Credit Ratings Agencies have been in the news a great deal in the wake of the collapse of Abil. The Moody’s decision to downgrade Capitec by two notches and then drop the rating of all SA’s Big Four banks drew sharp criticism, including from the SA Reserve Bank. Who are these agencies? What makes them so powerful? Futuregrowth’s Jason Lightfoot helps Biznews.com’s Alec Hogg with this Dummy’s Guide. – AHÂ
ALEC HOGG: This special podcast is brought to you by Futuregrowth Asset Management. Jason Lightfoot from Futuregrowth is with us on the line. There’s been a lot of talk lately about credit rating agencies, Jason. Not too many people know the background to them.  We know they’ve been around for a long time and they play an important part in the world’s financial system, but where do they come from?
JASON LIGHTFOOT: Alec, essentially, credit rating agencies serve a purpose of assisting borrowers to access capital from money from public capital markets. These ratings are issued by credit rating agencies. They range from various rating scales…from your Triple A’s, which the highest credit rating, right through to sub-investment grade debts, which falls below BBB-minus ratings. What they do is they conduct independent analysis and provide information around the creditworthiness of those borrowers to the buyers of such debt, to give the buyers a good sense of what the probability of default is of potential issuers of debt in the market.
ALEC HOGG: Whom would they employ? Who would go and work for credit rating agencies?
JASON LIGHTFOOT:  They employ a range of analysts who are deemed to be credit analysts and analyse the creditworthiness of the particular issuers as they come to them. A particular company will come through a credit rating agency to get a sense of their creditworthiness.
ALEC HOGG:Â Their business model: if I understand correctly, the organisation they go and do the credit rating on is the one who actually pays them.
JASON LIGHTFOOT: Yes, there is quite a conflict in that regard because the company looking for the rating is, in essence, paying for it. That’s correct.
ALEC HOGG: And so, if the company doesn’t like the rating that the ratings agency brings up…
JASON LIGHTFOOT: No, that’s the conflict. They could potentially say ‘we don’t like that particular rating. It’s too low in our minds. It’s going to result in a higher cost of borrowing for us. Let’s go to somebody else’.
ALEC HOGG: Okay, there are three that we know of: Moody’s, Fitch, and S&P. Are they all rated equally by someone like you who clearly, has to decide whether or not to believe the ratings that the put on companies?
JASON LIGHTFOOT: Regardless of who they are, they should… It’s more of an input into the investment process – very much akin to broker research and equity world – where it’s really an input/opinion. It’s not a hard and fast rule where you’d say that particular borrower is rated at a particular rating and that’s what it’s rated as. Obviously, one needs to find one’s own independent analysis to the creditworthiness of particular issuers.
ALEC HOGG: So if you see a Moody’s rating, you don’t necessarily believe that it’s accurate – one way or the other.
JASON LIGHTFOOT: As I said, yes, it’s merely an opinion. It’s nothing more than that.
ALEC HOGG: So much is made of them. Every time a rating agency comes out on a sovereign rating for example, on South Africa and they decide to drop their ratings of the country’s foreign debt, we all become panicked as a result of that. Should we be taking this more in our stride?
JASON LIGHTFOOT: It is a concern on the exchange rating from a sovereign point of view because that results in an increase in the cost of borrowing for that particular institute. It obviously has impact on the Rand as an example, so it does have a knock-on effect.
ALEC HOGG: If you look at South Africa’s current sovereign rating, where do we stand? Are they all equal – Fitch, S&P and Moody’s?
JASON LIGHTFOOT: Some of them are bad. If you look at S&P, they have South Africa’s rating as BBB-minus as opposed to Moody’s, which has it as BBB-flat. They obviously have different views and it’s all based on sluggish outlook on the economy, reduced tax collections, structural issues, concerns on labour, and the economic reforms etcetera.
ALEC HOGG: How big a difference is it then from Moody’s at BBB-plus and S&P on a BBB-minus. It seems as though it’s three different levels. Is it that relevant?
JASON LIGHTFOOT: It is in the same sort of band, but if you look at the S&P rating (BBB-minus), which is at investment grade, the next level is sub-investment grade so that’s going to have potentially severe impacts for the sovereign from a borrowing point of view if they should bond to the foreign market.
ALEC HOGG: But if S&P drops it below investment grade, that doesn’t necessarily mean that Moody’s and Fitch would, as well.
JASON LIGHTFOOT: No, it’s not likely. They look at things in various/different lights, but it will have an impact because if S&P are regarded as one of the top rating agencies. They’re all probably rated in an equal sense, but if I had to rate them, Moody’s would probably be up there.
ALEC HOGG: I’m sorry. If you had to rate them, would you say Moody’s is…?
JASON LIGHTFOOT: Yes, I’d say they’re probably on an equal standing, but they look at various things so different investors around the world will probably hold various opinions in higher regard. For example, the guys in the U.S. might prefer S&P versus the European investors who might prefer Moody’s.
ALEC HOGG: We did have that difference in opinion, didn’t we, over Capitec for instance, where the one came out and said ‘we think Capitec now needs to be downgraded two notches’ whereas another came out and said ‘no, we think Capitec is absolutely fine’.
JASON LIGHTFOOT: That’s correct, yes. Moody’s downgraded them down to BBB-plus, in fact. That was actually based on the whole Abil thing, the haircut that the unsecured investors were about to receive, and the fact that the Reserve Bank wouldn’t necessarily bail out bondholders, going forward. That’s also the reason why the Big Four banks were downgraded as well.
ALEC HOGG: Abil’s an interesting point because if a credit rating agency is going to be the canary in the financial coalmine, perhaps they should have been chirping a little louder.
JASON LIGHTFOOT: Yes, that is a criticism they’ve received over the last couple of years, in that they are more reactive as opposed to being proactive – just downgrading post the events. We all obviously, saw the concerns during the sub-prime crisis where the so-called structures were rated AAA and they were in fact, not quite there. They should probably have been below investment grade, given the fact that the underlying loans were sub-prime loans, and the underlying borrowers would be defaulting on their loans and they weren’t reacting on that bad news.
ALEC HOGG: It’s interesting. Sometimes people say democracy’s not a great system of government, but it’s the best we have. Is it a similar thing with ratings agencies? It’s not great, but there isn’t anything better at the moment.
JASON LIGHTFOOT: It is improving. We saw the Government recently, enacting the Credit Services Act, which to a certain degree, produces a higher standard of independence and diligence, and requires registration of ratings agencies. It goes hand-in-hand with having certain internal controls of conduct and compliance. To a certain extent, it is improving the role of credit rating agencies in the current environment.
ALEC HOGG: But your point that you made right in the beginning was ‘it’s not gospel’.
JASON LIGHTFOOT: It’s not gospel. It’s an input. It’s an opinion, really. Previously, in legislation, gold [inaudible 08:01], pension fund rules, as well as unit trust regulations had a requirement where investments from a nett point of view had to be officiated by a credit rating agency. Now that’s been taken away in its entirety, where investors have to take the subsequent hit themselves for ensuring that they understand the creditworthiness of the loans that they make.
ALEC HOGG: That’s interesting. How does it affect your life?
JASON LIGHTFOOT: Obviously, our view is that we’ve always been well suited to ensure that we are abreast of what the requirements are and what we need to be aware of in terms of assessing the creditworthiness of borrowers. Industry-wide, it’s resulted in investment firms having to ensure that they bulk up and that the analysts are brought up to speed in terms of valuing underlying risks.
ALEC HOGG: Whereas in the past, they might have outsourced that or delegated that responsibility to the ratings agency, they’re having to take more responsibility now.
JASON LIGHTFOOT: That’s pretty much, what was done in the past and particular if you look at the sub-prime crisis, investors were looking at the AAA rating – the highest rated quality to buy into our funds. To a certain extent, as teams, it’s a whole progression in terms of bringing people up to speed. To a certain extent, some investment firms will still rely on external ratings until that point where they’re obviously brought up to speed and have the internal capability to assess the risks.
ALEC HOGG: Insights from Jason Lightfoot from Futuregrowth. This special podcast was brought to you by Futuregrowth Asset Management.
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