Corporate Fiascos and the Role of Credit Ratings Agencies

Case Presented by- Prashant Priyadarshi Kuldeep Tiwary,harminder singh,jatinder singh

Flash back in the past

In capital market history,credit rating agencies were relatively late to appear ,being less than a century old.John Moody fonded the first rating agency in 1909 ,in the United States ,which in comparison with other countries had a large private bond market and an investing class clamoring for better information.

When the business of bond credit ratings by independent rating agencies began in the United States early in the twentieth century,bond markets-and capital markets generally-had already existed for at least three centuries.Moreover,for at least two centuries,these old capital markets were to an extent even global.That in itself indicates that agency credit ratings are hardly an integral part of capital market history

Credit Rating companies

Introduction
A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.

In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market.

A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.)

Credit Rating Agencies

FIRM
S&P MOODYS FITCH

GLOBAL SHARE
40 40 14

INSURANCE INDUSTRY SHARE 30

17 7

A.M. BEST
OTHER

14
2

44
2

USERS OF THE INFORMATION PROVIDED BY CREDIT RATING AGENCIES

Credit ratings are used by investors, issuers, investment banks, brokerdealers, and governments. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk; this generally increases the efficiency of the market, lowering costs for both borrowers and lenders.

This in turn increases the total supply of risk capital in the economy, leading to stronger growth. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities.

Ratings use by bond issuers

Issuers rely on credit ratings as an independent verification of their own credit-worthiness and the resultant value of the instruments they issue. In most cases, a significant bond issuance must have at least one rating from a respected CRA for the issuance to be successful (without such a rating, the issuance may be undersubscribed or the price offered by investors too low for the issuer's purposes). Studies by the Bond Market Association note that many institutional investors now prefer that a debt issuance have at least three ratings.

Ratings use by investment banks and broker-dealers

Investment banks and broker-dealers also use credit ratings in calculating their own risk portfolios (i.e., the collective risk of all of their investments). Larger banks and brokerdealers conduct their own risk calculations, but rely on CRA ratings as a "check" (and double-check or triple-check) against their own analyses.

Ratings use by government regulators

Regulators use credit ratings as well, or permit ratings to be used for regulatory purposes. For example, under the Basel II agreement of the Basel Committee on Banking Supervision, banking regulators can allow banks to use credit ratings from certain approved CRAs (called "ECAIs], or "External Credit Assessment Institutions") when calculating their net capital reserve requirements. In the United States, the Securities and Exchange Commission (SEC) permits investment banks and broker-dealers to use credit ratings from "Nationally Recognized Statistical Rating Organizations" (or "NRSROs") for similar purposes

Ratings use in structured finance

Credit rating agencies may also play a key role in structured financial transactions. Unlike a "typical" loan or bond issuance, where a borrower offers to pay a certain return on a loan, structured financial transactions may be viewed as either a series of loans with different characteristics, or else a number of small loans of a similar type packaged together into a series of "buckets" (with the "buckets" or different loans called "tranches")

RATINGS COMPARISON

LIMITATIONS AND CRITICISM

The paradox of credit ratings
Credit ratings pose an interesting paradox.On one hand,credit ratings are enormously valuable and important.Rating agencies have great market influence and even greater market capitalization.Credit rating changes are major news;rating agencies play a major role in every sector of the fixed income market.Credit ratings purport to provide investors with valuable information they need to make informed decisions about purchasing or selling bonds,and credit rating agencies seem to have impressive reputations.

Credit ratings and reputation:the dominant view

Indiviuals acquire reputations over time based on their behavior;if an individuals reputation improves,and other members of society begin to hold that individual in higher esteem,that individual acquires a stock of reputational capital,a reserve of good will,which other partied rely on in transacting with the individual.Reputational capital leads parties to include trust as a factor in their decision-making;trust enables parties to reduce the costs of reaching agreement.

The rating agencies have got off lightly from regulationso far If credit rating agencies evaluated themselves in secret, they might well be upgrading their own outlooks. For much of the past year they were numbered among those most vulnerable to punishment for their role in the credit crisis, largely thanks to the generous ratings they doled out on dubious mortgage-linked securities.

Criticism

Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months.

Some finance scholars have documented in empirical studies that yield spreads of corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that the market often leads a downgrade and questioning the informational value of credit ratings. This has led to suggestions that, rather than rely on CRA ratings in financial regulation, financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spreads when calculating the risk in their portfolio.

Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled.These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. Furthermore, because information about ratings changes from the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings.

The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. In some cases, large loans to companies contain a clause that makes the loan due in full if the companies' credit rating is lowered beyond a certain point (usually a "speculative" or "junk bond" rating). The purpose of these "ratings triggers" is to ensure that the bank is able to lay claim to a weak company's assets before the company declares bankruptcy and a receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called "death spiral").

Agencies are sometimes accused of being oligopolists, because barriers to market entry are high and rating agency business is itself reputationbased (and the finance industry pays little attention to a rating that is not widely recognized). Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses. The high profit on Moody's revenues (>50% gross margin), which are consistent with the high barriers to entry, do nothing to allay market fears of monopoly pricing.

Credit Rating Agencies have made errors of judgment in rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. This has led to problems for several banks whose capital requirements depend on the rating of the structured assets they hold, as well as large losses in the banking industry.

Why Fraud is a Costly Business Problem

Fraud Losses Reduce Net Income $ for $ If Profit Margin is 10%, Revenues Must Increase by 10 times Losses to Recover Affect on Net Income
Losses. $1 Million Revenue.$1 Billion

Fraud Robs Income

Revenues Expenses Net Income Fraud Remaining $100 100% 90 90% $ 10 10% 1 $ 9

To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.

Recent Financial Statement Frauds

Enron WorldCom Adelphia Global Crossing Xerox Qwest Many others (Cendant, Lincoln Savings, ESM, Anicom, Waste Management, Sunbeam, etc.)

Role of Credit Rating Agencies

The three major credit rating agenciesMoodys, Standard & Poors and Fitch/IBCAreceived substantial fees from Enron Just weeks prior to Enrons bankruptcy filingafter most of the negative news was out and Enrons stock was trading for $3 per shareall three agencies still gave investment grade ratings to Enrons debt. These firms enjoy protection from outside competition and liability under U.S. securities laws. Being rated as investment grade was necessary to make SPEs work

Advantage of credit rating Agency

So Why Did Enron Happen?

Individual and collective greedcompany, its employees, analysts, auditors, bankers, rating agencies and investorsdidnt want to believe the company looked too good to be true Atmosphere of market euphoria and corporate arrogance High risk deals that went sour Deceptive reporting practiceslack of transparency in reporting financial affairs Unduly aggressive earnings targets and management bonuses based on meeting targets Excessive interest in maintaining stock prices

Will there be another Enron?

Yes

Recent years have seen an increase in the number of financial statement frauds

No

Incentives still there (Stock Options, etc.)

1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)

Sarbanes-Oxley Bill contains many key provisions

Accountants are being much more careful

Executive sign off Requirement to have internal controls Rules for accountants (mandatory audit partner rotation; Oversight Board, limitations on services, etc.)

Thank you