Recent history on rating actions of the ‘Big 3’ agencies - on upgrades, downgrades, affirmations - has shown some wobbles to say the least. There was the debacle over ratings of collateralised debt obligations (CDO’s) in the U.S., which in many cases garnered ‘AAA’ (triple A) status, often based on a rating given to financial institutions behind CDO issuance.

And, now there has been the accidental downgrade of France’s ‘AAA’ sovereign debt by S&P (10 November 2011), through a message sent out to the agency’s subscribers. What is going on here? We are unlikely know much more until an investigation by S&P is conducted over what happened.

Nevertheless, it just shows that even the big boys are fallible. Considering just how much money corporates and other entities pay for such services one might expect better. Just weeks earlier in October the European Commission outlined plans that could gag the agencies from providing verdicts on financially stricken nations.

Even Cyprus’ finance minister Kikis Kazamias even got in on the act in the wake of the French mistake by saying CRA’s were responsible for fanning Europe’s financial crisis. He accused agencies of “fear-mongering” and that their downgrades turned into self-fulfilling prophesies. It was the same a decade ago when Argentine sovereign debt was downgraded and those actions served make the situation far worse.

But it also begs other questions. For example, should we be rating the agencies on their performance? After all it does happen in other areas of the capital markets such as with equity analysts rankings on EPS forecasts and stock recommendations (e.g. Thomson Extel’s annual equity analyst awards and AQ Research’s rankings on the FTSE Eurotop 300 stocks).

It makes one recall an occasion when the Finance Minister of one Asian nation was pressed by journalists asking: “What will you do if the agencies downgrade the country’s sovereign debt?”. He replied: “Don’t worry about any [potential] downgrade, but who will rate the agencies.”   It’s amazing to consider that the Big 3 CRA’s have virtually got off scot free after informal hearings by the U.S. Securities & Exchange Commission (SEC) as far back as March 2008, and more recently by the UK’s Treasury Select Committee where MPs quizzed representatives from S&P, Moody’s and Fitch on the woeful rating actions on Icelandic banks.

In the U.S., guidance was provided to the U.S. SEC from so-called ‘Subscriber-Pay’ prospective NRSRO’s* (Nationally Recognised Statistical Rating Organisations) on issues affecting the ratings market. This included information provided by smaller rating agency players such as Rapid Ratings, a New York-headquartered agency that employs no human analysts. Instead it crunches numbers on 62 weighted financial ratios gathered from filings of company results (e.g. 10-Ks and 10-Q).

From this crunching, a score - a Financial Health Rating (‘FHR’) - from 0-100 is generated. Now without going into the nuances of Rapid’s system, 90% of defaults among corporates occur when a FHR hits 40 or below (Rapid’s higher risk category), 50% at 25 or below (very high risk) and none above a score of 75. It should be noted that Rapid’s analysis is mostly company focussed. 

While these are just numbers, they do broadly correspond to ordinal system of the big agencies from ‘Aaa’ to ‘C’. Rapid has been successful in calling it right - and early - on a number of corporate entities. The most recent example can be seen with MF Global, with Rapid being the first ratings firm to call the risk the broker was carrying way back in May 2009. This was years before other ratings agencies.

But other instances of early calls show this was not a one-off fluke. The agency provided early warnings on the U.S. housebuilders (e.g. WCI) , which were an early signal of the sub-prime crisis, as well as alerts on Bear Stearns, Enron, Parmalat, Ford, US Steel and many others.

In the case of MF Global, factors that led to the organisation’s demise were quite simple: poor sales performance, poor profitability and poor debt service management. Exposure to Euro debt aside, by analysing financial information publicly available on their balance sheet, it had become apparent for several years that MF Global would not be able to stand an unplanned shock compared to companies that were better rated.

Specifically, Rapid’s analysis of MF Global’s full 2010 financials led it to adjust the rating to a new FHR of 26 (equivalent of a ‘Caa-2’/’CC’ rating), while the company still commanded investment grade ratings from Moody’s and S&P. Incredibly, at the time of filing for bankruptcy, MF Global still carried a ‘BBB-’ rating from S&P and had been downgraded to ‘Baa3’ to ‘Ba2’ by Moody’s just two business days earlier.

So, one conclusion is that the big agencies could do better. Another is that perhaps the business model of the leading incumbents should change from reliance on an ‘Issuer-Pays’ model, which is great for the larger agencies in terms of revenues, but not so beneficial for the market. To, a ‘Subscriber-Pays model as espoused by Rapid. As its rating analysis provided has proved insightful, unconflicted and helped the market through actionable ratings.

If the Big 3 are receiving juicy fees from issuers to provide ratings, then a danger exists that transparency and true objectivity will be stunted. It’s questionable also how fees can be charge for the rating work itself and ongoing maintenance, whilst a separate department of the same agency charges for research services on those same entities. Is that really going to be objective? The market needs a levelling playing field rather than the rating agency oligopoly that exists today. The Big 3 need to stop ‘Drinking the Kool-Aid’!

By Roger Aitken

*NOTE: Currently nine firms registered with the SEC as NRSROs. These are: A.M. BestCompany; DBRS; Egan-Jones Rating Company; Fitch; Kroll Bond Rating Agency (formerly known as LACE Financial); Moody’s; Rating & Investment Information; Realpoint LLC and, S&P.