“An institution run by a bunch of bureaucrats who couldn’t run a corner candy store is not necessarily a bad credit risk,” ran one particularly good rebuff from a defensive Moody’s executive in late 1997. It was not a vintage year for the credit-rating agencies in Asia.
There is no question that a re-rating of Asian credits was in order. But both Moody’s Investors Service and Standard & Poor’s (S&P) are open to criticism over the way events overtook them. Investors carp that as recently as September they bought $1.5 billion of Korea Development Bank bonds when the state-backed issuer was a highly rated A+/A1 – in other words a safe credit. Presumably, says one investor, the long-term ailments that dog the Korean economy today were just as bad in September. If the agencies had done their job, spotted them, and reflected them in their ratings a lot of international investors wouldn’t have bought those KDB bonds – which are now rated BBB minus by S&P and Baa1 by Moody’s which is junk.
For the trustees of normally conservative US and European funds, the recent ratings turmoil was a sobering experience. If you want to see a grown man cry ask him about Thailand’s 7.75% issue of 2007, rated A/A3 back in May. The more conservative funds that held this paper did so under investment criteria that permitted A minus/A3 paper or above but nothing beneath. So when the sovereign rating got revised closer to high-yield levels, such funds were forced to sell the bond. The spread on the bond in question moved from 89 basis points over US treasuries as of May 30 to a peak of 530bp over on October 28. This was just four days after S&P downgraded Thailand to BBB from A minus, and less than a month after Moody’s downgraded it to Baa1 from A3. Since both rating agencies had acted the trustees had no choice but to instruct their fund managers to sell the bonds even in bad market conditions. Little wonder some investors are a little critical.
Both S&P and Moody’s are relatively late arrivals to non-Japan Asia and not everyone is convinced the agencies are completely on top of their brief. “Ratings in Asia seem to lag rather than tell you any worthwhile information in advance,” points out DK Patel, a private investor based in Hong Kong.
“They’ve built up a reputation in the US,” says Marshall Mays, chief strategist at Nikko Research Centre in Hong Kong. “Now they’re going overseas. The assumption – a very generous one – is that they can do the same abroad as they have at home.”
But Asia is a much tougher environment to work in than the US. “The relative success of rating agencies only reflects the underlying system,” says the head of one of Hong Kong’s biggest fund managers. “In the US there is full disclosure and transparency and this appears to make them more accurate. Here [in Asia] they’re dealing with a much less transparent underlying market.”
One syndicate head commented:”In the past you called up and asked to get a rating done for an issuer. You’d be told to wait one and a half months. These guys are so busy, and fair enough, they’re chasing revenues like all of us. But you have to ask, if they’re that busy who’ve they got watching the existing ratings?”
When asked about the widespread criticism of his firm’s performance in Asia in 1997, S&P’s Hong Kong boss, Paul Coughlin, retorts: “I think some people in the last few weeks have got a bit carried away. They’ve generalized from a few ratings – that they deem a failure – and concluded that all the other thousands are useless too. But if you look across the thousands of ratings we’ve issued does it give you a good indication of risk? Happily it does.”
As he makes this point, Coughlin gently waves S&P’s annual statistical report which calculates default rates and S&P’s record in predicting their likelihood. The overwhelming evidence is that yes, S&P is very good at predicting default risk and assigning that risk a rating. Moody’s report is similarly impressive. It shows that between 1970 and 1994, 640 corporate issuers defaulted on their long-term public debt. Only two had investment-grade ratings from Moody’s when they defaulted.
However the statistics in both cases are derived from the US, so they’re not an ideal benchmark by which to judge whether similar standards are being achieved in less-transparent Asia. Both agencies are aware of this. “The timeframes of measurement are fairly long,” says Ken Pinkes, Moody’s New York-based chief credit officer. “You almost have to wait and see if the track record sustains itself. I’m confident it does [in Asia], but I can’t demonstrate it statistically. There isn’t sufficient data yet.”
In the absence of any hard-and-fast data, some experts are sceptical that it is possible to achieve the same standards in Asia right now. “XYZ is rated BBB minus. I say fine. But I can’t believe they rate these companies with the same degree of certainty as in the US,” says credit specialist Drake Pike, an executive vice-president at Hong Kong-based investor Tokai Asia.
The single-biggest challenge facing the rating agencies in Asia is the region’s lack of transparency. This is particularly telling with the agencies’ unsolicited or, in S&P-speak, “public information” ratings. These are not necessarily done with the cooperation of the entity being rated, and that means they rely heavily on published information. In S&P’s case, Coughlin estimates about 20% of its 170 or so Asian ratings are of the public information variety; Moody’s does not disclose its percentage.
The problem is that such published information can be supremely misleading, as one credit specialist explained to Euromoney. Take the example of a major state-owned bank in the Indian subcontinent. In 1994 it increased its BIS ratio to 10.5% through a $300 million injection of fresh capital from the government. But the government didn’t have $300 million so it borrowed it from the bank by issuing government bonds for the same amount subscribed to by the bank in question. The bonds carry a coupon of 12% so the bank gets an additional profit of $36 million, which suddenly gives it a return on assets of 2.5% – very good by Asian standards. This is totally artificial, says the credit specialist, because the bank is bankrupt. “It shows you can be very creative, especially with state-owned banks,” he says. “This has happened all across the region with state-owned banks, so the ratios can mean absolutely nothing.”
Certainly, the overexposed and undertalented banking sectors of Asia have played a villain’s role in the current crisis. Part of the agencies’ failure to spot early warning signals is because they rate so few Asian banks as a proportion of the total – for example, only eight of Indonesia’s 230 banks.
A better picture of what was happening would have emerged if in-depth ratings had been carried out in more of the banks. S&P belatedly appears to have recognized this link. It has attempted to estimate the vulnerability of Asian countries to banking crises. It puts China and India in the upper of its five brackets and estimates that the resolution of a banking crisis could cost both countries between 35% and 60% of their GDP.
Then again, perhaps the agencies would have found it impossible to rate more banks even if they’d had the opportunity and been offered a fee for it. Both are stretched. Moody’s has five analysts in Hong Kong plus a bigger office in Tokyo. S&P has a similar structure, but has 16 people in Hong Kong. Both say they bring in people from New York and London as required, but Coughlin of S&P is honest enough to admit: “We’ve been run ragged this last year. It’s been round the clock”.
As one banker put it: “They opened their offices a couple of years ago and sent over a few experienced analysts whose job it was to train the locals. But they were just stretched too thin. To be honest, the situation fell apart in Asia two years before their business plan could cope with it.”
Moody’s, which rates about 225 companies in the region, says it uses an “analytic leverage model” whereby senior professionals are supported from below by junior local staff – who are thereby trained. But the junior staff are often former equity analysts in local brokerages used to selling a good story rather than performing incisive analysis.
The other problem rating agencies face is staff retention. Their best people are poached by investment banks offering better financial packages. For example, one of Moody’s key sovereign and banking analysts, Lynn Exton, joined Merrill Lynch in mid-1997 to work in credit research. Merrill also employs ex-Moody’s staffers Christian Voss and Denis Girault in its rating advisory unit.
While the US is always the model, the practicalities of doing business and building a commercially viable operation in Asia pose unique challenges. The foremost problem is Asian sensitivity to criticism. Governments and companies view a credit downgrade as a serious insult and this may inhibit the agencies in their actions.
The experience of Moody’s in India illustrates the point. Last March it revised the sovereign’s outlook from stable to negative, although retaining its Baa3 investment-grade rating. This, however, was interpreted as a great pyschological insult and provoked a storm of public abuse.
Members of parliament took a very dim view of Moody’s 49-point questionnaire to the government. One former prime minister commented that it used to be the World Bank and the IMF that impinged on India’s sovereignty, but “now it was a private agency”. Opposition leader Atal Behari Vajpayee said the government should not reply and MPs chanted “shame, shame”. Even finance minister, Palianappan Chidambaram said Moody’s was “wrong” and added: “I mean whoever gave them the inputs must have given it to them at least four months ago.”
It is easy to forget how difficult it was – even just nine months ago – to say anything that flew in the face of the conventional wisdom that the Asian economic miracle was indestructible. Investment bankers and traders were as resistant to warnings as governments.
When Moody’s lowered Thailand’s short-term foreign currency debt rating in 1996, for example, bankers roundly criticized the move. Moody’s correctly suggested Thailand was vulnerable to a financial shock. In early 1997 it cut the rating from A2 to A3, which led Siri Ganjarerndee, an assistant governor at the Bank of Thailand, to declare: “We’re going to have to talk to them about this, it’s not correct to use information based on speculation. We’re going to have to give Moody’s accurate information and facts.”
Under such pressures from the authorities, Moody’s move was relatively bold, certainly bolder than S&P, which did nothing. But was it bold enough? This one-notch cut obviously sent out signals to investors. But if there had been less pressure from the government, would it have made the cut deeper, and sooner, and thus prevented investors from buying Thai bonds which Moody’s has downgraded to junk status? Does Pinkes of Moody’s think the need for saving face in Asia make downgrades tougher? “I don’t know if the process takes any longer, but oftentimes it is more intense,” he admits. There is also the danger of losing ground to rivals – as potential mandates to rate state-owned industries go to less-hostile rating agencies.
There are more than just two agencies vying for mandates in Asia. Such competitive pressures can lead rivals to trade insults.
US agency Duff & Phelps (D&P) arrived in Asia about 18 months ago and rated India for the first time in mid-1997 – giving it a solid investment grade. However, it did so in a manner that one Indian newspaper characterized with the headline: “Global rating agencies play out their rivalries on locals’ turf.” David Roberts, a senior vice-president at D&P, told one newspaper that his agency would take an independent view of the country regardless of recent assessments by competitors (for which, read Moody’s) and that a rating from D&P would have “value to international investors seeking insights” into the country because D&P was the “only international credit-rating company with a presence on the ground in India”. D&P is run in Asia by a former S&P man, Chin Gan, who has also worked for Nomura and JP Morgan. It rates about 30 sovereigns, banks and corporates, and operates in Hong Kong with four analysts.
Then there is Fitch IBCA. The merger in October of IBCA of Europe and Fitch of the US to create Fitch IBCA has catapulted both players into the big league. Fitch gives IBCA access to the US market while Fitch is being merged with an organization that over the past 10 years has doubled in size every 2.5 years.
“We have been the overwhelming leader among sovereign rating agencies,” says Christopher Huhne, a managing director at Fitch IBCA. “In 70% of cases where we’ve made a directional change [in a rating], it was later followed by either Moody’s or S&P.” He is optimistic about the growth potential in Asia: “We’re the junior agency in Asia. But then none of the agencies are very big here because it’s tended to be a bank finance region.”
The agency that has been in Asia longest is Thomson Bankwatch. It has been in the region for 12 years and rates 340 banks. “We have 25 Bankwatch analysts,” says Philippe Delhaise, the president of the firm in Asia. He thinks his firm has intrinsic advantages. “We have been doing this a long time, and giving our opinions irrespective of what the various banks’ ratios are, based on our experience of spying on banks, being misled in the past, and having knowledgeable friends all over the region,” he says.
Bankwatch holds regular workshops where it feels it can be more frank than in print. Delhaise produces slides shown at one of these in January 1995. One is about Thailand and reads: “Vulnerability to capital flight, high reliance on short-term foreign funding and minimal liquid assets provides a potentially lethal cocktail.”
Bankwatch likes to emphasise its local knowledge. But some of the agencies are going one step further and setting up joint ventures. D&P is following this route in India, and also has a 50% stake in Rating Agency Malaysia. “We know rating agencies are good at their jobs when the data is good,” says Chin Gan, “But in Asia there will always be situations where we have problems with the levels of professionalism of the companies that give us the data. That’s why we need local knowledge and local insights.”
S&P has a 9.6% stake in Credit Rating Information Services of India, plus a joint venture with Taiwan Ratings Corporation. In 1996 it signed a technical assistance pact with Pefindo of Indonesia.
Moody’s is sceptical about an excessive reliance on the local route, preferring to go it alone. “If you’re too locally focused you’re more vulnerable to the environment you work in, and are more vulnerable to pressure,” says Pinkes.
The difficulty is managing the difference between international and local standards. Once again India provides an example of this with the collapse of the CRB group with $260 million in liabilities last June. Credit Analysis and Research, an independent agency, had given finance company CRB an A rating in September 1996. The agency had rated it an upper medium grade credit up until April 1997 when the central bank banned CRB from taking further deposits. The CRB case led the Indian securities regulator to undertake a review of domestic rating firms.
To joint venture or not to joint venture is a perennial business dilemma. But for the rating agencies it’s particularly so. That’s because the only asset these firms have is their reputation and the credibility that goes with it.
Last year investors got hurt by investment-grade credits they thought were safe, but which suddenly displayed volatility associated with junk. “Investment-grade investors don’t buy volatility,” says Steve Taran, a managing director at Lehman Brothers.
And that leads to the issue of whether agencies should have a volatility indicator to distinguish between investment-grade credits in different countries. In the recent turmoil investors learnt the hard way that not all investment-grade credits are the same. “I’m quite interested in the idea of giving volatility ratings,” says Huhne at Fitch IBCA. “It’s a useful piece of market information.”
Pinkes, the chief credit officer at Moody’s in New York, says: “We’ve never considered this. I have to consider whether we could achieve a satisfactory degree of consistency. I suspect there would be demand for it.”
Says Chin Gan of D&P: “Rating agencies have to be very careful with their power. If they are too pre-emptive they might in fact precipitate the problems they are warning about.”
With the talk in Asia turning to moratoriums across the region, the agencies were in an uncomfortable position. Just before Christmas Moody’s avoided being caught with its oants down again – that is having a country it rated investment grade call a moratorium. Instead it downgraded Thailand, Indonesia and Korea to junk status. This led to selling by institutions which can only hold investment grade paper putting further downward pressure on prices.
Another affect will be a slowdown in securitized issuance since the monoline insurers that back such structures mainly work with investment grade paper. So all the talk among fee-hungry bankers of securitizing Asia’s most troubled debts as a way out of trouble may not come to very much.
