macroeconomic issues of countries is also because of the fact that the CRAs did not have the right people who fully understands the economies.

So CRAs are far from perfect but they are here to stay !!  

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