Saterday Presentation 17 March

8/2/2019 Saterday Presentation 17 March

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Corporate Fiascos and the Roleof Credit Ratings Agencies

Case Presented by- Prashant Priyadarshi

Kuldeep Tiwary,harminder singh,jatinder singh


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Flash back in the past

In capital market history,credit rating agencies were relatively late to appear,being less than a century old.John Moody fonded the first rating agency in 1909

,in the United States ,which in comparison with other countries had a largeprivate bond market and an investing class clamoring for better information.

When the business of bond credit ratings by independent rating agenciesbegan in the United States early in the twentieth century,bond markets-and

capital markets generally-had already existed for at least threecenturies.Moreover,for at least two centuries,these old capital marketswere to an extent even global.That in itself indicates that agency creditratings are hardly an integral part of capital market history


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Credit Rating companies


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Introduction

A credit rating agency (CRA) is a company that assigns credit ratings for issuersof certain types of debt obligations as well as the debt instruments themselves.In some cases, the servicers of the underlying debt are also given ratings.

In most cases, the issuers of securities are companies, special purpose entities,state and local governments, non-profit organizations, or national governmentsissuing debt-like securities (i.e., bonds) that can be traded on a secondary market.

A credit rating for an issuer takes into consideration the issuer's credit worthiness(i.e., its ability to pay back a loan), and affects the interest rate applied to theparticular security being issued. (In contrast to CRAs, a company that issues creditscores for individual credit-worthiness is generally called a credit bureau orconsumer credit reporting agency.)


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FIRM GLOBAL SHARE INSURANCEINDUSTRY SHARE

S&P 40 30MOODYS 40 17FITCH 14 7A.M. BEST 14 44OTHER 2 2

Credit Rating Agencies


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USERS OF THE INFORMATION PROVIDED BY CREDIT RATINGAGENCIES

Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agenciesincrease the range of investment alternatives and provideindependent, easy-to-use measurements of relative credit risk; thisgenerally increases the efficiency of the market, lowering costs forboth borrowers and lenders.

This in turn increases the total supply of risk capital in the economy,leading to stronger growth. It also opens the capital markets tocategories of borrower who might otherwise be shut out altogether:small governments, startup companies, hospitals, and universities.


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Ratings use by bond issuers

Issuers rely on credit ratings as an independent verification of their own credit-worthinessand the resultant value of the instruments they issue. In most cases, a significant bondissuance must have at least one rating from a respected CRA for the issuance to besuccessful (without such a rating, the issuance may be undersubscribed or the priceoffered by investors too low for the issuer's purposes). Studies by the Bond Market

Association note that many institutional investors now prefer that a debt issuance have atleast three ratings.

Ratings use by investment banks and broker-dealers

Investment banks and broker-dealers also use credit ratings in calculating their own riskportfolios (i.e., the collective risk of all of their investments). Larger banks and broker-dealers conduct their own risk calculations, but rely on CRA ratings as a "check" (anddouble-check or triple-check) against their own analyses.


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Ratings use by government regulators

Regulators use credit ratings as well, or permit ratings to be used forregulatory purposes. For example, under the Basel II agreement of the BaselCommittee on Banking Supervision, banking regulators can allow banks touse credit ratings from certain approved CRAs (called "ECAIs], or "ExternalCredit Assessment Institutions") when calculating their net capital reserverequirements. In the United States, the Securities and ExchangeCommission (SEC) permits investment banks and broker-dealers to usecredit ratings from "Nationally Recognized Statistical Rating Organizations"(or "NRSROs") for similar purposes

Ratings use in structured finance

Credit rating agencies may also play a key role in structured financial transactions.Unlike a "typical" loan or bond issuance, where a borrower offers to pay a certainreturn on a loan, structured financial transactions may be viewed as either aseries of loans with different characteristics, or else a number of small loans of asimilar type packaged together into a series of "buckets" (with the "buckets" ordifferent loans called "tranches")


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RATINGS COMPARISON


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LIMITATIONS AND CRITICISM

The paradox of credit ratings

Credit ratings pose an interesting paradox.On one hand,credit ratings are enormouslyvaluable and important.Rating agencies have great market influence and even greatermarket capitalization.Credit rating changes are major news;rating agencies play amajor role in every sector of the fixed income market.Credit ratings purport to provideinvestors with valuable information they need to make informed decisions about

purchasing or selling bonds,and credit rating agencies seem to have impressivereputations.

Credit ratings and reputation:the dominant view

Indiviuals acquire reputations over time based on their behavior;if an individualsreputation improves,and other members of society begin to hold that individual inhigher esteem,that individual acquires a stock of reputational capital,a reserve of goodwill,which other partied rely on in transacting with the individual.Reputational capitalleads parties to include trust as a factor in their decision-making;trust enables partiesto reduce the costs of reaching agreement.


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The rating agencies have got off lightly from regulationso far

If credit rating agencies evaluated themselves in secret, they mightwell be upgrading their own outlooks. For much of the past yearthey were numbered among those most vulnerable to punishmentfor their role in the credit crisis, largely thanks to the generousratings they doled out on dubious mortgage-linked securities.


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Credit rating agencies do not downgrade companies promptly enough. Forexample, Enron's rating remained at investment grade four days before thecompany went bankrupt, despite the fact that credit rating agencies had beenaware of the company's problems for months.

Some finance scholars have documented in empirical studies that yield spreads

of corporate bonds start to expand as credit quality deteriorates but before arating downgrade, implying that the market often leads a downgrade andquestioning the informational value of credit ratings. This has led to suggestionsthat, rather than rely on CRA ratings in financial regulation, financial regulatorsshould instead require banks, broker-dealers and insurance firms (among others)to use credit spreads when calculating the risk in their portfolio.

Criticism


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Large corporate rating agencies have been criticized for having too familiar a relationship withcompany management, possibly opening themselves to undue influence or the vulnerability of beingmisled.These agencies meet frequently in person with the management of many companies, andadvise on actions the company should take to maintain a certain rating. Furthermore, becauseinformation about ratings changes from the larger CRAs can spread so quickly (by word of mouth,email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings.

The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for thatcompany would go up, but other contracts with financial institutions may be affected adversely,causing an increase in expenses and ensuing decrease in credit worthiness. In some cases, largeloans to companies contain a clause that makes the loan due in full if the companies' credit rating islowered beyond a certain point (usually a "speculative" or "junk bond" rating). The purpose of these

"ratings triggers" is to ensure that the bank is able to lay claim to a weak company's assets beforethe company declares bankruptcy and a receiver is appointed to divide up the claims against thecompany. The effect of such ratings triggers, however, can be devastating: under a worst-casescenario, once the company's debt is downgraded by a CRA, the company's loans become due infull; since the troubled company likely is incapable of paying all of these loans in full at once, it isforced into bankruptcy (a so-called "death spiral").


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Why Fraud is a Costly Business Problem

Fraud Losses Reduce NetIncome $ for $

If Profit Margin is 10%,Revenues Must Increase by10 times Losses to RecoverAffect on Net Income Losses. $1 Million

Revenue.$1 Billion

Fraud Robs Income

Revenues $100 100%Expenses 90 90%Net Income $ 10 10%Fraud 1Remaining $ 9

To restore income to $10,need $10 more dollars of

revenue to generate $1more dollar of income.


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Recent Financial Statement Frauds

Enron

WorldCom Adelphia

Global Crossing

Xerox

Qwest

Many others (Cendant, Lincoln Savings, ESM,Anicom, Waste Management, Sunbeam, etc.)


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Role of Credit Rating Agencies

The three major credit rating agenciesMoodys,

Standard & Poors and Fitch/IBCAreceived substantialfees from Enron Just weeks prior to Enrons bankruptcy filingafter most

of the negative news was out and Enrons stock wastrading for $3 per shareall three agencies still gaveinvestment grade ratings to Enrons debt.

These firms enjoy protection from outside competition andliability under U.S. securities laws.

Being rated as investment grade was necessary to makeSPEs work


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Advantage of credit rating Agency


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So Why Did Enron Happen?

Individual and collective greedcompany, its employees,

analysts, auditors, bankers, rating agencies andinvestorsdidnt want to believe the company looked toogood to be true

Atmosphere of market euphoria and corporate arrogance High risk deals that went sour Deceptive reporting practiceslack of transparency in

reporting financial affairs Unduly aggressive earnings targets and management

bonuses based on meeting targets Excessive interest in maintaining stock prices


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Will there be another Enron?

Yes Recent years have seen an increase in the number of financial

statement frauds 1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)

Incentives still there (Stock Options, etc.) No

Sarbanes-Oxley Bill contains many key provisions

Executive sign off Requirement to have internal controls Rules for accountants (mandatory audit partner rotation;

Oversight Board, limitations on services, etc.) Accountants are being much more careful


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Thank you

Documents

Saterday Presentation 17 March