Chapter 9. More Failed Monitors : Credit Rating Agencies and Lawyers
While the media has mostly concentrated on the failures of the executives, accountants , and analysts, we would be remiss if we didn't mention the failure of two other potential monitors: credit rating agencies and corporate lawyers. Both the credit agencies and attorneys should be considered as monitors in the corporate system. While corporate lawyers are hired and paid by the company executives, their fiduciary duty is to the corporation. It seems that most corporate attorneys have been more devoted to the executives than to the shareholders. One difference between credit agencies and other monitors is that they focus on protecting a company's bondholders and other creditors. This chapter details the role of credit agencies and lawyers in the corporate system and examines how credit agencies might have played a role in the business scandals.
Credit Rating Agencies
The level of safety in a bond is very important to investors. The very best return a bondholder can get is to receive the interest payments and get the principle back. Therefore, bondholders focus on safety. Corporate bonds are given a safety rating so that you can tell if a firm's debt is safe or risky. At least one of three firms, Moody's Investors Service, Standard & Poor's, and Fitch Ratings, conduct a credit analysis and give a firm a grade. This grade tells investors how risky the bonds of the firm are.
A Brief Historical Perspective
To understand how the credit industry works and how important it is, a brief history is in order. John Moody invented credit ratings in 1909 when he published a manual of ratings on 200 railroads and their securities.  He made his money by charging investors for the book. By 1916, the Standard Company, the predecessor to Standard & Poor's, started rating bonds. Fitch started bond ratings in 1920. By the 1970s, photocopy equipment was so prevalent that too many investors were obtaining the ratings without paying for the published books. However, the demand for the ratings was so great that the rating companies were able to give the ratings to investors for free and earn money by charging the bond issuers fees to rate their bonds.
After the stock market crash of 1929 and the following Great Depression, the government was looking for ways to restore confidence in the banking system. The securities acts of 1933 and 1934 went a long way toward increasing regulation of the banking and securities industries. These laws are discussed in Chapter 7. However, in 1936, the government expanded the role of credit ratings by requiring that commercial banks only hold high-quality debt. Specifically, the U.S. Comptroller of the Currency decreed that the banks could only own "investment-grade" bonds. The categories of ratings are illustrated in the next section. Because one large and influential type of investor (commercial banks) needed credit ratings on securities in order to buy them, all bond issuers wanted to be rated. Today, anyone who wants to issue debt securities in the United States needs to get them rated. This applies to companies, state and local governments, and even foreign governments .
This fee arrangement creates a conflict of interest. While a credit rating is supposed to help investors understand the riskiness of a bond issue, it is the company that pays the bill. In other words, a company planning a bond issue could discuss it with several credit agencies and see which one would rate it at the highest grade. A high-quality rating for a company means that it could offer bonds at a low interest rate and still easily sell them all. A lower-quality rating would require offering the bonds at a higher interest rate. A lower rating would cost the firm millions of dollars more in interest payments. Unscrupulous rating agencies could sell high ratings to firms that were willing to pay higher fees to get them. In the wake of the 1975 scandalous bond default of Penn Central Corporation, the SEC designated three ratings agencies as the only ones that satisfy rating regulations. The three anointed agencies, called Nationally Recognized Statistical Rating Organizations, are Moody's, Standard and Poor's, and Fitch. The SEC later designated four more agencies as valid. However, mergers between the firms have left only the three original firms. Only having three agencies creates an uncompetitive environment for the industry.
The situation of having a small number of firms in the industry is called an oligopoly. The SEC rules protect the three firms from further competition by preventing any other firms from joining the industry. Other, small credit rating agencies have tried and failed to get the SEC designation. For example, Egan-Jones Rating Company rates debt securities. Since the SEC does not recognize it, debt issuers will not pay Egan-Jones to rate their securities. Therefore, the company must count on investor subscribers to generate revenue.  Sean Egan runs the small agency and cannot get the SEC designation until his firm is bigger, but the company cannot afford to get bigger without the designation.
With a lack of competition by new entrants, the three credit rating agencies operate in a very profitable business. The credit analysis process does not require expensive factories or machine tools. The low expenses and low level of competition lead to highly profitable business. Moody's profit margin is estimated to be 50 percent and Standard & Poor's' is closer to 30 percent. Regardless, these three firms have been immensely rewarded in the protected environment.
To assess the worthiness of companies' credit, the credit agencies employ financial analysts who examine a firm's financial position, business plan, and strategies. This means that the analysts carefully go over the public financial statements issued by the company. However, the SEC has also granted the agencies an exemption from disclosure rules so that companies can reveal non-public or sensitive information to the agencies in confidence. Companies are under no obligation to reveal special information, but they often do so in order to convince the agencies that their debt should be rated highly. Because of the importance of credit ratings, the credit analysts often get to directly question the CEO and other top executives when conducting a review of a company.
The rating systems of Moody's and Standard & Poor's are shown in Table 9-1. Notice that the two rating agencies have similar systems.  Although not shown in the table, both agencies can partition the ratings further. Moody's includes 1, 2, or 3 after the rating to show that the firm is near the bottom, middle, or top of the scale within the category. Standard & Poor's uses a “ or + sign. Consider two companies that want to borrow $1 billion by issuing bonds. The first company is rated in the "high quality" category by the rating agency. This firm will have to pay 6.9 percent (or $69 million) in interest every year. The second firm is rated "Non-Investment Grade" and would have to pay $99 million annually. This difference is substantial. Riskier companies pay higher interest.
If a company becomes financially stronger over time, the bond rating will also improve. Therefore, the interest rate demanded by investors will fall, as illustrated in the table. When interest rates fall, bond prices rise. So if a firm becomes safer, the price of its bonds will increase. This is what the bondholders desire . Alternatively, if the firm becomes riskier, bond prices fall. The worst-case scenario for a bondholder is for the issuing company to default on the bonds and file for bankruptcy protection. Bondholders typically receive only a small portion of their principal back if a firm defaults.
Table 9-1. Ratings of Bond Safety and Example Bond Yields
The ratings that the three main credit agencies issue have historically been good predictors of the default potential of a debt issuer. Only 0.5 percent of the firms rated at the highest level (best quality) default.  This percentage increases to only 1.3 percent for issuers rated as high quality. However, the increase in the default rate substantially increases to 19.5 percent in the non-investment grade bonds and 54.4 percent in the CCC category.
When a firm begins to struggle financially, the credit agencies begin to downgrade the ratings on its securities. A bond issue rated AAA “ might be downgraded to AA+ or even AA. If the business operations or cash position of the firm continues to decline, the rating could fall further. Each downgrade signals investors that the bonds are becoming riskier. In response, the price of the bonds declines and the investors experience a capital loss. The term investment-grade in the regulations is interpreted as ratings of BBB “ or higher. If a bond slips to BB+ or lower, it is not considered investment-grade. In fact, the popular term for non-investment grade bonds is junk bonds. For additional protection of a bondholder's principle, many modern debt offerings include a rule (or covenant) that requires the company to increase the interest payment made on the bonds if the rating slips to junk status. Some bond covenants require the company to pay back all the principle if the rating slips to junk. While this sounds like a good idea for bond investors, in practice it often triggers the very bankruptcy filing that bondholders are trying to avoid. A firm's debt is downgraded to junk bond status because the company is having some financial difficulty. If the firm suddenly owes higher interest payments or even hundreds of millions of dollars in principle, it is pushed into a more financially precarious position. The very covenants that try to protect the interest of bondholders can actually drive a company toward insolvency.
One of the criticisms of the credit agencies is that they have started to enter the consulting business. Being both consultants and credit raters creates a conflict of interest similar to the one that occurs when auditing firms are also consultants for a company. If the credit agency is earning lucrative fees consulting for a firm, it might not be able to give unbiased analysis of the firm's financial position. Just as auditing firms should not be allowed to audit companies for which they are acting as consultants, credit agencies should not rate the debt securities of companies they consult for.
The credit agencies have also been given the same First Amendment rights as the media. When disgruntled companies or investors have sued the credit agencies, agencies have been successful in using free speech protection as a defense. The combination of regulated protection from new competitors , exemptions from disclosure rules, and First Amendment protection in court make the credit agencies nearly invincible. That is, it is nearly impossible for market forces (like competition) or the court system to discipline them.
The credit rating agencies are also criticized for rating decisions on individual issuers. Take, for example, Moody's downgrade of Japan's government debt on May 31, 2002. The change in ratings took the grade down two notches to A2 from Aa3. Japanese government officials were furious at the move. They argued that Japan has the second largest economy in the world and the highest savings rate. The new debt rating suggests to investors that Japan's creditworthiness is on par with Israel, South Africa, Poland, and Cyprus, but is below that of Hungary, Botswana, Chile, and the Czech Republic.  Japanese officials argue that it is absurd for their ratings to be below that of developing countries where Japan provides economic assistance.
While the total record of the credit agencies is pretty good, they have made some dramatic mistakes. For example, the agencies completely missed the financial trouble and bankruptcy filing of Orange County, California, in 1994. In the early 1990s, the economic output of Orange County would have ranked it among the top ten countries in the world. By every standard, the county was one of the wealthiest in the United States. As such, the credit agencies rated the municipal bonds of the county as very safe ”a grade of AA “.
Much of the money raised with bond issues in the county and other places in California was invested by Orange County until it was needed to build the school, hospital or other project the capital was raised for. The county treasurer, Robert Citron, invested the funds. The investment of municipal money is usually done in very safe instruments. However, Citron was using some complicated interest rate derivative securities that carried higher risks.  Those risks became real to the county when it had to announce a "$1.5 billion paper loss" on December 1, 1994. On December 7, the county filed for bankruptcy protection. The credit rating agencies responded by downgrading many of the bonds from "high quality" to "close to default." That is quite a large downgrade! However, it was too late for bond investors. The agencies had rated the county as good investment-grade debt right up to the bankruptcy filing.
Another questionable call by the credit agencies occurred at the issuance of WorldCom bonds in May 2001. WorldCom issued an American record $11.9 billion of bonds, of which $10.1 billion was new financing. WorldCom, and the massive debt issue, was rated investment grade ”A3 by Moody's and BBB+ by Standard & Poor's.  The massive offering by WorldCom should have come with a robust analysis by the investment banks, as the underwriters, and the credit rating agencies.
One year later, in May 2002, the credit agencies downgraded WorldCom debt to junk bond status. The rationale behind the downgrade was that Worldcom's $30 billion in total debt was too high.  While this is true, why didn't the debt level concern the agencies in the previous year when WorldCom increased its debt by 50 percent with the massive bond issue? It seems incredulous that the agencies could have put their seal of approval on the giant bond issue and then use that same issue one year later as a reason to downgrade the company. It was the high rating given by the agencies that allowed WorldCom to borrow so much money in the first place. It was the very next month, on June 25, 2002, that WorldCom disclosed it had improperly booked $3.8 billion as capital investments instead of operating expenses over the previous five quarters . Several more billion dollars in accounting fraud was discovered over the next couple of months.
The credit agencies are not blameless in the corporate scandals. Indeed, their special relationship with companies allows them to get private information that other monitors, like independent analysts, might not receive. Of the outside monitors , credit rating agencies might have been in the best position to detect corporate fraud and warn investors. Yet, in some cases, they were one of the last to respond to the troubles. The collapse of Enron is a good example.
The decline in Enron's stock price should have been a big warning that something was amiss. The price was $90 per share in August 2000. By April 2001, the stock price had fallen to $60 per share. In the late summer, the price continued to fall to less than $40 per share. Even in November 2001, just before Enron declared bankruptcy, the stock was down to less than $5 per share. As it turned out, the credit agencies might have been more of an enabler than a watchdog.
The investment banking chapter illustrated how deeply involved JPMorgan Chase and Citigroup were with the Enron partnerships. The banks had raised capital for the partnerships used by Enron to falsify loans as profits. The banks had invested hundreds of millions of dollars of their own money in Enron and its associated partnerships. The banks knew that if Enron filed for bankruptcy protection, their losses would be enormous . The banks also knew that if the credit rating agencies were to downgrade Enron to non-investment grade status, at least $3.9 billion in debt repayment would be immediately required. Enron would be forced to declare itself insolvent.
On November 8, 2001, the news about the partnerships and the massive losses became public. The stock price was down to less than $10 per share. The banks needed to act quickly or take massive losses. On that day, Robert Rubin, the former Treasury secretary under the Clinton administration, called Peter Fisher. He asked Fisher, the current undersecretary of the Treasury, if he would talk with the credit agencies about the Enron situation.  Rubin wanted the credit agencies to work with Enron and the bankers to see if there was an alternative solution to an immediate downgrade. What was Rubin's interest? He was working for Citigroup, one of the bankers. Fisher rightly decided that it was not a good idea and did not make the calls.
Nevertheless, it appears that the SEC-designated credit agencies delayed in downgrading Enron to non-investment grade. At first, they merely downgraded the firm to the lowest levels of investment-grade ratings. Non-designated credit agencies like Egan-Jones downgraded Enron's debt to junk status, but the big three waited. Since companies seek a rating on debt they issue and investment banks help them issue the debt securities, banks and credit agencies frequently work together. The bankers may have used this relationship to convince the credit agencies to give them some time to save Enron. That is, the bankers wanted some time to get additional cash for Enron and even find a buyer for the company.
To locate a buyer, investment banks Merrill Lynch and JPMorgan just looked across town from the headquarters of Enron and found Dynegy. Enron and Dynegy executives went into negotiations for a merger during November 2001. If they could agree, Dynegy would infuse Enron with $1.5 billion of cash to tide them over until the final merger could take place. The credit rating agencies knew that if the merger did not take place, Enron would be in deep financial trouble. Yet, instead of communicating this enormous risk to bondholders via a downgrade to junk bond status, they waited. Given what the agencies knew, this was a big gamble for bondholders. If the merger went through, the financial situation would be improved, but if it didn't, Enron would likely go into bankruptcy. This might be the kind of risk that investors take in speculative stocks, but not in investment-grade bonds. The stock price had fallen to less than $5 per share. The credit rating agencies failed to warn investors how risky the situation had become.
On November 26, 2001, the Enron merger with Dynegy was dead. Enron was still discovering how vast the problems with the partnerships were becoming. Dynegy claimed that it wasn't being told about all the problems. No one could tell how much Enron was really worth. The designated credit rating agencies downgraded Enron to junk bond status on November 28, 2001. Enron's stock price fell to $0.61 per share. On December 2, 2001, Enron filed for bankruptcy protection. Bondholders had to wait in line at bankruptcy court with other creditors and hope to get some of their principle back.
In defense of their actions, the credit rating agencies claim that Enron executives lied to them. While this might be their defense, it is no excuse . The agencies have unusual access to executives, but it is not their job to believe what the CEO of a company says. It is their job to validate the information they receive and then analyze it to form their own conclusions. What good are they as independent monitors if they simply follow the lead of the company executives?
Summary of Credit Agency Problems
The credit agency's purpose is to be a monitor of debt issuers in the protection of public investors. However, the way the industry is structured creates a situation in which the agencies do not often deal with the investors whom they are protecting. Instead, they are paid by the debt issuers to give a rating. They work with the issuers and the investment bankers to obtain information about the debt issue. Most of their business relies on the interactions with corporate participants , not with investors. Over time, this situation may warp the agencies' best intentions and lead them into acting in the best interest of companies or bankers instead of investors. The Enron case is an example of this.
This may not be a big problem if other forces were able to monitor and discipline the agencies when they get off track. However, the government has made them a closed and uncompetitive industry. Therefore, typical market forces are not at work. In addition, the government does not regulate the industry. Lastly, they seem to have unusual immunity in the court system under the First Amendment that prevents investors from seeking damages when they make errors. The lack of disciplinary forces can make the agencies lax in their watchdog duties .
These problems may become even more important. The new Basel proposals for commercial bank capital requirements may use the type of ratings used by the credit agencies to assess the riskiness of a bank's entire portfolio.  Indeed, since the agencies' ratings on bonds tell these banks which ones they can buy, it is likely that the agencies will be involved with rating the portfolios.