Credibility of Credit Rating Agencies - Research Paper Example

? Credibility of Credit Rating Agencies of the of the This research paper includes an in depth study ofvarious inter related topics which gives a good understanding of the globally connected financial industry. It explains various aspects of the financial industry and their resulting consequences. To start with, the role of the credit rating agencies in the 2007-08 global financial crises has been discussed in details. This part explained how the rating system of these agencies was influenced by hefty incentives and how that triggered the 2007-08 financial crises. This part of the study suggested why the credibility of credit rating agencies came into the scrutiny. Following that, a detailed study was done regarding the agency costs and its effects on the value of a company. It was seen that, agency cost mostly arises due to the principal agent problem. The principal agent problem is nothing but the situation that is characterized by a conflict of interest between the principal and the agent who are the managers and the shareholder respectively. This conflict of interests leads to agency costs and thereby decreases the value of a firm. Thereafter, the information asymmetry and its implications on the financial services industry have been explained. It has been seen that this factor has led to severe economic downturns in the recent times. One such example was the 2007-08 financial crises where huge extent of information asymmetry existed between the financial institutions and their potential investors which acted as a catalyst triggering the financial crisis. The following sections explained the reason for the credit crunch and its implications in the economy of Qatar. It was reported that Qatar was expected to be resilient to the global financial crisis. Thereafter a final conclusion has been provided. Table of Contents Introduction 4 Credit Rating Agencies and the financial crisis 4 Agency costs and its effects on firm value 5 Consequences of information asymmetries in financial markets 6 Reasons for the credit crunch 7 Implications on Qatar’s economy 8 Conclusion 9 References 10 Introduction The spectacular development in the structured finance market before the 2007-08 financial crisis was only possible because collateral debt obligation (CDO) tranches offered an ostensibly attractive mixture of risk and return. Credit Rating agencies played a critical role by certifying most of the CDO tranches created by financial institutions with investment grade ratings that assured the potential investors about their safety. Furthermore, CDO tranches appealed more to the investors particularly because they offered higher returns compared to the similarly rated corporate bonds. The ratings which were certified to those CDOs appealed to the investors who assumed that the ratings represent a general and vigorous indication of default risks (Griffin & Tang, 2011). However, the rating based approach failed completely in the year 2007-08 with the collapse of the CDO market. In fact the ratings were such inappropriately done that some of the triple-A rated CDO tranches lost 90% of their value and were consequently downgraded as junk (Wojtowicz, 2013). This idea will serve as the ground work of this research. The following sections will explain the involvement of the credit rating agencies in the 2007-08 global financial crisis and comments will be made regarding the credibility of these agencies. These facts will be related to agency costs and the effects of such agency cost on the value of the firm will be explained. Thereafter, another topic that will be described in detail is information asymmetry and its consequences in the financial markets. Finally the reasons for the credit crunch and its implication on Qatar’s economy will be discussed followed with a conclusion. Credit Rating Agencies and the financial crisis The rapid development of the international financial markets over the last two decades would have been impossible without the credit rating agencies. The availability of clear and internationally accepted markers of the risk of default prompted the investors to invest in international securities whether corporate or government bonds. Without the certified credit ratings the investors would not be able to assess the credit quality of these international securities on their own. The credit rating agencies have been working for decades in order to formulate a simple and readily understandable system through which investors would be able to invest in securities which they are not familiar about. As far as the corporate and government bonds are concerned, the credit rating system had been largely successful thereby enabling investors to diversify their portfolios (Utzig, 2010). However, the scenario changes completely in during the 2007-08 subprime mortgage crises. The ratings provided the credit rating agencies played a critical role in the marketing of risky mortgage backed securities such as the collateral debt obligations that brought the US financial services industry into its knees. The investment banks bundled chunks of individual mortgages which were hard to trade by themselves. These mortgages were bundled into tranches that could be traded (bought and sold) just like any other bonds. These financial instruments were thereafter sold to investors. However, in order to market these products in front of the investor pool, the financial institutions counted on the ratings that the instruments received from the credit rating agencies in order to tempt the investors who were seeking for greater return. The failures of the credit rating agencies acted as a catalyst that led to the destruction of the US financial services industry and henceforth the economy of the country. The three credit rating agencies namely Standard & Poor's, Fitch Ratings and Moody's Investors Service enabled the financial meltdown. Attaining a top price for the securities was not the only reason. Receiving higher ratings for the financial instruments was just as important that allowed the investment banks to sell these products. The mortgage backed securities which were the locus of the crisis could not be marketed and sold had they not have received the seal of approval from the credit rating agencies mentioned above. Credit rating agencies made the mistake of assuming the likelihood of the recent financial history repeating itself. During the period of financial crises, Lehman Brother’s own debt still has an investment grade rating while they filed for Bankruptcy protection. The rating agencies made another mistake in rating structured debt products whose value was associated with the value of mortgages (Hull & White, 2010). One such structured debt product is the collateral debt obligations. The agencies assessed the recent trends in the housing market and finally concluded to base their worst case analysis on a 10% decline in the housing market. Thereafter the home prices fell drastically more than the set 10% decline in a worst case scenario. This demonstrates that the model implemented by the rating agencies were way too conservative. In addition to that, the factor that tempted credit rating agencies to give investment grade ratings to structured products which were not worthy at all are profit incentives. They were paid in huge amounts by debt issuing companies. The model created hefty incentives for agencies in order to influence them to bend their standard so as to gain business (Bar-Isaac & Shapiro, 2012). Structured debt products were potentially vulnerable to rating fluctuations for the sake of business. These products are likely to fail if the economy downturns and this gave the credit rating agencies a reason to say that the economic meltdown changes the facts that were promised before while the products were sold. Thus the products were created and the ratings were virtually bought by the investment banks that focused on increasing the short term profitability (Bolton, Freixas & Shapiro, 2012). Out of the 75% debt securities which were rated as being AAA by the agencies, more than 70% defaulted that triggered the economic meltdown. These facts put forward a big question to the credibility of the credit rating agencies. This is particularly because investors more often than not are inclined towards using the rating as a guiding tool while investing instead of doing their own due diligence. This stresses the importance of having a transparent mechanism whereby the rating agencies could provide appropriate rating to the structured debt instruments thereby enabling the investors to make proper and informed investments and henceforth upheld their integrity and credibility (Krantz, 2013). Agency costs and its effects on firm value Agency cost arises typically because of a conflict of interest between the managers and shareholders of a company. Shareholders expect the management run the company in such a way that maximises the value of the shareholders. However, a manager may choose to run the company in a way that safeguards their own personal interest thereby maximising their personal power and wealth which is not directed towards the best interest of the shareholders. The existence of information asymmetry between shareholders and the managers is the primary reason attributed to the principal-agent problem. The agent (manager) is working on behalf of the principal (shareholders) who is not apprised of the actions that are being taken by the agent and they are not aware of the repercussions of the actions that are being taken. This information asymmetry leads to adverse selection problems and moral hazards. The agency cost rises mainly due to the divergence of control, separation of ownership and contracting costs which significantly affect the value of a firm (Xiao & Zhao, 2012). Empirical researches have suggested that type II agency problems such as the agency conflicts controlling and minority shareholders affects a firm’s value significantly (La Porta, Lopez-de-Silanes & Shleifer, 1999). Xiao & Zhao (2012), who studied the severity of agency problems by excess control rights oif the ultimate controlling shareholders, explained that higher excesses controlled rights reduce the value of a firm significantly. Nam et al. (2006), who investigated the effect of agency costs on the value of single-segment and multi-segment firms, explained that there are number of references to agency cost which leads to value discounts of multi segmented firms. According to the authors managers choose to diversify in order to increase the size of the firm and to benefit from the prestige and power which they derive as a result of managing a larger firm. However, sometimes managers choose to make these decisions irrespective of the opinions of the shareholders. This leads to a conflict of interest between the agents and the principals. If the diversification plans some becomes unsuccessful that significantly affects the value of a firm. Managers do sometimes diversify with a strong underlying idea and that is to mitigate risk from their non diversifiable human capital. However, shareholders sometimes do not perceive this as the right strategy and suggests the managers to refrain from doing so. In doing so, the company loses a prospective opportunity of diversification that would have reduced the risk exposure of the company significantly. Later the company’s value depreciates when they are actually exposed to certain degree of risks owing to this conflict of interest which is actually the agency cost. However, it has been witnessed quite often that managers diversify to entrench themselves and extract benefits from shareholders through investments that they design. This has often given rise to principal agent problems and is associated with the agency cost that the company bears which thereafter reduces the value of the firm. The authors have also concluded that multi segmented firms are more vulnerable to agency related to problems particularly because of their complexity in operations and management structures. Consequences of information asymmetries in financial markets The information asymmetry or ‘lemon’ problems arise from disparity in information and conflicting incentives between entrepreneurs and savers. The factors associated with this problem have the potential to lead to the malfunctioning of the financial market. Assuming the example of a situation where half the ideas laid out by a business are good and half of the business ideas are bad. Both the entrepreneurs and the investors are rational and the value investments are subjected to their own information (Flannery, Kwanb & Nimalendran, 2004). If the investors fail to perceive the difference between the good and the bad ideas, then the entrepreneurs having the bad ideas will try and claim that the ideas are as valuable as the good ones. Recognizing the possibility of such as situation, investors will vale both the ideas at an average level. Thus, if this information asymmetry is not fully resolved then the financial market will realistically undermine some good ideas and on the other hand overvalue some bad ideas with respect to the information available to the entrepreneurs (Healy & Palepu, 2001). This will severely break down the functioning of the capital market. This is one of the reasons that acted as a catalyst triggering the financial crisis (Liao et al., 2013). This is particularly because a huge extent of information asymmetry existed between the investment bank who designed the debt instruments and the investors who invested in those instruments relying over the ratings that were certified to those products by the rating agencies. The consequences of the asymmetric information syndrome in the financial market can be best understood in the sourcing of external funds by the corporations. Every corporation has to inexorably adopt the external source of funding while they prepare the combination of owners fund and the borrowed funds. The funds which are externally sourced however, comes with a condition that is to be complied by the parties involved in this transition. The condition is that both the parties will have to exchange relevant information with each other. However the question lies whether both the parties comply with this condition or not. The borrowing entity willingly or by force chooses to conceal vital information for making their case strong as a candidate seeking to obtain external source of finance. In order to make their case strong entities put s in lot of effort to conceal uncomfortable economic information regarding the real risk associated with this lending or the project to be invested into (Clarkson, Jacobsen & Batcheller, 2007). Consequently, this information asymmetry reduces the ability of the lending entity to forecast or assess the risks associated with the project. Thus, the viability and feasibility of the project is miscalculated owing to this information disparity. This information disparity leads to imperfect decision which has a cascading effect on the financial market thereby resulting in an economic crisis. The starting point of this economic meltdown can be traced back to the financial mess as a result of this imperfect information available within the market. This also shifts the priority in the way the borrowed funds are being utilized. This leads to a further increase in the cost of external finance as firms are starving for adequate funds in order to attain the predetermined rate of return on the investments made by those borrowed funds. Due to this increase in the cost of external finance, firms are forced to cross the safety limits of project viability. This leads to an unwanted increase in the costing due to the compounding of interest. Consequently the value of assets starts to depreciate which further leads to an increase in the count of nonperforming assets and bad debts. This further degrades the functionality of the financial market (Healy & Palepu, 2001). Reasons for the credit crunch The onset of the credit crunch can be traced back to the period when the US mortgage lenders started selling inappropriate mortgages to almost everybody regardless of their income and their creditworthiness. It was expected that with the booming housing market the mortgages will remain affordable. Due to excessive deregulation, mortgage brokers got paid for selling inappropriate mortgages. Incentives were designed in order to tempt the brokers to sell mortgages even if they were expensive and there was high chance of default. In order to sell greater number of subprime mortgages, the financial institutions bundled them into consolidated packages and sold to other financial companies. The mortgage companies borrowed in order to be able to lend mortgages. Thereafter these mortgage debts were purchased by financial intermediaries. The underlying strategy behind this trading was to spread the risk but instead it spread the problem that acted as a triggering point of the global financial crisis. The investment banks who designed this debt instruments paid hefty amount to credit rating agencies in order to influence them to certify this risky debt instruments with high rating. This was done so that the investment banks could effectively market and sell these products to the investors. Majority of these mortgages had an introductory period of about 1-2 years of lower interest rates. However, after the introductory period, the interest rates started to increase gradually. The US government had to increase the interest rate in the year 2007 in order to tackle inflation. As a consequence, interest payment became more expensive. This drastic increase in the interest rate saw many home owners defaulting in their mortgages as they could not afford to pay the interests. The increase in the mortgage defaults signalled the end of the US housing boom. The prices of hoses started to fall which led to further problems associated with mortgage issuance. Many medium sized US mortgage companies declared themselves bankrupt as a result of this increasing rate of default. Financial intermediaries who bought the structured products such as the collateral adept obligations suffered huge losses. Banks has to write off huge losses and thus they refrained from lending any further especially in the subprime industry. As a result, it became very difficult to raise funds by borrowing money all around the world. The cost of inter-bank lending also increased significantly. It led to a domino event and thus the economy of the most of the countries started melting down. The markets dried up. The firms who were exposed to the subprime lending market were severely affected. The gradual decrease in the rate of borrowing was a significant contributor to a slowing US and the world economy and thus led to the credit crunch which is commonly referred to as the recession (BBC, 2009). Implications on Qatar’s economy The Qatar financial centre conducted a Dun & Bradstreet business optimism index for Q1 of 2009 in November 2008 amidst the global financial crisis. The authority reported rising concerns about the decline in the price of crude oil and the decelerated global economic growth. The sentiments of this particular region have been severely impacted due to the spill over effects of the global financial crisis. However, the Qatar Financial Centre reported that the country will manage to do fairly well in these tough times. The country will be able to tackle the effects of the global financial crisis with the ample support provided to the authorities by the government. The BOI results indicate that the country will be very resilient in face of the global financial crisis. It has been reported that the country’s prospects for the year 2009 seem fairly optimistic. According to the survey about 53% of the businesses belonging to the non hydro carbon sector are expecting an increase in the volume of sales and hence the net profit. This indicates that even in the face of an economic slowdown the demands in Qatar are expected to stay firm. The companies belonging to the hydrocarbon sector are being cautious while implementing strategies and taking actions as this is the sector which is most likely to be affected as a result of the global financial crisis. Overall, it is expected that the county will withstand the impact if the financial crisis. It has also been reported that a vast majority of respondents who participated in the survey are confident of the fact that Qatar can overcome the negative effects of the European and the US financial crisis. However, business officials are being more cautious in their approach. It has been witnessed that majority of the business are saying that their sale prices will remain flat instead of decreasing or increasing. They not trying to over value or undervalue the performance of their respective businesses. The businesses are postponing their recruitment and investments plans until the situation regarding the effect of the global financial crisis becomes clearer. The results have indicated that the Government of Qatar and the businessmen based in the country are taking a mature and balanced approach in order to tackle the recent market disruptions (Qatar Financial Centre Authority, 2009). Conclusion This paper covers a range of topics that are inter-related to each other. Having done an in-depth study of the role of the credit rating agencies in the global financial crisis it can be said that the credibility of this rating agencies came under a lot of controversies. This is particularly because the rating agencies play a crucial role in ensuring the stable functioning of the financial markets. Investors believe in the ratings provided by these rating agencies while making hefty investments. The failure of these rating agencies in conducting a transparent rating method led to the onset of the global financial crisis. The rating agencies need to review their regulations and impose strict measures which adhere to reduce the loopholes that are present within the rating mechanism. The study also covered the issue of agency costs and the effects that it has on firm value. It was seen that the major contributor to a company bearing agency costs is the principal agent problem that arises because of a conflict of interest between the managers and the shareholders a particular company. This depreciates the value of a company significantly. Information asymmetry was also another topic that was discussed in details thereby highlighting the consequences of such disparity in the financial market. It was seen that information asymmetry arises due to fact that entities sometimes hide crucial facts regarding their status which more often than not lead to the functional break down of the market. This stresses the importance of formulating strict regulations related to information disclosure. 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