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Why are we rating? Standard & poor's recent downgrade of the US has put the power and methods of credit rating agencies into sharp focus. How do they work? To whom are they accountable? And how can your company manage its relationship with them effectively?

The financial crisis has shattered the myth that the judgement of credit ratings agencies is impeccable and has brought the dangers for investors of being "blindly" and "uncritically reliant" on their findings to the forefront.

Regulators on both sides of the Atlantic have taken aim at the agencies, threatening to curb their power and improve their governance. In fact, a US congressional panel described them as "essential cogs in the wheel of financial destruction". The industry itself has attempted to mollify critics by beefing up its own self-regulation and transparency. Yet while the failings of the big three agencies - Standard & Poor's (S & P), Moody's, and Fitch - have been laid bare, governments and corporates still rely on their views to attract investment and raise capital.

The role of a credit rating agency is to gauge the creditworthiness of organisations issuing debt instruments - such as corporate and government bonds - so that investors, banks, regulators and other market operators can use them to measure relative credit risk. Billions of dollars-worth of debt is issued and borrowed based on their analysis. If a company or government is "downgraded", investors either feel compelled to dump their investments, or force the organisation to change tack - quickly.

Many companies, governments and public sector organisations have fallen out of love with credit rating agencies when they have either not achieved the rating they think they deserve, or have been downgraded. As ratings can influence banks' willingness to lend credit and suppliers' payment




At the beginning of August S & P downgraded the US's credit rating to AA+ from its top rank of AAA, i saying that the deficit reduction plan passed by the US Congress did not go far enough. Greece, the UK and Japan have also suffered ratings downgrades within the past year.

In August, Los Angeles, which had recently seen its $7bn investment portfolio downgraded by S & P, fired the rating agency after it cut its rating of LA's general investment pool to AA from AAA. "We have really lost faith in S & P's judgement," interim treasurer Steve Ongele said. Following its downgrade of US debt weeks earlier, S & P also downgraded dozens of other municipalities with large investments in US Treasury notes. One of them, northern California's San Mateo County, decided not to renew its contract with S & P, while Florida's Manatee County also dropped its contract with the company.

Edward Lampert, the US billionaire majority shareholder and chairman of Hoffman Estates-based Sears Holdings Corp, has often complained about ratings agencies, outlining his criticisms in his "letters" to investors. In February 2010, for example, Lampert referred to the agencies' "simplistic analyses" that resulted in the retailer having a lower credit rating thaa rivals, even though he said it carried less debt than many of them, had a higher market capitalisation, higher earnings and a more diverse business portfolio.

"We can understand rating agency caution surrounding economic events, the retail environment and the potential for things to get worse," Lampert said in his February letter. "In our case, it turns out that our performance far exceeded many observers' expectations and we hope to receive credit for this performance in the form of higher credit ratings and more balanced analysis."

Companies also fear that downgrades will tarnish their reputation and drive away potential customers. In February 2011, Manulife Financial Corp, the Toronto-based owner of the Boston-based John Hancock family of mutual funds, told analysts that it was having ongoing discussions with the rating agencies following a downgrade from A to A - a couple of months previously.

However, chief executive Donald Guloien was still quick to criticise them for failing to pick up on what he believed were the favourable financial trends that the company was experiencing. "We really don't know when they'll get it," said Guloien. "Give it six months or a year and maybe the ratings agencies will start to notice that Manulife is substantially de-risked from where it was before," he added.

Some experts believe that the criticism stems from a failure to understand how the agencies work and the information that they are looking for, a reluctance to communicate with them, coupled with a sense of "over-optimism" about an organisation's financial standing and risk exposure. Rick Enfield, business practice manager at Asset Control, which specialises in data management solutions for financial institutions, says that, "There is a difference between achieving or wanting an accurate rating, and one that best suits an organisation's purposes."

Georg Schroeder, director in the debt advisory team at accountants Deloitte, says that, "Companies tend to have a certain view of how their businesses are performing. If investors and analysts don't share that view then they tend to be blamed for not properly understanding the business, its financials or its strategy."

He adds: "A lot of companies tend to only engage with credit rating agencies a month before their ratings come up for their annual review and are then surprised when they might not receive the rating they were hoping for."

Schroeder believes that companies need to have more frequent engagement with the agencies so that they have a better understanding about the information they need in order to provide a rating. "The agencies can only provide ratings based on the information they have to hand; if information is not disclosed or is deliberately withheld they will tend to give a conservative rating. Regular face-to-face meetings with analysts will help management teams establish what information they should aim to disclose."

For example, he says, agencies are not just interested in the financial health of the company, but they also want to know about "softer" issues, such as corporate investment in new premises, equipment and IT infrastructure, staff retention levels, commitment to training, corporate governance and reputation management. Furthermore, agencies are looking for a broader management understanding of the sector and any macroeconomic trends that might affect the industry, as well as their procedures to identify and mitigate these risks.

"Companies tend to make the mistake that they are just being rated according to their own financial performance and the risks they face individually. This is not correct. Credit rating agencies also take into account the performance of the industry sector - a company is unlikely to score the highest investment rating if the sector in which it operates is in decline, despite the company's own financial performance and outlook," says Schroeder.

A closer, more communicative relationship can pay dividends, says Schroeder. For example, if a company is considering acquiring a competitor to increase its market share and service offering it could ask a credit rating agency to carry out a "scenario assessment". This could involve analysing the price of the transaction, quantifying the value that the merger is forecast to create, examining the assets being bought, providing an appraisal of the new management team, looking at how the deal is being financed and valuing staff redundancies and disposals.

"A company that is going to embark on such a major restructure will need to have an updated rating and it might as well try to engage with a credit rating agency at the earliest opportunity," says Schroeder. "By carrying out a scenario assessment, the management team will get a better view of how analysts will rate the transaction, as well as having an opportunity to address any concerns that the rating agency may have prior to the merger going live and the rating being awarded."


Yann Umbricht, partner and head of professional services firm PricewaterhouseCoopers' treasury group in the UK, also believes that stronger engagement is crucial. He says that companies should arrange regular face-to-face meetings with analysts from the rating agencies, and that these meetings should be led by a senior member of the management team, such as the corporate treasurer, the chief financial officer, or even the chief executive. "The management team sets the tone for the business. It is therefore important that it engages directly with the analysts that will rate its performance," he says.

Umbricht also warns organisations to make sure that the information they present to analysts stands up to scrutiny. All information relating to the company's future outlook needs to be properly substantiated, he says.

"If a credit rating agency does not believe that a projected target can be achieved it will ask for the information upon which that projection has been calculated. An error in the calculation may be understandable, but not having any firm figures to back up the projections is inexcusable and will lead to a very conservative rating as the agency will have less faith in the financials the management team, and the business."


Attacks on credit rating agencies focus on two charges: firstly, their methods of rating and categorising debt instruments do not make it easy enough for investors to see the true levels of risks they carry. Secondly, agencies receive their fees from organisations issuing debt and constructing debt instruments, which means that they aire being paid by the issuers whose securities they rate.

These are not the only abuses that have been raised with regards to the agencies' work. On 8 August, William Harrington, a former Moody's Investors Service derivative produets senior vice president, said in a 78-page filing to the US Securities and Exchange Commission (SEC) - the financial regulator that is considering new rules to reform the agencies - that agency analysts are pressured through a culture of "intimidation and harassment" to give clients the ratings they want out of fear they will otherwise fire the agency and take their business to another one". He also said that Moody's analysts whose conclusions differed from what its clients wanted were "viewed as 'troublesome/ i.e. independent" and often harassed, disciplined, transferred or fired.

Harrington, who worked for Moody's from 1999 until he resigned last year, also wrote that, "The goal of management is to mould analysts into pliable corporate citizens who cast their committee votes M line with the unchanging corporate credo of maximising earnings of the largely captive franchise."

Moody's did not respond to arequest for comment.

Yet some experts believe that credit ratings should only be used as a guide anyway and that investors should use their own research to determine whether an investment is safe or not. Jonathan Croft, partner at AdviCorp, an investment company that specialises in distressed debt, says that "a credit rating agency is not a substitute for an investor's own credit analysis".

"How often is the information that a credit rating agency bases its opinions on out of date? More often than not their research lags behind current events so investors and stakeholders do not get an accurate view of the company's position, or the macroeconomic events that may be affecting the industry sector that it is a part of. Investors should always carry out their own checks," he says.

RELATED ARTICLE: Major credit rating agency k country downgrades, 2011

January: Standard & Poor's downgrades Japan from AA to AA-

March: Moody's downgrades Greece from Ba1 to B1

May: Standard & Poor's downgrades Greece from BB- to B-

July: Moody's downgrades Portugal from Ba1 to Ba2

July: Moody's downgrades Greece from Caal to Ca

August: Standard & Poor's downgrades US from AAA to AA+

September: Standard & Poor's downgrades Italy from A+/A-1+ to A/A-1

September: Moody's downgrades Slovenia from Aa2 to Aa3

Neil Hodge is a regular contributor to Financial Management
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Title Annotation:Economics
Author:Hodge, Neil
Publication:Financial Management (UK)
Date:Nov 1, 2011
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