How to balance credit ratings

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How to balance credit ratings

There are two types of information -– the type you seek out and the type you prefer not to know about. Many people pay heed to the information they need and want to know about. The information you prefer not to know could be displeasing. The essence of communication is to create an environment where information that doesn’t please all can be freely discussed and explored. To be successful in stock and bond investments, one also needs a balanced view by learning about the information that isn’t necessarily interesting or pleasing.

The information provider also separates information. Most people would want to share self-serving information. In order to prevent asymmetric distribution of information, a third voice is needed to add objectivity and credibility to the information. Credit-rating agencies can play the third-party role in the capital market. Investors without full accessibility to an individual company would refer to corporate information and evaluation by credit rating agencies when deciding to invest in a corporate bond or paper. They also can prevent insolvency in an economy and industry. Credit rating agencies therefore are essential parts of the economy, industry, and capital market.

The global financial crisis in 2008 raised questions about the credibility of credit rating agencies that wielded enormous power to determine the fate of a country and enterprise with their rating scores. In the movie “The Big Short” that satirized the events leading up to the 2008 crash based on Michael Lewis’ book on the collapse of the subprime-mortgage market, a Standard & Poor’s analyst when criticized for giving out triple A-ratings to triple-Z loans, said, “If we don’t give ]the banks] what they want, they will go to Moody’s.

Credit rating agencies have been profiting by selling investment-grade ratings to companies. Despite the risk of a bubble bust from inflated home prices in the United States, they rewarded high ratings to subprime mortgage securities. When crisis loomed, they degraded them to junk bonds. The party that was expected to provide an objective third eye to add balance in the information feed ended up only distorting the market.

The local industry is no exception. Raters have been blamed for the Tongyang Securities crisis in 2013 and partly for the troubles stemming from the shipbuilding and shipping sector. The government is reportedly studying measures to strengthen the integrity of the rating industry.

Rating on individual companies without consideration of financial support from a parent company or group, licenses to a fourth rating company to ease excess from a three-player system, and rating systems independent of the bond issuer are some of the measures under consideration. There are several prerequisites to improve the reliability of credit ratings and ensure balance in information.

First of all, conflicts of interest must be prevented by addressing the business model of credit-rating companies. Currently the bond issuer pays credit-rating companies for rating on its debt. The rating company inevitably must consider its corporate client position in its rating.
Until the early 1970s, the big three – Moody’s, Standard & Poor’s and Fitch – ran their business on subscriptions, providing their corporate information to investors upon payment. When rating information became more accessible through fax and copies, issuers became the client for rating agencies instead of the investors.

For objective rating information, recipients should be the ones paying for the information. This is particularly so for Koreans who tend to be stingy on rewarding services. But few want to pay unless the information is worth the money. The rating agencies therefore must be able to provide even the information that companies prefer not to share.

Second, to ease the asymmetry in information, the bond market must become as efficient and informed as the stock counterpart. New information is immediately reflected in the stock market, which isn’t the case for the bond market. When Enron was swept up in an accounting fraud scandal, sending its stock prices tumbling for weeks, its debt rating remained at investment grade until four days before the company went bankrupt.

In Korea, even as share prices of Hyundai Merchant Marine and Hanjin Shipping nosedived to be worth a third of what they were in the early 2010s, their debt kept an “A” investment grade.

Ratings companies should be made to re-evaluate debt of a company whose stock price undergoes a sharp swing so that investors become knowledgeable to the true conditions of the issuer and outlook on the bonds.

Translation by the Korea JoongAng Daily

JoongAng Ilbo, Aug. 12, Page 35

*The author is chief executive of KORAMCO Asset Management.

Lee Hyun-seung
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