By now the refrain's become almost a cliché: Ratings agencies are late on the call. Why is it that they too often downgrade companies after the news hits the front page or comes streaming across the business wires?
The agencies are sorely conflicted. How can investors take seriously the reports by analysts, no matter how astute, if they are passing judgment on the very clients who pay them?
The agencies operate as a de facto cartel, and why are there are so few of them that seem to wield so much clout? When was the last time so many--the nearly 6,000 publicly traded companies on the New York Stock Exchange and the Nasdaq with trillions of dollars in outstanding bonds--were beholden to so few, the handful of ratings houses that routinely put corporate titans through cold sweats. Valid questions all.
But before we fire away at the hard-working souls toiling away in front of Power Excel spreadsheets, keep this in mind. Analysts working for Moody's, Fitch, Standard & Poor's, A.M. Best and Weiss are assigned to rate dozens of companies, and for the most part, they do a good job. In a 12-month cycle, these agencies rate thousands of companies.
Yes, you only hear the hue and cry when analysts overlook the financial position of a company or of an entire sector. In other words, critics raise their hackles only when the ratings experts get it wrong or not right enough. For sure, the ratings houses missed the call on Kemper a few years back, and there probably weren't enough analysts making aggressive downgrades in the spring and summer of 2007 against all the bond insurers that imploded nearly a year later in connection with the subprime lending scandal of the past 18 months.
But nobody ever screams for joy when the analysts get it right, which is most of the time. Nobody ever calls an analyst to thank them when a downgrade has tipped off an alert risk manager or investor that the sector's leading company is likely to miss an earnings estimate or that there's something amiss with that company's risk management program.
Perhaps the lack of recognition is to be expected. After all, the analysts are paid well by the corporate clients looking for the best rating possible. Analysts are supposed to get it right and, with the possible exception of grade school, rarely are kudos dispensed to people for doing what they are supposed to do or are paid to do.
Corporate chieftains, wary of the extra cost of raising capital with a lowered rating, have sweated through analysts' visits.The agencies represent a tight little community, the gatekeepers of bond quality, and as such they wield enormous clout.
I bet there's probably not one insurance company treasurer or chief financial officer who wouldn't welcome or benefit from an alternative bond rating system to the one now used by the agencies. But the dearth of options is not the agencies' problem. It's hardly fair to blame them for the lack of alternatives to our bond rating system.
Some of the criticism leveled against the ratings houses is fair, but the agencies have shown they are willing to listen and change. The more progressive ratings houses are now taking into account whether insurers maintain a robust enterprise risk management program before issuing a bond rating.
S&P, for example, has periodically upgraded its capital adequacy model ever since it was first introduced in 1991. The model now reflects changes in exposures and new capital requirements of regulators. Its last major upgrade was in 2006. Fitch similarly introduced its "Prism" model that same year to evaluate the capital adequacy of insurers.
So the ratings houses are under the same pressures as the very companies they are assigned to cover. They are at least open to change and are willing to listen, whatever their flaws.
Until there's a better system, this one will just have to do.
September 1, 2008
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