Wednesday, October 14, 2009

Bond Ratings: Why, how and what next?

In the aftermath of the bond market calamities (for investors and issuing companies), the ratings agencies (S&P, Moody's and Fitch) have come under assault from all sides. Legislators and regulators have accused them of being too close to the companies that they rate, with the implication that companies/bonds are being over rated. Academics have piled on, arguing that there is little information in bond ratings and that ratings agencies offer poor and delayed assessments of default risk. Finally, a few former employees have come forward with claims that bond ratings, at least in some cases, are stale and not backed up by serious research.
http://www.nytimes.com/2009/10/11/business/economy/11gret.html

I would like to at least step back and consider some broad issues related to ratings:

1. Why do we need bond ratings in the first place?
As long as there have been people on the face of this earth, there have been lenders and borrowers. For much of recorded time, a lender (money lenders in ancient times, banks in more recent periods) assessed the credit quality of a borrower and set the interest rate accordingly. It was the advent of the bond market in the last century that changed the dynamics and created the need for ratings agencies. When a company issues bonds and investors price these bonds, these investors do not have the resources to assess credit risk on their own. Ratings agencies stepped into the gap and provide this credit risk assessment. Thus, the ultimate service provided by bond ratings is to bond traders, and bond issuers benefit only indirectly.

2. What is the information content in a bond rating?
Ratings agencies have access to all of the financial information that the rest of us do - financial statements, past and present, analyst reports, industry analysis etc. In addition, they can ask for private information specifically related to default risk, which can then be used to finesse or modify the rating. The problem with the private information is that it comes from the management of the firm, which of course has an interest in providing more good news than bad news.

The simplest way to measure whether the market thinks there is information in a bond rating is to look at whether market prices of bonds change when their ratings are changed. The evidence there is mixed. While there is a consistent price change, with bond prices increasing (decreasing) on bond upgrades (downgrades), most of the price change seems to happen before the rating is changed. In other words, markets seem to anticipate ratings changes. That does not make ratings less useful but they are often lagged measures of default risk.

3. Is there a potential for conflict of interest and bias in ratings?
Going back to the origins of ratings, it is clear that bond buyers should be the ones paying for the ratings and they do so now, albeit indirectly. Ratings agencies are compensated by the companies that are rated, which does create a conflict of interest, though the conflict is nowhere near as intense as some other conflicts that bedevil us (such as auditors who have consulting revenue from the companies they audit or investment banks operating as deal makers & advisors on M&A deals). The price paid by companies is a relatively small one (3-5 basis points of the size of the issue) and it is not as if companies that are down graded can pull up stakes and refuse to be rated. (Let's face it. There are more ratings downgrades in a quarter than equity research analyst sell recommendations in a decade.) The price paid by companies is then passed on to bond buyers as a slightly higher interest rate on the bond.

There is a bigger potential for conflict of interest with mortgage backed securities and other bonds that are issued against pools of assets, not by companies by often by intermediaries. There, Moody's and S&P do have an interest in growing the market and attaching higher ratings does increase market growth, which increases future revenues and so on...

There is much talk now of changing this model but the alternatives are not that attractive. One is to charge a small tax on every bond sold, collect the proceeds in an entity (probably government run) which will then pay the costs to have all bonds rated. The question then becomes choosing the ratings agency (ies) to do the rating and the pricing mechanism (fixed price, auction). The other is to increase competition among ratings agencies, with the argument that competition will make them worry about getting rating right, though this would exacerbate the conflict of interest, at least in the short term.

4. What should we do going forward?
Before we pile on ratings agencies and blame them for our bond losses, we have to recognize that they were not the only ones to under estimate default risk. Most banks in developed markets made the same mistake, as is clear by the losses being written off on loan portfolios. Thus, I would not blame the ratings mistakes primarily on conflicts of interest or poorly trained ratings staff or some conspiracy the0ry too dastardly to behold. Rather, I think ratings agencies were caught up in the mood of the moment, just as the rest of world was, where housing prices always went up, people had permanently stopped defaulting and recessions were a thing of the past.

In closing, my fear is that we will throw the baby out with the bath water and make radical changes in the ratings process. Having valued companies in markets with bond ratings and in markets without, I can tell you with absolute conviction that I would rather deal with lagged and flawed bond ratings than no bond ratings at all.

9 comments:

Ron Carleton said...

There is no way to blame the credit mess on the rating agencies. Aside from the municipal bond market, almost all bonds (i.e. corporates and asset backed securities) are owned by institutional investors, typically with hundreds of millions of dollars under management. These investors should have their own credit analysts on staff, not rely on the rating agencies. See our views on credit analysis at: www.commentsoncredit.com

Steve Chuang said...

I'm not sure if competition would lead to more accurate ratings. Agencies have been competing for a long time and I don't think the market really knows which agency has been most "right" over time.

Maybe some "ratings-squared" agency could publish ratings on the ratings agencies' actual performance over time, allowing people to know who is actually better, and incentivize the agencies to be more accurate.

Abhishek Kumar....IIM KOZHIKODE said...

housing prices would always go up....everyone thought so...the banks, the ratings agencies and even the govt., because otherwise a well thought out and prudent legislation would have been in place. The irony is that how such people and organizations with such vast knowledge and experience in finance could think that housing prices would go up forever? That the very concept of a bubble was redundant.... Now Mr. Damodaran what these tycoons of ur country have done is irreparable esp. in terms of the damage that it has caused to the economies that were aping the USA. ..... These economies had lately converted to the open market system.. in the hope that it was the only answer to the questions of hunger and poverty that their economy faced...... After opening up they became outsourcing hubs for the US... most of them couldn't develop their own industries... and their ecopnomies became solely dependent on the performance of the US and the whims and fancies of its policy makers...........Dueto the slowdown it is these countries that have been greatly affected......True the US is worried about its own unemployment problems.... bot what about people who in distant lands work for the US, though not being its citizents,... and earn some amt. of money that is pathetically low to meet basic human necessities....... Instead of being too preoccupied with its own <= 8.5% unemployment rate.....Doesn't it become imperative for the us to do more.......

And now coming back to bond ratings.....it seems much like astrology .... where that astrologer commands respect whose prophecies are more consistent than others..... the very nature of the market should be to encourage more no. of agencies rather than just S & P and Moody's..........In this pool soon will emerge an agency that is consistent and demands the respect of the market.

Another worry area is why change in ratings lag the way markets see things... doesn't it also mean that the ratings are just a reflection of what the market already knows......... Rather it also implies that the kind of insider info that the ratings agencies are supposed to obtain fron the company management.. is not done... and what they get is just rosy news....


And about mortgage backed bonds...the lesser said the better....the very evident lack of info... makes the ratings extremely vulnerable......i would even think that in this particular segment.....ratings are lobbied for and much influenced.........comments Mr. Damodaran

Aswath Damodaran said...

Sounds to me like selective rationalization. If the market system is to blame for whatever pain has been inflicted in these countries -I presume that you are talking about Asia - then it must have been also to blame for whatever gain was generated in the previous two decades. You know what! Most people would take the trade off. India and China operated for millenniums under your alternate government-controlled (elite run) systems and what did they have to show for it? In two decades, the market system has changed both countries in immense ways. Has all the change been for the better? Of course, not.. But consider the millions of people who have been raised from poverty to the middle class in both countries before you decide the old system worked better.
One more thing.. When you point your finger at the "tycoons" (I presume you are talking about investment bankers here) remember that four fingers are pointing back at you. Anyone who bought a house bought into this vision of everlasting glory as well..

Immortal said...
This comment has been removed by the author.
Immortal said...

Blamin squarely on bond ratin agency is not justified by any means watsoever...it was a collective failure and more importantly it is the greed that did everyone in including the issuers to intermediares to investors....

the only solution tht seems wise to me is settin up Central authority regulatin agencies ratin bonds...it mke sense since the public investment is attracted based on rating of these agencies n must be regulated....

To be honest we all r gradually gettin insensitive to such bubbles...n can only wait n watch wats next....people who have their greed in check will survive and make money..n rest will disappear eventually...

Gaurav Mehta said...

On bond ratings,i don't think Moody's or S&P went wring because they were paid for by the Companies they were rating. Because there is hardly any competition among rating agencies, Companies have no choice but to get themselves rated from the three big agencies. So where does the need arise for giving better ratings? if that was the case there would be no companies rated CCC ect. I think they just got caught in the momentum and did not do the basic stuff right. Now that the crisis has happened, the rating agencies have been pushed to the ground, it definately makes sense to trust them more now than ever as they would be at their best having borne the brunt of everyone's anger the past two years.

Amit said...

Prof. Damodaran, you rock!! Your blog gives me new directions to think every time I read it. Lucky students who get a chance to sit in your classroom. Thanks

Annabel Thomas said...

Found this post extremely interesting. I have just written a dissertation on a similar topic. In my opinion i feel its the advisory services offered by the CRAs, that should really be under scrutiny.

How can a CRA providing an advisory service to the bond issuer and then also rating it possibly be independent? They know how greater level of toxic debt can be bundled in whilst still remaining a AAA rated bond. It seems a case of whoever pays the piper calls the tune....