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Credit Rating Agencies – Need for Reform

Credit rating agencies (ACC) – Need for Reform

1. Crisis – Lights in the credit rating agencies

"The rating agencies use their control of information to deceive investors in the belief that the pig is a cow and a rotten egg is a chicken barbecue. Collusion and misrepresentation are not elements of a truly free market "- U.S. Congress Gary Ackerman U.S.

The smooth functioning of global financial markets depends in part on a sound assessment of investment risk and the rating agencies play an important role in the promotion of investor confidence in these markets.

The harsh rhetoric well above invites us to focus our attention on the operation of credit rating agencies. Recent debacles Following is even more important to consider the application of rating agencies just as advisers.

i) Sub-Prime Crisis: In the recent subprime crisis, rating agencies were attacked by more and more favorable in their CDOs secret collusion volume of trash in the area of subprime mortgages, a crisis that is having repercussions around the world. To give a background, the issuers of loans mortgage were guilty of packaging subprime mortgages and securitization and CDO market as the secondary mortgage market. Rating agencies have failed in their duty to warn the world of finance this malpractice of a fair and transparent assessment. It's shocking, gave favorable ratings to CDO for reasons that should be considered.

ii) Enron and WorldCom: The companies were rated "investment grade" by Moody's and Standard & Poor's, three days before it filed for bankruptcy. Rating agencies have voted for risk products, and in some cases to these risk products and as fat fees.

There may be other highly valued by the Enron and WorldCom to wait bankruptcy. Rating agencies must be reformed to enable cancer pin point, but in the front and strengthen security in the financial markets.

2. Credit ratings and rating agencies

i) Credit rating: a structured methodology to rate the creditworthiness of approximately Mode institution, or credit commitment (eg a product) or a debt or claim of such a transmitter and an obligation.
ii) Credit Rating Agency (CRA) is a specialized agency in the work of previous classification. Evaluations made by the rating agencies are not recommendations to buy or sell any assets, but only one indicator.

Notes can be divided into
i) requested Note: If the rating is based on a request to say a bank or a company that also participates in the rating process.
ii) unsolicited Note: when the rate of the rating agencies claim a public interest organization.

Rating agencies help the savings scale, because help to avoid investments in tools and internal credit analysis. It also allows market intermediaries and retail investors to focus on their skills leaving basic complex notation agencies reliable employment.

3. Notation Note Agencies

Agencies that assign credit ratings businesses include

AM Best (U.S.)
Baycorp Advantage (Australia)
Dominion Bond Rating Service (Canada)
Fitch Ratings (U.S.)
(Moody's USA)
Standard & Poor's (U.S.)
Personal Credit Pacific (Peru)

4. Rating agencies – Power and Influence

Several market participants who use and / or are affected by credit ratings

a) Issuer: Good rating improves the liquidity of credit issuers also the prices which in turn satisfy investors, lenders and other counterparties involved.
b) Exemption side business enterprises, such as the purchasing of mutual funds, pension funds and insurance companies use credit scores to other important factors for their own internal credit ratings and investment analysis that helps identify the differences in price, the level of security risk, compliance policy by requiring parking in the investment fund asset quality, etc. Many restrict their funds to higher grades to make them more attractive to investors cautious.
c) Retail Business: As businesses of the buyer for many companies sell high as scores brokers use risk management and commercial.
d) Regulation: the use of the term of the regulation of credit ratings in different ways, for example, the Basel Committee on Banking Supervision has banks to use external credit ratings to determine the allocation of capital. Or, to cite another example, restrictions in public service or funds pensions of public employees of local or national governments.
e) investors and taxpayers: credit to the meaning of changes in value, rating changes can benefit or harm investors in securities and value erosion also affects taxpayers through the cost of debt.
f) private contracts: Letters have experienced a significant impact on the balance of power between the contracting parties that the notation is inadvertently applied to the organization as and not just their debts.

Rating Downgrade – A spiral of death:

A haircut can be a vicious circle. Let see this in several steps. First place goes off. Today, the banks want to complete early repayment of bankruptcy. Company can not pay as a result an additional discount. This begins a death spiral that leads to the collapse of the Companys closing final.
Enron deal with this escalation clause that requires repayment total of the loan in case of damage. When closure has taken place, this clause has been added to Enron's financial difficulties by pushing into financial trouble.
Pacific Gas and Electric Company is another species that has been under pressure from counterparties and lenders require reimbursement for injuries at a discount. PG & E could not raise funds to pay its short term obligations aggravates their falling into the spiral of death.

5. Rating agencies as victims

Agencies rating against the following challenges

a) Lack of information: A claim that rating agencies is their inability to access information accurate and reliable transmitters. rating agencies that mourn issuers deliberately withhold information not in the public domain, for example, contingencies Undisclosed that may affect the liquidity of the issuer.

b) System of compensation: credit rating agencies act on behalf of investors, but they are in most cases paid by the issuers. There is a potential conflict of interest. As the rating agencies are paid by those who do not rate, point inverter view of the market, which are under pressure to give their customers a positive note – other than the client moves to another agency for help. Rating agencies are riddled with conflicts of interest that could prevent them from providing accurate and honest assessment. There are conflicting reports with some rating agencies admit are offset by investors who go bankrupt. Others strongly deny conflict of interest that the defense costs of individual issuers received are a very small percentage of their total income so that no single issuer has a substantial influence of a rating agency.

c) The allegations of pressure market: skills are opportunistic and not based on logic and that they would resort to unfair practices due to inherent conflicts of interest are rejected by the rating agencies as malicious, because the activity is the reputation rating based on evaluations and incorrectly can reduce the agency's reputation on the market. In a nutshell reputation are sufficient to guarantee the exercise of appropriate levels of care in the rating process.

d) Assessments exaggerate float accusations that the number of agencies actively promote too much emphasis on their assessments and encourage companies to do the same. Rating agencies that against credit ratings are used out of context, through no fault of their own. They apply to the organizations themselves and not only the debts of these organizations. A favorable credit rating is unfortunately used by companies as a seal of approval for the marketing of individual products. A Users should be aware that the note has always been more stringent against the scope of the investment being evaluated.

6. Rating agencies, authors

a) arbitrary adjustments without accountability or transparency: the rating agencies may downgrade and upgrade and can include lack of information of the nominal, or product as a possible defense. for obscure reasons it is likely that the dismantling of impact on the issuer, the market assumes that the agency is to aware of certain information that is not in the public domain. This may cause the issuers of securities and volatile speculation.
Sometimes considerations eextraneous determine if an adjustment would occur. Rating agencies do not downgrade companies when they should. For example, many of Enron remained at investment grade four days before the company went bankrupt, despite the agency staff had been aware of the problems of the company for months.

b) Due diligence is not done: there are some obvious contradictions that rating agencies are reluctant to tackle, due to conflicts of interest as mentioned above. For example, if we focus on the ratings of Moody's, we find the following inconsistencies.

All three have over the same envelope that requires banks to move to riskier investments.

c) the ACC orders to management: the business logic required to establish links closely with business management and allowing it to be noted that the relationship affect the rating process. They have been found to act as advisers to the activities economic and pre-classification measures that suggest beneficial effects on the side of the Companys. Exactly at the other extreme are institutions that are charged adaptation unilaterally, while the company denied the opportunity to explain their actions.

e) Creation of barriers to entry: the bodies are sometimes accused of being members of the oligopoly, because barriers to entry are high and the credit rating agency business itself is based on reputation (and the sector Financial, showed little interest in a classification not recognized). All agencies routinely make big profits (Moody's, for example, is more than 50% gross margin), which indicate monopoly prices.

f) promotion of ancillary services: The rating agencies have been active related, pre-qualifying and consulting firms to complete their assessments Core Business. Issuers may be required to purchase ancillary services rather than a favorable rating. To complicate matters, except for Moody's rating agencies are all private companies and other financial results not separated from their activities related to income.

7. Some recommendations

a) Public disclosure: The scope and quality of information in financial statements and balance sheets must be improved. More importantly, the analysis made by management should require disclosure of off balance sheet arrangements, contractual obligations and liabilities and commitments. Shortening the time period between the end of a quarter of the issuer or the exercise and the date of filing of the quarterly or annual report will allow rating agencies to obtain information at first. These measures will improve the ability of rating agencies rate for issuers. If the rating agencies to conclude that important information is not available, or transmitter is less future, the agency may reduce the likelihood, refuse to issue a warning or even delete an existing note.

b) due diligence and competence analysts, rating agencies: Analysts should not rely solely on the words of the management but also perform their own due diligence in consideration of various public documents, exploring the opaque disclosures, review of proxy statements etc. We need a more rigorous degree (or more) to be an employee of the credit rating agency.

c) Elimination of barriers to entry: Increase the number of players can not completely reduce the oligopolistic power some well established, but at best he will be vigilant to undergo a certain level of competition and market forces to determine who really is the best rating reflects the financial market.

d) Cost Note: Whenever possible, the document should be published. If disclosure of confidential information raises the question of business confidence, then the agency must at least be the subject of intense financial regulation. The analyst compensation should be based on merit demonstrated on the basis of their qualifications accurately and not to the detriment of the issuer.

e) The review process transparent: Agencies should make public the basis their results, including statistics for measuring sales performance historical default rates. This will protect investors and improve the reliability of ratings credit. Regulators should require rating agencies to disclose its procedures and methods for assigning ratings. Rating agencies should conduct an internal audit of its scoring methods.

f) support for companies to be independent: Although the ancillary activity is a small part of total revenues, the rating agencies still need to establish policies and procedures for evaluating ancillary expanded firewall. separation service and rating analysts should be used for the marketing of ancillary businesses.

g) Risk Disclosure: The number agencies to disclose material risks discovered during the process of risk assessment or risk appears to be adequately addressed in public communications, the authority regulator for further action. Rating agencies must be more proactive and conduct information audits to look for formal issuer fraud not only limit their role to assess the creditworthiness of issuers. Evaluation of the triggers (eg, repayment of the loan in case of decommissioning) must be discouraged wherever possible and must be disclosed if it exists.

These measures if implemented could improve market confidence in rating agencies and their ratings may be a key tool to boost investor confidence by improving the safety of financial markets in general.

Resource List

i) http://www.zyen.com/Knowledge/Articles/assessing_credit_rating_agencies.htm
ii) http://www.chasecooper.com/News-Regulatory-Basel-II-2007-10-01.php
iii) http://www.blackwell-synergy.com/doi/abs/10.1111/j.1468-0491.2005.00284.x?cookieSet=1&journalCode=gove
iv) http://www.house.gov/apps/list/speech/ny05_ackerman/WGS_092707.html
v) http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2373869.ece
vi) http://www.cfo.com/article.cfm/9861731/c_9866478?f=home_todayinfinance
vii) http://en.wikipedia.org/wiki/Credit_rating_agency

About the Author

Nagraj Gummala has been in the Banking & Financial services domain for almost 6 years and is currently working in Cognizant Technology Solutions (Switzerland) as a Senior Business Analyst in the Basel II Risk Management division. He has written several papers on credit risk, his current area of interest being credit derivatives with specific focus on pricing of options and futures. Nagraj is a mechanical engineering graduate from IIT, Mumbai and a management post-graduate from IIM, Bangalore.

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