Long-time subscribers will be aware that we like to keep a weather eye on what the ratings agencies are saying, since the organisations that rate the credit-worthiness of bond and other debt instrument issuers provide perhaps the most rigorous insight into the fundamental economic health of an organisation, and with the growing dissatisfaction with current methods of regulation around the world, which still allow collapses like the Barings Bank Plc fiasco and the Maxwell Communications Corp Plc and Bank of Credit & Commerce International Ltd frauds to take everyone by surprise, ratings agencies could start assuming a new prominence. Unlike stock analysts, the first requirement of ratings agencies are fundamentally different is to be right – not for the next two or three months, but for the life of the debt instrument being rated.
Petulantly as the weather
The reason for this is that their customers are in the main funds that are required to follow a very cautious investment strategy because the livelihoods of widows and orphans really do depend on their doing their job well. Stock analysts on the other hand have as their primary responsibility giving the broker that employs them a pretty investment story with which to arm the sales force. An analyst can tip off the sales force that he or she has had a change of mind and then go public almost on a whim, and can switch from bullishness to bearishness and back as petulantly as the weather, each change of tack drumming up more business for the broker. The ratings agencies, with the two big New York agencies overwhelmingly dominant, on the other hand are required to research companies and their markets much more thoroughly and they relatively rarely change a rating once it has been granted. An earnest of their thoroughness is that when a company’s ratings are put on CreditWatch for possible upgrade or downgrade, they frequently stay there for four to six months before a decision is announced to change or to hold the ratings where they are, and a change is seldom by more than one step. It is however important to understand the limitations of the ratings agencies too. Their raison d’etre is to give a highly informed view on the likelihood that a company will be able to continue paying interest on its debt for the life of the issue and whether it will be able to repay it at par when redemption comes due. A company’s shares can be in the dog-house, with the market valuing it at less than one year’s sales because its prospects of sustained and growing profits are so poor, yet it can still justify an A rating if its balance sheet is rock-solid and there is no reason to suspect that it will default on its debts in any foreseeable circumstances. Of course the ratings agencies are no more able than anyone else to foresee a takeover that may completely change the fundamentals, and if one appears, the debt will automatically go on ratings watch. Thus the ratings agencies will rate highly even companies like Digital Equipment Corp, whose prospects of rebuilding the kind of growth business it enjoyed for its first 20 years are zilch, simply because the likelihood of it being unable to meet its debt repayments is so low, because the dull and slow-growing business on which it is majoring still generates copious cash. In New Zealand, the stunningly impressive home of social and economic iconoclasm, the central bank has already moved to end direct regulation of banks and replace it with tougher disclosure requirements and an obligation that ratings appear on all documents and communications. A similar requirement on companies around the world too could save a deal of heartache.
