[Viewpoint] A failing grade for rating agencies

Hyundai Group founder Chung Ju-yung’s last business ambition was to build a memory chip plant in Eugene, Oregon, in 1996 for the conglomerate’s chipmaking affiliate Hynix Semiconductor to escape U.S. anti-dumping regulations and punitive actions. The U.S. plant would employ American workers to turn out memory chips, complete their assembly at Hynix’s manufacturing base in Icheon, Gyeonggi in
Korea, and then sell the products back to the U.S. market.

Hynix sought a syndicated loan to finance the construction, but failed to gain commercial lenders because the parent Hyundai Group’s shortage of financial guarantee availability. At the time, I advised that the semiconductor company issue unsecured bonds that do not require financial guarantees.

But the challenge was getting investment grade ratings from international credit agencies Moody’s and Standard & Poor’s to price the corporate bonds. I explained to the two agencies that the bonds would be securitized by the cash flow prospects of the memory chip business as well as the Group’s undertaking to commit capital increment as and when requested by the Bond investors. The two rating agencies bought the argument that the collateral securitization would serve as a functional equivalence of a financial guarantee by the Hyundai Group without using the debt guarantee portfolio of the main creditor bank. The bonds were rated with a BBB investment grade rating and the offering was oversubscribed by institutional investors from around the globe.

These rating agencies had the ability to rally institutional investors from all parts of the world at a moment’s notice. Still, I wondered why they pocketed bond assessment fees from the bond issuer -

Hyundai Electronics - not the investors who profited from the ratings.

Two years later, as Korea went under the bailout program from the International Monetary Fund, everyone came to learn the names of the international rating agencies as the television news showed scenes of senior government officials courting young due diligence teams from the U.S. At the time, everyone was in awe of the absolute power of the U.S. credit rating agencies.

A couple of weeks ago, there was a seminar at the Seoul Financial Forum as a part of the G-20 Summit preparation. I spoke on the need for reform of the international credit rating agencies. When the subprime crisis broke out three years ago and when the first G-20 Summit in Washington touched on the issue of revamping the credit rating agencies. But no progress has been made since.

Ratings agencies face a conflict of interest in that the bond issuer pays for the ratings service. I suggested that the G-20 Summit conference in Seoul in November should include an overhaul of the international rating agencies as part of its official agenda.

International credit rating agencies came under heavy fire this week for their downgrade of the sovereign debt of Greece, Portugal and Spain. They were criticized for inherent conflicts of interest.

Two weeks ago, the U.S. Senate Permanent Subcommittee on Investigations released a 500-page report on moral hazards and conflicts of interests on the part of the rating agencies. The U.S. must revamp the rating agencies’ system to create order in its own market as well as the broader global capital market.

To reform the rating agencies, the pay system must first of all be overhauled. But if rating agencies receive payment from bond buyers, there is the problem of a “free ride.”
So it is better that bond issuers keep paying for the rating fees, but to a fund operated by the Securities and Exchange Commission rather than to rating agencies. The commission will oversee the fund and pay the rating agencies accordingly based on objective guidelines. Under the new system, rating agencies will be able to grade the bonds objectively without considering their payers - bond issuers.

Second, rating agencies must increase hiring of analysts from Asian and other emerging economies. New York-based rating agency analysts cannot know the precise state of each economy better than the country’s central bank, the Austrian central bank Governor Ewald Nowotny said.
International rating agencies should recruit more graduates from emerging markets to diversify their Western-style assessment. Otherwise, they will face strong challenges from new regional rating agencies.

Third, analysis by individual bond investment companies and risk protection instruments like credit default swaps can be viewed as alternatives to assessments by the rating agencies. Global capital will get intermediated more and more through emerging markets.
The rating agencies will be shunned if they do not raise transparency in their fee system and diversify the origin of their employees.

*Translation by the JoongAng Daily staff.
The writer is chairman of Deutche Bank of Korea and honorary chairman of the MIG Alley Chapter of the U.S. Air Force Association.

By Kim Soo-ryong