The Rating Agencies and Their Credit Ratings: What They Are, How They Work and Why They are Relevant (Wiley Finance): 661 - Hardcover

Langohr, Herwig; Langohr, Patricia

Hardcover

ISBN 10: 0470018003 ISBN 13: 9780470018002

Publisher: Wiley, 2009

Synopsis

Credit rating agencies play a critical role in capital markets, guiding the asset allocation of institutional investors as private capital moves freely around the world in search of the best trade-off between risk and return. However, they have also been strongly criticised for failing to spot the Asian crisis in the early 1990s, the Enron, WorldCom and Parmalat collapses in the early 2000s and finally for their ratings of subprime-related structured finance instruments and their role in the current financial crisis.

This book is a guide to ratings, the ratings industry and the mechanics and economics of obtaining a rating. It sheds light on the role that the agencies play in the international financial markets. It avoids the sensationalist approach often associated with studies of rating scandals and the financial crisis, and instead provides an objective and critical analysis of the business of ratings. The book will be of practical use to any individual who has to deal with ratings and the ratings industry in their day-to-day job.

Reviews

"Rating agencies fulfil an important role in the capital markets, but given their power, they are frequently the object of criticism.  Some of it is justified but most of it portrays a lack of understanding of their business.  In their book The Rating Agencies and their Credit Ratings, Herwig and Patricia Langohr provide an excellent economic background to the role of rating agencies and also a thorough understanding of their business and the problems they face.  I recommend this book to all those who have an interest in this somewhat arcane but extremely important area."
-Robin Monro-Davies, Former CEO, Fitch Ratings.

"At a time of unprecedented public and political scrutiny of the effectiveness and indeed the basic business model of the Credit Rating industry, and heightened concerns regarding the transparency and accountability of the leading agencies, this book provides a commendably comprehensive overview, and should provide invaluable assistance in the ongoing debate."
-Rupert Atkinson, Managing Director, Head of Credit Advisory Group, Morgan Stanley and member of the SIFMA Rating Agency Task Force

"The Langohrs have provided useful information in a field where one frequently finds only opinions or misconceptions. They supply a firm base from which to understand changes now underway. A well-read copy of this monograph should be close to the desk of every investor, issuer and financial regulator, legislator or commentator."
-John Grout, Policy and Technical Director, The Association of Corporate Treasurers

 

About this title

About the Author

HERWIG LANGOHR was Professor of Finance and Banking at INSEAD, in Fontainebleau, France, which he joined in 1976, specialising in corporate finance, financial services and corporate governance. Professor Langohr served on several boards of directors, including the Board of Directors and the Audit Committee of the financial services group KBC Group N.V. He was also a regular advisor in corporate finance and strategy in the banking sector. He contributed to academic journals such as The Journal of Monetary Economics, The Journal of Financial Economics and The Journal of Money, Credit and Banking and a number of professional journals. He passed away on 28 May 2008 at the age of 64.

PATRICIA LANGOHR is Professor of Economics at the ESSEC Business School, in Cergy, France, since 2005. Her research specializes in industrial organization, dynamic models of competition and the financial services industry. Prior to that, she was a researcher at the Bureau of Labor Statistics in Washington D.C. Professor Langohr obtained her PhD in Managerial Economics from Kellogg at Northwestern University. She has a Diploma in Economics from the Humboldt Universität in Berlin and a Maîtrise in Monetary Economics and Banking from the Université Paris IX Dauphine.

From the Back Cover

Credit ratings have become a universal phenomenon throughout the capital markets, relied upon by investors, issuers and regulators alike. Issuers understand the fundamental effect of their rating on financing costs, and investors make buying (and selling) decisions based heavily on these scores. Regulators have incorporated credit ratings into everything from allowable investment alternatives for institutional investors to required capital for global banking firms.

Credit rating agencies and their output are vital in overcoming the information asymmetries of the capital market. The Rating Agencies and their Credit Ratings is a comprehensive explanation of what they are, how they function and why they are relevant, addressing a broad range of issues from the credit rating process and the performance of credit ratings, to the nature of competition in the credit rating industry and its regulation.

The book is organised into three distinct sections. Part A provides an introduction to credit ratings, their broad and diverse applications, and describes the credit rating process. Part B focuses on credit rating analysis, providing analysis of how rating actions and inactions interact with the market. Finally, Part C examines the credit rating industry, explaining where it comes from, what its main characteristics are, how the main players compete, and what results it produces for issuers, investors and shareholders.

Written by experienced Professors Herwig Langohr and Patricia Langohr, this book provides a unique and exhaustive introduction to credit ratings, developing the reader’s understanding of credit ratings and the credit rating agencies that produce them. It combines breadth of perspective, substantiation of arguments and depth in reflection, provided by the analysis of extensive field interviews, academic research, rating agency data and regulatory hearings and testimony.

From the Inside Flap

Herwig Langohr was Professor of Finance and Banking at Insead, in Fontainebleau, France, which he joined in 1976, specialising in corporate finance, financial services and corporate governance. He visited numerous academic institutions such as The Wharton School, The Darden School and the Universität Konstanz (Germany). He was holder of the Goldschmidt Chair in Corporate Governance at the Solvay Business School (Brussels). Professor Langohr served on several boards of directors, in particular on the Board of Directors and the Audit Committee of both the financial services group KBC Group N.V. and KBC Insurance N.V. He was Dean MBA and member of the Executive Committee at INSEAD from 1993-1995. He was also a frequent director of Executive Programs and a regular advisor in corporate finance and strategy in the banking sector. He was a contributor to academic journals such as The Journal of Monetary Economics, The Journal of Financial Economics and The Journal of Money, Credit and Banking; to numerous professional journals and newspapers and a regular publisher of case studies. He passed away at the age of 64 on May 28^th 2008.

Patricia Langohr is Professor of Economics at the Essec Business School, in Cergy, France, since 2005. Her research specializes in industrial organization, dynamic models of competition and the financial services industry. She teaches microeconomics, industrial organization and business economics. Prior to that, she was a researcher at the Price and Index Number Research division of the Bureau of Labor Statistics in Washington D.C. Professor Langohr obtained her PhD in Managerial Economics and Strategy from the Kellogg School of Management at Northwestern University in December 2003. She has a Diploma in Economics from the Humboldt Universität in Berlin and a Maîtrise in Monetary Economics and Banking from the Université Paris IX Dauphine.

Excerpt. © Reprinted by permission. All rights reserved.

The Rating Agencies and Their Credit Ratings

What They are, How They Work, and Why They are RelevantBy Herwig Langohr Patricia Langohr

John Wiley & Sons

Copyright © 2008 Herwig Langohr and Patricia Langohr
All right reserved.
ISBN: 978-0-470-01800-2

Chapter One

Introduction

Not all that glitters is gold. Often have you heard that told. Shakespeare: The Merchant of Venice.

1.1 CONTEXT AND PREMISES

1.1.1 The Benchmarking of Default Prospects Remains Deeply Rooted in Business Analysis

There is not in this country ... a central point at which all companies are required to present annual statements of their affairs. It is not uncommon for leading companies to publish no reports whatsoever. Some make them unwillingly, with no design to convey information upon the subjects to which they relate. Results that are full and explicit are accessible only to a small number of parties interested. Fewer still have the means of comparing results for consecutive years, without which it is impossible to form a correct opinion as to the manner in which the work has been conducted or of its present or prospective value.

Henry Varnum Poor rendered the description above in 1860. He was editor of The American Railroad Journal. The country was the United States. The audience was a group of London-based investors being asked to fund infrastructure growth in the United States without a hint of the risks involved.

Poor's purpose was to alert investors to the need to be informed about default risks involved in lending money. Many of the London-based investors lost vast amounts of money when railroad and canal companies that they financed went bankrupt - as any investor today loses on average 65% of the face value of a bond when it defaults. Henry Poor went on to say that:

what is wanted is a work which shall embody ... a statement of the organization and condition of all our companies, and at the same time present a history of their operations from year to year which would necessarily reflect the character of their management, the extent and value of their business, and supply abundant illustrations with which to compare similar enterprises that might be made the subject of investigation and inquiry.

Three types of businesses emerged in the 19th century to publish reports that enabled investors to make better-educated investment decisions and to, directly or indirectly, pressure obligors to respect their obligations - the specialized financial press, credit reporting agencies, and investment bankers. One of the first specialized business publications on record was The American Railroad Journal, which was started in 1832. Henry Poor transformed it into a publication for investors in railroads when he became its editor in 1849. To fill the gap he had identified, Poor eventually created his own firm. It embarked upon collecting operating and financial statistics on US railroad companies. The company started publishing the results annually in 1868 as the Manual of the Railroads of the United States. One of the first credit reporting agencies, founded in 1841, was The Mercantile Agency. Through a network of agents, it gathered information on the business standing and creditworthiness of businesses all over the US, and sold its service to subscribers. The merchant banker was of course the consummate insider, insisting that securities issuers provide all relevant information related to company operations on an ongoing basis, sometimes insisting on being on the board for that purpose. One of their hallmarks was also that they 'vouched for the securities they sponsored', as had already happened in 1835-1845 when the debts of several American States had been restructured.

The foundations of these businesses lay in their grasp of the issuer's business in its competitive environment, so credit analysis originated as business analysis. It focused strongly on the quality of the portfolio of opportunities that companies were actually pursuing, on the success with which management was pursuing them, on the ability to respect the debt obligations that the companies had incurred to finance their development, and on the character of the management to be willing to honor them. These businesses formed the information infrastructure in which the bond markets expanded in the 19th century. The fact that business reporting and financial statements are vastly better today in many parts of the world than they were in 1860 is in no small part due to the activities of these 19th-century businesses, which predated the CRAs.

In 1909, John Moody initiated agency bond ratings in the US, marking the expansion of business analysis to include credit risk analysis for rating purposes. Originally, this only covered the bonded debt of the US railroad companies. The purpose of the analysis became more targeted toward rating an issuer's relative credit quality, but the foundations of the ratings continued to focus on the issuer's business fundamentals.

Rating actions in the automobile industry highlight the extent to which ratings continue to focus on business fundamentals. As an example, consider S&P's December 12, 2005, downgrade of General Motors (GM) corporate credit to B, affecting $285 billion. Exhibit 1.1 reproduces the action announcement in extenso. Summing it up, note how S&P refers at length to GM's business position as the key driver of the downgrade. S&P emphasizes the point by going out of its way to remind investors that GM's liquidity position and borrowing capacity give it substantial staying power. But that power is limited by GM's ability to generate positive free cash flow (FCF), and that ability is currently impaired due to the difficulties in turning around the performance of GM's North American automotive operations. S&P explains that GM suffers from meaningful market share erosion related to a marked deterioration of its product mix, despite concerted efforts to improve the appeal of its product offerings. S&P also refers to the aging of GM's SUV models. Credit rating is, and remains, thus deeply rooted in business analysis. No spreadsheet ratings can replace this.

Exhibit 1.1 S&P Research Update: General Motors Corp. Corporate Credit Rating cut to 'B'; Off Credit Watch; Outlook Negative (December 12, 2005)

Credit Rating: B/Negative/B-3

Rationale

On December 12, 2005, Standard & Poor's Ratings Services lowered its corporate credit rating on General Motors Corp. (GM) to 'B' from 'BB-' and its short-term rating to 'B-3' from 'B-2' and removed them from Credit Watch, where they were placed on October 3, 2005, with negative implications. The outlook is negative. (The 'BB/B-1' ratings on General Motors Acceptance Corp. [GMAC] and the 'BBB-/A-3' ratings on Residential Capital Corp. [ResCap] remain on Credit Watch with developing implications, reflecting the potential that GM could sell a controlling interest in GMAC to a highly rated financial institution.) Consolidated debt outstanding totaled $285 billion at September 30, 2005.

The downgrade reflects our increased skepticism about GM's ability to turn around the performance of its North American automotive operations. If recent trends persist, GM could ultimately need to restructure its obligations (including its debt and contractual obligations), despite its currently substantial liquidity and management's statements that it has no intention of filing for bankruptcy.

GM has suffered meaningful market share erosion in the US this year, despite prior concerted efforts to improve the appeal of its product offerings. At the same time, the company has experienced marked deterioration of its product mix, given precipitous weakening of sales of its midsize and large SUVs, products that had been highly disproportionate contributors to GM's earnings. This product mix deterioration has partly reflected the aging of GM's SUV models, but with SUV demand having plummeted industry wide, particularly during the second half of 2005, it is now dubious whether GM's new models, set to be introduced over the next year, can be counted on to help to restore the company's North American operations to profitability.

In addition, GM is paring the product scope of its brands. The company has also announced recently that it will be undertaking yet another significant round of production capacity cuts and workforce rationalization. But the benefits of such measures could be undermined unless its market share stabilizes without the company's resorting again to ruinous price discounting.

One recent positive development for GM has been the negotiation of an agreement with the United Auto Workers providing for reduced health care costs. Yet, this agreement (which is pending court approval) will only partly address the competitive disadvantage posed by GM's health care burden. Moreover, cash savings would only be realized beginning in 2008 because GM has agreed to make $2 billion of contributions to a newly formed VEBA trust during 2006 and 2007. It remains to be seen whether GM will be able to garner further meaningful concessions in its 2007 labor negotiations.

This year has witnessed a stunning collapse of GM's financial performance compared with 2004 and initial expectations for 2005. In light of results through the first nine months of 2005, we believe that the full-year net loss of GM's North American operations could approach a massive $5 billion (before substantial impairment and restructuring charges) and that the company's consolidated net loss could total about $3 billion (before special items). With nine-month 2005 cash outflow from automotive operations a negative $6.6 billion (after capital expenditures, but excluding GMAC), we expect full-year 2005 negative cash flow from automotive operations to be substantial. GMAC's cash generation has only partly mitigated the effect of these losses on GM's liquidity.

Deterioration of GM's credit quality has limited GMAC's funding capabilities. On October 17, 2005, GM announced that it was considering selling a controlling interest in GMAC to restore the latter's investment-grade rating. GM recently indicated that it is holding talks with potential investors. As we have stated previously, we view an investment-grade rating for GMAC as feasible if GM sells a majority stake in GMAC to a highly rated financial institution that has a long-range strategic commitment to the automotive finance sector. Even then, GMAC still would be exposed to risks stemming from its role as a provider of funding support to GM's dealers and retail customers. However, we believe a strategic majority owner would cause GMAC to adopt a defensive underwriting posture by curtailing its funding support of GM's business if that business were perceived to pose heightened risks to GMAC.

One key factor in achieving an investment-grade rating would be our conclusions about the extent to which financial support should be attributed to the strategic partner. We will continue to monitor GM's progress in this process and the potential for rating separation; however, if the timeframe for a transaction gets pushed out, or if there is further deterioration at GM, GMAC's rating could be lowered, perhaps to the same level as GM's. Ultimately, in the absence of a transaction that will significantly limit GM's ownership control over GMAC, the latter's ratings would be equalized again with GM's.

The ratings on ResCap are two notches above GMAC's, its direct parent, reflecting ResCap's ability to operate its mortgage businesses separately from GMAC's auto finance business, from which ResCap is partially insulated by financial covenants and governance provisions. However, we continue to link the ratings on ResCap with those on GMAC because of the latter's full ownership of ResCap. Consequently, should the ratings on GMAC be lowered, the ratings on ResCap would likewise be lowered by the same amount. Or, if the ratings on GMAC are raised, as explained above, ResCap's ratings also could be raised.

Short-Term Credit Factors

GM's short-term rating is 'B-3'; GMAC's rating is 'B-1.' GM's fundamental challenges are short- and long-term in nature. The rapid erosion in GM's near-term performance prospects points up its high operating leverage and the relative lack of predictability of near-term earnings and cash flow. Still, GM should not have any difficulty accommodating near-term cash requirements for the following reasons:

GM has a large liquidity position; cash, marketable securities, and $4.1 billion of readily available assets in its VEBA trust (which it could use to meet certain near-term benefit costs, thereby freeing up other cash) totaled $19.2 billion at September 30, 2005 (excluding GMAC), compared with loans payable in the 12 months starting September 30 of $1.5 billion.

As of September 30, 2005, GM had unrestricted access to a $5.6 billion committed bank credit facility expiring in June 2008, $700 million in committed credit facilities with various maturities, and uncommitted lines of credit of $1.2 billion. We are not aware of any financial covenants that appear problematic.

GM could save some cash by cutting the common dividend.

Under current regulations, GM faces neither ERISA-mandated pension fund contributions through this decade nor the need to make contributions to avoid Pension Benefit Guaranty Corp. variable-rate premiums. Its principal US pension plans are overfunded for financial reporting purposes. However, under certain pending legislative proposals, the size of GM's pension liability could increase for ERISA purposes.

Given the intense competitive pressures the company faces, GM has little leeway to curtail capital expenditures, which are budgeted at $8 billion for 2005.

GM has virtually no material individual, non-strategic, parent-level assets left that it could divest, excluding GMAC and its assets.

GM's liquidity could be bolstered by the sale of a portion of its ownership stake in GMAC, and we would expect sale proceeds to represent adequate compensation for the related loss of GMAC earnings and dividends. We assume that GM would retain such proceeds as cash or equivalents, or use them to reduce debt or debt-like liabilities. On the other hand, owing to GMAC's enhanced independence, we believe there is increased risk that, in certain circumstances, GMAC could curtail its funding support of GM's marketing operations, precipitating potential problems for GM.

For GMAC, the key element of its financial flexibility is its ability to use securitization and whole-loan sales as funding channels, and we believe the ABS and nascent whole-loan markets are now accommodating issuance by GMAC in the near term without materially affecting market pricing, but this remains a risk factor.

Consistent with the practices of its finance company peers, GMAC relies heavily on short-term debt, albeit less so than historically. As of September 30, 2005, GMAC's short-term debt totaled $85 billion (including current maturities of long-term debt and on-balance-sheet securitizations, but not including maturing off-balance-sheet securitizations). GMAC's unsecured bond spreads have been extraordinarily volatile and wide. Given current capital market conditions, GMAC is highly unlikely to issue any significant public term debt in the near term. Between likely persisting market jitters and the size limitations of the high-yield market, it is uncertain whether and to what extent GMAC will be able to access the public unsecured debt market economically.

GMAC's managed automotive loan and lease asset composition is highly liquid, given that about half of its total gross receivables is due within one year and that a substantial portion of receivables is typically repaid before contractual maturity dates. However, we take only limited comfort from this because GMAC is constrained in its ability to reduce the size of its automotive portfolio, given its need to support GM's marketing efforts.

Several factors support GMAC's liquidity:

As a first line of defence, GMAC has a large cash position - $24.3 billion at September 30, 2005 (including certain marketable securities with maturities greater than 90 days).

GMAC also has substantial bank credit facilities. As of September 30, 2005, it had about $49 billion of bank lines in addition to auto whole-loan capacity and conduit capacity, not all of which were committed lines. Of the $7.4 billion facility, $3.0 billion expires in June 2006 and $4.4 billion in June 2008. We are not aware of any rating-related triggers that will impede GMAC from accessing the committed facilities in the wake of the recent downgrades. There is a maximum leverage covenant of consolidated unsecured debt to total stockholders' equity of 11.0 to 1.0. At September 30, GMAC's actual leverage under the covenant was 7.3 to 1.0. The $7.4 billion facility was established largely for backup purposes, and we believe GMAC would be loathe to borrow under it except as a last resort.

Most of GMAC's unsecured automotive debt issues and borrowing arrangements include an identical, fairly strict negative pledge covenant. Subject to certain exceptions, the granting of any material security interest (other than through securitizations) would cause all unsecured automotive debt to become secured.

(Continues...)

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Edition details

• Publisher: Wiley
• Publication date: 2009
• ISBN 10: 0470018003
• ISBN 13: 9780470018002
• Binding: Hardcover
• Language: English
• Edition number: 1
• Number of pages: 528