It is necessary to set up an Indian public sector CRA to increase competition and provide benchmark standards, says Jaimini Bhagwati
On November 10, 2008 the credit default swap (CDS) spread for ICICI five-year senior US$ debt was around 8.3 per cent. That is, investors in ICICI debt seeking protection against an ICICI default would need to pay 8.3 per cent annually on the principal amount “insured” through a CDS contract (CDS spreads vary even on an intra-day basis depending on the market’s perception of a firm’s creditworthiness). On the same date, the State Bank of India’s (SBI) CDS spread for five-year senior US$ debt was about 4.5 per cent and for another public sector bank, namely the Bank of India (BoI) the comparable number was 5 per cent (Source: Bloomberg). Effectively, international credit markets view ICICI’s default risk as much higher than that of SBI or BoI.
In stark contrast to the market’s views on the creditworthiness of ICICI, in October, 2008 Standard and Poor’s (S&P) long-term foreign currency credit rating for ICICI stood at BBB- and the sovereign rating for India was also BBB. The Government of India (GoI) does not issue sovereign bonds in hard currencies and the interest rates on SBI’s Indian Rupee bonds are usually at least 0.8-1 per cent higher than that for comparable maturity GoI securities. Consequently, GoI should be rated much above ICICI. Incredibly, a year or so ago ICICI was rated higher than GoI. On an international across-time note, the current BBB- credit ratings for GoI and ICICI are much lower than the irresponsible AAA ratings which were provided by S&P and Moody’s for a variety of complex mortgage-backed securities (MBS) including collateralised debt obligations (CDOs).
A number of studies have been done on the relationship between Credit Default Swap (CDS) spreads and credit ratings. For example, this relationship was examined by John Hull, Mirela Predescu and Alan White of the University of Toronto in a 2004 article titled “The Relationship between CDS spreads, Bond Yields and Credit Rating Announcements”. This study found that widening CDS spreads were reflected in rating downgrades but if spreads tighten ratings do not move upwards as readily.
S&P, Moody’s and other credit rating agencies (CRAs) have been blamed for their contributory role in the on-going international financial crisis since the ratings for asset-backed securities were excessively generous. It is evident now that there was a conflict of interest between CRAs’ drive to increase their rating fee income and the objectivity with which they rated MBS.
To recapitulate, S&P and Moody’s are two US-based CRAs which have dominated global rating markets for a long time. And, S&P, Moody’s and Fitch are agencies which have been deemed by the US capital markets regulator Securities and Exchange Commission (SEC) as Nationally Recognised Statistical Rating Organisations (NRSRO). As NRSROs, these CRAs have a quasi-regulatory role and are required to disclose their methodologies.
In India, the Credit Rating Information Services of India Ltd (CRISIL) and Investment Information and Credit Rating Agency of India (ICRA) have captured most of the rating market. CRISIL is majority owned by S&P and ICRA’s largest shareholder is Moody’s.
On October 22, 2008 Deven Sharma, the S&P President testifying before the US House of Representatives Committee on Oversight and Government Reform, stated that “ratings are not recommendations for investment”. This is an extraordinary claim since CRAs assign ratings based on creditworthiness. Although individuals and firms should do their own due diligence, it is only to be expected that between alternative investment choices, if other considerations are the same, investors are likely to pick the higher rated ones.
In the same testimony, Deven Sharma also mentioned that “virtually no one anticipated what is occurring”. This statement is surprising given the evidence of the emails which were exchanged between CRA employees. For instance, it is understood that as early as December 15, 2006 an analytical manager in S&P’s collateralised debt obligation (CDO) group wrote to another senior manager in the same agency that the rating agencies continue to create an “even bigger monster — the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters”. Another email between rating agency staff stated that “our staffing (shortage) issues make it difficult to deliver the value that justifies our fees”. (Source: Summary Report of Issues Identified by the Securities and Exchange Commission Staff’s Examinations of Select Rating Agencies dated July 2008).
The CRAs have defended themselves against the charge that because they are paid by issuers they feel pressured to provide ratings which are higher than warranted. However, Jerome S Fons, who was the managing director for credit policy at Moody’s until 2007, told the US House Committee on Oversight and Government Reform that “the securities’ issuers pay the agencies to issue ratings, and the agencies’ interests can eclipse those of investors”. In this context, CRISIL and ICRA have not attracted adverse attention since Indian asset-backed securities’ markets remain underdeveloped and even plain vanilla corporate debt markets have not progressed much. Hence, now is the time to take anticipatory action to prevent a divergence in the interests of CRAs and those of investors.
One of the reasons why CRAs have been found wanting is that S&P and Moody’s are in duopoly in most financial markets and a corrective measure would be to increase the level of competition. Higher competition and a better balance between income maximisation and investors’ interests could be achieved in India by the setting up of a majority government owned CRA. It is high time that benchmarks are set for the credit rating function since it provides critically important inputs for debt and equity issuance and investment activities. A public sector CRA should be conservative in its creditworthiness assessments and provide guidelines for investors on how best to interpret its credit ratings.
To summarise, for CRAs there is a near duopoly situation internationally and in India. The ratings provided by private sector CRAs have been inconsistent with market signals and rating agencies have pushed for higher earnings at the cost of investor interests. Further, it is likely that if this quasi-regulatory function is left exclusively to private sector CRAs, ratings would continue to be governed by profit maximisation considerations. It follows that it is necessary to set up an Indian public sector CRA to increase competition and provide benchmark standards.
The author is India’s Ambassador to Belgium, Luxembourg and the European Union. Views expressed are personal