The Ratings Fallout From Enron
Roger P. Nye is President of Global Investment Advisors, Inc., a Short Hills, New Jersey-based international capital markets consulting firm.
The bankruptcy of Enron, the giant energy trader, has focused attention on the rating agencies. Why was the company still rated investment-grade by Moody's Investors Service, Standard & Poor's and Fitch when the market was trading its bonds at junk levels?
In Their Defense
Events move fast, market confidence is fleeting, and credit cliffs can occur suddenly. Creditworthiness can change quite suddenly, especially if expected support from a third party does not materialize or a loss of confidence causes a liquidity shortage. Moreover, issuers are not obligated to provide the agencies with non-public data when the agencies ask for them. Finally, Enron's complex financial engineering and Byzantine off-balance sheet operations were daunting to comprehend.
New Emphases
Nonetheless, in response to market criticism and ongoing discussions with investors, S&P and Moody's have announced several new emphases in their rating processes. They have promised to try to make ratings "more responsive" to market trends and to levels of confidence in a credit and in particular to:
* Make more aggressive rating changes, e.g., multi-notch downgrades in reaction to adverse news rather than a slow dropping of the ratings over time
* Shorten the rating review period, make more rating changes without formal rating reviews, and resolve CreditWatches more quickly
* Provide more frequent commentary and link it to market events, such as earnings releases
* Focus more on liquidity and funding risks
* Incorporate security price behavior into their surveillance process
* Review equity price triggers and other contingent commitments embedded in financing arrangements
* Be more explicit about the potential decline in ratings
* Be more aggressive on accounting and governance issues
Implications For The Market
On the one hand, the rating agencies are right to amend their approach. Old procedures were not time-sensitive; data were outdated by the time of the rating decision. In addition, if market circumstances result in loss of confidence by suppliers, lenders and counterparties, there can be clear changes in an issuer's liquidity and funding risks that should be recognized immediately.
On the other hand, the agencies' current approach has resulted in a high correlation between ratings and default rates. The long-established methods of determining ratings have been effective predictors of default risk. Changing rating practices may skew that strong correlation.
More frequent multi-notch downgrades could impair the value of ratings because the long-term perspective they are supposed to represent will be diluted. Ratings are intended to reflect intrinsic risk and lose their meaning if an issuer is taken down from A minus to B+ in one day. More ratings volatility seems inevitable.
If rating reviews are resolved more rapidly, this is good for the market because the old process was too slow and cumbersome. Issuers, on the other hand, may not be allowed enough time to act on correctable conditions.
Implications For Issuers
* Whenever the agencies get embarrassed by a perceived rating failure, such as the Asian meltdown of 1997-98, they tighten up their internal analytical and managerial controls and take a more conservative posture, meaning new ratings and rating reviews start out with a downward bias.
* The agencies will more aggressively question off-balance-sheet transactions, contingencies and obligations. Issuers should expect greater inspection of disclosure standards and practices.
* When the agencies mention "more aggressive rating changes," let's be frank. They mean more frequent downgrades, not more frequent upgrades. Lower ratings, not higher ones, shield the agencies against embarrassment. Therefore, the ratio of downgrades to upgrades could increase.
Plus Ça Change...
The fundamentals of the rating process will remain in place. Neither agency will admit to basic flaws in how they do ratings or how often they change them. The changes amount to slight modifications and shifts in emphasis, not an overhaul of the rating process. They will hasten their review processes and provide clearer rating rationales and ratings outlooks. Investors should benefit.
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