Saturday, 18 January 2020

Moody’s Investors Service President Responds to Criticism, but why now?

Today’s post will be concerned with Moody’s. We will look at a recent article in the Financial Times, and the surprising response to it from the President of Moody’s Investors Service, the rating arm of the Credit Rating Agency. What is surprising is that Michael West responded at all, because a. the rating agencies do not usually respond to such broad criticism, and b. there was really no need to. However, we shall see that there may well have been a need to, as recent geopolitical developments may prove to be a massive victory for the agency and it may be vital that the agency seeks to reassure the marketplace about its ability to be of use, and as impartial as possible.

 The original article in the Financial Times, an opinion piece by Patrick Jenkins entitled ‘Credit Ratings, like dodgy boilers, can still blow up the house’, offers very little other than the usual criticism of the credit rating model of the modern era. For example, Jenkins says that ‘whenever there is an asymmetry of knowledge… the scope for being ripped off is large’, following this with ‘the realm of credit ratings is more heavily stacked against the users than the flaky plumber of mechanic could even dream’. The basis of this is, according to Jenkins, that rating agencies ‘use essentially backward-looking methodologies… this approach also makes ratings pro-cyclical when things do go wrong’, and also that whilst some big bond investors have implemented their own in-house rating departments to negate the potentially negative effects of the conflicts of interest that plague the credit rating industry – he uses the example of Pimco -, ‘most debt investors cannot afford such an overhead’. He cites Scope Ratings, who we discussed recently, as an example of a new offering hoping to ‘shake up the model’, but concludes that on the basis of ineffective regulations and the settled fines which have proven to be ineffective, ‘rating agencies got off lightly’. This leads him to conclude that the outlook for the future of the relationship between agencies and marketplace is a ‘depressing’ one, because the agencies are reporting massive increases in revenues – quarterly results show that S&P’s net income rose by 25%, and Moody’s 22%. The reason for this growth, according to Jenkins, is because record-low interest rates are encouraging increased debt issuances – last year marked a new $2.6 trillion high for corporate bond issuances. However, the response from Michael West hints at another reason for the change in approach from the agency.

In a letter response entitled ‘Moody’s greatest asset is the quality and integrity of our credit ratings’, West starts by declaring that ‘I am writing to clarify important facts regarding Moody’s Investors Service’s credit ratings and their value to the market’. These so-called facts, according to West, are that the ratings are, in fact, ‘predictive, forward-looking opinions based on quantitative and qualitative analysis, combining empirical and statistical research with the credit judgments and opinions of experienced analysts’. He attaches to this the common line of the agencies that credit ratings are meant to be used alongside a broad range of analysis, not the sole basis of any investment decision. So, no surprises so far. He then declares that the agency is careful not to mix the rating and commercial elements of the business, although as we read yesterday with Morningstar, doing this in reality is extremely difficult to maintain. He then states the similarly common line that the issuer-pays remuneration model is actually a public good, rather than an area of real concern, as it makes ratings freely available to the public and allows the agencies to continue their business. This is joined by, almost naturally at this point, a criticism of the investor-pays model because ‘investors, like issuers, have a stake in the outcome of ratings’ and the model is subject to similar conflicts of interest. He concludes by confirming that ‘ultimately, the success of our business depends on trust in the independence of our ratings. Our greatest asset is the quality of our analysis, and this is reflected in the strong, long-term performance of our ratings as highly predictive of credit quality’. Now, before we move to the reason as to why West would have even bothered to reply, it is worth examining his statements and countering these ‘facts’. First, it is mostly true to say that the ratings are indeed forward-looking – reviewing the ratings shows us that they attempt to use a number of factors to predict the creditworthiness of a given entity or product. Fine. Second, whilst careful consideration may be given to the separation of raters and commercial officers, the reality is that this is both regulatory enforced, and they have fallen foul of this many times in the past and will, more than likely, fall foul of it again – it is an inherent conflict of interest. This is because of two elements: the structure of rating committees, and human psychology. Committees are supposed to be constructed so that every analyst has a fair vote in the rating process, but in reality they do contain senior officers who can, and have influenced the decision of the committee to go with what the agency needs, commercially. Also, a junior analyst is placed, fundamentally, in a difficult position when a more senior member of the organisation is present and voting – committees are simply not immune to commercial influence. Third, the criticism of the investors-pays model is based on broad, and incorrect assertions. To say that investors can asset pressure on the rating process just like issuers is not true, just based upon poor logic. To make the process commercially viable, the rating would have to be available to a number of investors, and those investors will not all be interested in the same portion of the rating, or may be utilising them for very different means, whereas issuers simply want the best rating they can for their issuance and/or debt position. In truth, the biggest issue with the investor-pays model is that you simply cannot derive the same revenues from it. Third, the accuracy of the credit ratings angle is true, but only from a corporate bond angle. The accuracy of the Big Two’s structured finance ratings are much lower when analysed historically. Lastly, the notion that Moody’s value is derived from their integrity and impartiality is very easy to counter – many onlookers have suggested that their ratings have very little informational value. The contention is that the value is derived from signalling to regulators or investors; that is it. For regulations, compliance can be monitored via ratings. For investors, an issuer’s creditworthiness can be signalled. However, for regular readers, all of this will not be of any major surprise. So, why has West chosen to respond.

There is no definitive answer of course, but one particular recent event may well provide an answer. This week President Trump signed the first phase of a Trade Deal with China. This deal, of course, contained plenty of elements but there is one in particular of interest. Yahoo Finance reported that ‘US credit rating firms are emerging as some of the winners in the trade deal signed between Washington and Beijing’. The reason for this is because the deal confirms that ‘China commits that it shall continue to allow US service suppliers, including wholly US owned credit rating service suppliers, to rate all types of domestic bonds sold to domestic and international investors’. I wrote an article recently on the changing face of Chinese credit rating provision after S&P became the first US rating agency to be allowed within China on its own basis, and it appears now that Moody’s has been given the green light to join them – as we expected. Moody’s CEO Ray McDaniel was in an unsurprisingly buoyant mood, declaring that ‘China has taken important steps on credit rating agency market opening… the US-China Phase I agreement acknowledges and enshrines those commitments in a bilateral trade agreement, which we support’. This trade deal, and the invitation to internationally-used credit rating agencies is a fundamental component to China’s plans to expand across the globe via their One Belt One Road initiative, which Yahoo Finance supposes has accelerated the opening of China’s $21 trillion capital market by up to 8 months. When President Trump was vehemently arguing that the US has ‘won’ during the negotiations, the reality is that China has gotten everything that it wanted, just in a longer-term fashion. However, for the agencies, it is almost akin to winning the lottery, and it is for this reason that West has chosen to respond. It is vital that Moody’s is considered to be impartial, fair, forward-looking, and most of all useful in this stage of its development – nothing can jeopardise the riches that will come with the opening of the Chinese capital markets. I expect to see much more of what is, essentially, an optics campaign, in the coming months and years because securing their position at the front of the queue can almost guarantee the company’s success moving forward. Though the market is dominated by the Big Two, Fitch are not an inconsequential player. Also, with Morningstar moving into fourth place with the acquisition of DBRS, the oligopolistic model does protect Moody’s but that protection is not absolute. Opinion writers would do well to expect responses from the rating agencies in the coming period.

Keywords – credit rating agencies, China, US, Business, @finregmatters

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