The rating challenge

Amtek downgrade has lessons for the rating industry

Early this week, JP Morgan Asset Management, an asset manager for individuals and institutions, lifted the cap it had imposed on redemptions from two of its debt mutual fund schemes after a sharp fall in their net asset value. The withdrawal of the cap may signal that the immediate problems for investors are over. But the incident, nevertheless, highlights a far more serious problem for those who invest in debt instruments. What had prompted JP Morgan Asset Management to place the redemption cap was the sudden withdrawal of rating of troubled component maker Amtek Auto’s debt instrument, in which it had made investments. Another credit rating agency had cut its rating by 12 notches in one stroke. This was not an isolated event. Media reports have recounted several instances in the last one year of ratings being cut suddenly and sharply: Jaiprakash Associates, Bhushan Steel, Punj Lloyd, Monnet Ispat & Energy and Shree Renuka Sugars, among others.

Undoubtedly, the growing trend of rating downgrades adversely impacts investors in debt instruments. In such a situation, investors need to write down the value of their investments at one go after a sharp downgrade. A downward revision in rating also means either the analyst in the credit rating agency was not fully aware of what was happening or chose to ignore the information. Proxy advisory firms have raised this issue more than once. For listed companies, there is enough information available in the public domain, which can help credit rating agencies warn investors of any stress that may be building up. Their failure to do so is, therefore, troublesome.

To be fair to rating agencies, it is not possible to anticipate the future accurately, especially situations of extreme volatility. Macroeconomic factors as well as the industry outlook can change dramatically. As companies listed on stock exchanges need to get the ratings of their debt instruments revised every quarter, and the unlisted ones need to do so once a year, radical and sudden changes in ratings can happen because it is possible for the business scenario to alter within two quarters.

But when sharp revisions happen on a regular basis, the quality of the initial ratings is bound to be called into question. Some people have said that the payment model is at fault. The company pays the rating agency only after it accepts its rating. That could be one of the reasons for the high initial ratings and subsequent resets. Though credit rating agencies maintain that the compensation paid to the executives, who rate a company, is totally insulated from the fees paid by the company, there could be some substance in the observation. Many have advocated a switch to the “investor pays” model to solve this problem. However, it is a fact that investors, too, prefer high ratings because they help keep the value of their investments high. This, too, leads to a conflict of interest.

There are no easy answers to the imbroglio. In 2008, when the global financial meltdown happened, serious questions were raised on the expertise of credit rating agencies. After the Amtek Auto episode in India, the debate has been reignited. And this has happened in spite of the fact that it is actually possible to measure the outcome of a credit rating agency’s work: how many times was it able to predict a default accurately?