“Investors tend to take credit ratings at face value and rely on them too heavily.” So says ESSEC Economics Professor Patricia Langohr, who with her father, INSEAD Finance and Banking Professor Herwig Langohr, has written a book called 'The rating agencies and their credit ratings'.
Published at the height of the AIG rescue and Lehman Brothers bankruptcy, the book is timely, coming as it did at the time of the near-collapse of a banking system apparently lulled into a false sense of security over the creditworthiness of sub-prime mortgages and their various derivatives.
Basically, Langohr cautions ‘buyer beware’ and reminds us that by definition a credit rating is just “a benchmark measure of probability of default.”
But the use of credit ratings over time has broadened the scope to include two more roles: measuring credit risk consistently across all segments (and creating a standard); and using ratings as references in contracts and regulations.
“Credit ratings have become ubiquitous and arcane,” opines Langohr.
There are a number of reasons this came about. One was a lack of competition. “The three ratings agencies weren’t afraid of losing their business,” says Langohr. “There is nowhere else to go to get a credit rating except Moody’s, Standard and Poor’s, or Fitch. We need more market discipline.”
She would rather see competition in the segment than regulation or certification by the US Securities and Exchange Commission (SEC) or another financial agency. “Regulators should not certify the ratings agencies,” she says. “Certification would give (yet another) possibly false sense of security.”
The belief is well-founded. As recent stock market gyrations and bursting real estate bubbles show, investors relied on ratings almost exclusively, and got burned. “Investors must take a closer look at rating agencies and what they say,” Langohr told INSEAD Knowledge. “Investors should monitor the agencies and their investments. Credit ratings are only a small part of the picture.”
Competition in the field of credit ratings is likely to be slow, while regulations are easier to apply – especially under the current sentiment in world stock markets, Langohr is fearful the move to regulate will be too severe. “Europe was on track with a code of conduct, but now market regulators are getting more intrusive. They seem to want certification,” she says.
Part of the difficulty – at least in terms of the public’s perception – is the business model by which rating agencies are paid: by the issuer. The model actually goes back to the early-1970s, “when investors themselves paid the ratings agencies,” Langohr says. The problem was that the publication of ratings could easily be copied and (after the liquidity crisis following the default of US railroad company Penn Central on its commercial paper in 1970) issuers were willing to pay for a rating in order to show the market that, creditwise, they were sound.
“The investor can buy an issue without a rating, but an issuer cannot go to the capital markets without a rating,” Langohr points out. “And capital markets cannot function with secret ratings – for example, even if only a few investors have the actual ratings, these would be quickly revealed through market prices or the internet.”
So who pays? Langohr sees no conflict of interest that cannot be dealt with, if the issuer continues in this role. She prefers the clarity of issuer-payment to investor-payment opacity, at least for corporate issuers, but advises investors to “do their research, do their homework on understanding the ratings, and consider other tools like market implied ratings” or risk getting caught up in another bubble being burst like those involving WorldCom and Enron.
Rating actions may trigger huge capital flows and they may work with multi-billion-dollar issuers, but the industry itself is not a place to get rich. What does it take to work here? “A really profound desire to get the rating right,” says Langohr. “These people are not commercially-driven, they don’t get high salaries as in banking. They should fit in a collegial atmosphere; they need analytical power and independence of mind.”
But was there a commercial motive behind the agencies’ agreeing to rate virtually everything put before them? Didn’t their credibility suffer?
“They should refuse to rate some specific products,” Langohr says. They should “just say: ‘Sorry, we don’t have enough information to rate this product,’ especially some structured finance instruments, because not enough is known about them. They should be putting their reputation before short-term profit, and this could help them in the long run become more profitable.”
So what does the future look like for the rating agencies? Langohr sees more diverse and niche entrants coming into the field, greater investor awareness and scrutiny, as well as, hopefully, the occasional refusal to rate a financial instrument. “We must go back to basics,” she says. “Credit ratings should be just a measure of probability of default that is comparable across various products. It is also important to have visible ratings (and ratings quality), in the sense of transparency. But ever more importantly, if we want to have really high quality rating information, we need investors themselves to watch the agencies and for regulators to back off from direct certification.”
Yes, “buyer beware.”
'The Rating Agencies and Their Credit Ratings: What They Are, How They Work, And Why They Are Relevant' is published by Wiley.