The rating game

THE BOTTOM LINE

DEIRDRE McMURDY December 26 1994

The rating game

THE BOTTOM LINE

DEIRDRE McMURDY December 26 1994

The rating game

THE BOTTOM LINE

DEIRDRE McMURDY

These are probably pretty dumb questions. But nevertheless, they are questions that more than a few people must be mulling over these days. With the recent

flap over the sudden bankruptcy of Orange County in California, and the spectacular failure of Confederation Life, where are the credit rating agencies that are supposed to serve as an early warning system for investors? Where are all those ferocious financial pitbulls who allegedly nip at the heels of debtladen governments and terrorize overextended corporations with threats of rating revisions that will hike the cost of borrowing more money? With all the fuss about the bite and bark of these critters, why didn’t they begin to howl long before the Reichmanns toppled, before Royal Trust faded away, before Trizec crumbled? Why did they keep their muzzles on until well after provincial and federal government debt soared to such perilous levels?

Only a few months before the recent debacle in Orange County— where the aptly named treasurer Robert Citron dabbled in derivative products that were lethally leveraged to interest rates—two U.S. rating firms, Standard & Poor’s and Moody’s, assigned their highest short-term rating to the county’s latest issue of floating-rate bonds. On Dec. 7, one day after Orange County officially filed for bankruptcy, Standard & Poor’s finally lowered its debt rating to junk-bond status. Since then, as bewildered bondholders sift through the wreckage, both rating firms have announced that they will now re-examine the creditworthiness of other American municipalities. Thanks, guys.

In Canada, this tendency to locking the bam door after the horse has bolted is just as common. And it is so disturbing because many of the investors that get bagged by glitches in the warning system are pension funds, which represent the savings of real people. At a time when social security programs are headed for an overhaul, these collective nest eggs are more sacred than ever.

Basically, pension fund managers are not permitted to buy any security that is rated below a set “investment grade.” That means that companies and governments are highly motivated to preserve their credit ratings in order to keep borrowing and to do so at the lowest possible cost. The lower the credit rating and the greater the risk attached to a bond or credit instrument, the greater the yield must be to attract buyers. And a downgrade can have a devastating effect on the cost of capital.

But therein lies the rub: credit raters are paid by both sides of a transaction. They work for the buyers and the sellers of the rated security. Buyers subscribe to a service, paying an annual fee for regular reports and updates. At the same time, corporations or governments shell out about $20,000 to have one of their debt issues rated for market consumption. (That compares with the cost of about $200,000 in the United States.) Such a triangular, high-stakes arrangement makes any \ entity that is active in 3 the domestic debt marf ket a rich source of revI enue—as well as a z source of considerable £ potential pressure on the raters.

In equity markets, an investment research report that was directly sponsored by a company would be categorically dismissed for being unacceptably biased. And the fact that stock brokers underwrite share issues and also dispense investment advice to clients is a perenially touchy subject. But for some strange reason, when it comes to debt, it is accepted without question that companies must pay for the privilege of being rated. What if investors ponied up to pay the full cost for truly independent credit analysis? Wouldn’t they actually have a product that might save millions of dollars in the long term? Just asking.