Learn from the past

As far as I understand, Credit Ratings are a big deal in other markets. There have been many research papers published on questions like; do the credit rating actions have any impact on the stocks/market?, how does the stock markets react to these ratings announcements, etc. Some have conducted event-studies to understand the nexus between credit rating announcements (positive or negative) and the stock performance on the listed markets. A paper by Magdalena Grothe of European Central Bank themed, “Market Pricing of Credit Rating Signals” finds that “The results show that the effects of rating actions on market prices are significant and depend on the current state of the market. While during favourable market conditions rating actions are not crucial for market pricing, they become very significant in the periods of crisis”. Another study from our neighboring India suggests that credit rating downgrades cause considerable negative reactions while upgrades tend to result negligible positive response.  However, to my knowledge, it has not been an area researched in Sri Lanka.

Credit Ratings were a major subject of discussion in the aftermath of the GFC. Credit Ratings Agencies (CRAs) were also partly blamed as one of the contributors to the financial crisis. This video from the famous 2010 documentary movie Inside Job gives you some thoughts which were critical.

In this background, the discussion moved further ahead with a search for better alternatives to conventional credit ratings. However, to-date I do not see any major alternative gaining ground over conventional credit ratings which seem to prevail and discussion seems to have tapered away. Interestingly enough, the ratings agencies also have not come up with different solutions to counter the arguments against them. (may be they think that the existing system works or their business was not threatened as yet by any new methods suggested or by any alternative providers like Invictus, INCRA  and Trepp. However the chairman Mr Kamal Mustafa of Invictus claims that couple of CRAs approached them to be acquired). This paper discusses in great detail the drawbacks of issuer paid credit ratings, alternatives for issuer paid credit rating agencies and resiliency of issuer paid CRAs.

In fact this post is not going to be about the global credit ratings industry, but I wanted to look at certain developments that have taken place in the Sri Lankan credit ratings environment. Firstly, I will give a brief about the Credit Ratings Industry in Sri Lanka.

One million dollar industry

Currently, there are three recognized Credit Rating Agencies (CRAs) in Sri Lanka. Fitch Ratings Lanka, Lanka Rating Agency and ICRA Lanka are those. These market intermediaries are regulated by the Securities and Exchange Commission of Sri Lanka (SEC). Credit Rating is not a mandatory thing in Sri Lanka though it is mandated if an issuer looks to raise money via the listed bond market. Further, the investor community has also demanded rated products making it necessary for issuers to obtain credit rating (entity as well as instrument ratings) if they are to tap the securitized market, commercial paper market, etc.

As shown in the figures on the table (the data were extracted from Annual Reports of SEC) the industry has now grown to be a one million dollar industry. Over the last three years, total revenue of the industry grew from LKR35 million to LKR136 million. This is equivalent to over 90% annual growth rate. Even more noteworthy was the fact that the industry has emerged profitable over this same period and the margins are pretty good at around 34% PBT margin at present. Given the current activity level in the credit markets in Sri Lanka, I expect the industry revenues to double in 2014. This growth might come as a hurdle to maintaining integrity, independence, quality of work, etc due to pressure from issuers.

  

Frictions among issuers and CRA

In a new development in the ratings industry in Sri Lanka there were differences in opinions between issuers and the rating agencies. Consequently, Hayleys PLC and LOLC pulled out from the original agency and contracted another one (RAM Ratings Lanka now known as Lanka Rating Agency in the case of Hayleys PLC and ICRA Lanka  in the case of LOLC). It’s not the interesting thing, with the new contract the issuers were able to gain the same rating back. Similarly, late 2014 Softlogic Holdings PLC got downgraded by Fitch Ratings Lanka and they were able to regain the original rating from Lanka Rating Agency.

Thus, it appears to anyone that these subsequent ratings are inflated (or the contrary may be true, i.e., the former’s rating is deflated). Moreover, investors are left wondering who’s right or wrong, where the process is heading, etc. In fact, from my experience I know that some investors consider the ratings provided by these agencies as substandard.

I believe that either there is governance issues at corporate level (both issuer and CRA level) and/or rating agencies do not possess the required technical knowledge to understand the businesses and the industries they are evaluating.

Market seems to be ignoring rating actions

Another noteworthy thing about ratings actions is that market seems to ignore the information contained in the ratings announcements. This may be due to the fact that this was not new information to the market and/or the market behaves totally irrational.

Technically, a rating downgrade means that the entity’s risks have risen and as a result, from what I know, the investors required returns are higher now. As a result the intrinsic value of the entity goes down. Hence, theoretically this should result in a drop in price.

On 25 August 2014 (a week before rating downgrade) JKH.N000 was at LKR243.00. As of 3 September 2014 it was at LKR249.50. On the same date the Company got downgraded to AA+ from AAA by Fitch Rating Lanka. One of my colleagues was asking me whether the share would come down due to this bad news. (that was his reading of the market). I told him that it will go up as the Lankan market behaves very erratically. As predicted, it kept moving up and by 12 Sept 2014 it was at LKR259.50. See the price chart below.

Watch out! The impact could be shocking

Recently, there has been a rapid growth in issuances in the market. In 2013 and 2014, there were 30 and 24 listed debenture issuances respectively on Colombo Stock Exchange. These issuances have raised a staggering LKR131,258 million (c. USD1 billion) collectively. Growth in listed debentures is known but the asset backed, commercial paper segments are not known publicly. The size of this segment must also be significantly high.

As Dion Bongaerts of ECB quotes, “The IMF has estimated that the losses incurred on largely AAA rated structured products amount to $3.4trln globally”. IMF has given a good explanation as to what the systemic risks are of a rating crisis in a boom cycle and a bust cycle. In a global context, IMF finds that there has been about one rating crisis every three years in the twenty two year period before 2009.

Bottomline

CRAs are operating in a for-profit market. Hence, there is always space for one agency to capitalize over other as evidenced in Sri Lanka in the recent past. Frictions among issuer and rating agency gives another agency a chance to poach the issuer. This will always be the case as long as the ratings are issuer paid. Nevertheless, alternative models have not yet been able to challenge the conventional rating form. However a rating crisis can wield significant impact on the financial system. It is of utmost importance to avoid a rating crisis in Sri Lanka. The systemic risks of a rating crisis can go even beyond the losses incurred in the listed debenture market. Market participants can also become contributors to a good rating culture by acting rationally. Thus, news such as rating downgrade or even worse swapping CRAs to get the same rating in a downgrade situation can be penalized by requiring higher returns to commensurate with the higher level of risks.