The good, bad and ugly in global credit ratings

In October, global ratings agency Moody’s warned of a likely downgrade of credit and deposit scores of three Kenyan banks – KCB, Equity and Co-operative, citing the country’s deteriorating fiscal strength and liquidity.

The agency had just placed Kenya’s B1 rating on review for downgrade due to persistent deficits as high borrowing costs continue to drive government indebtedness higher, among other factors.

In one way, it’s a brutal time to be an investor in any of these stocks. But is it so? Is a credit rating too legit? Is it a seal of approval? Here’s my three way take on rating companies and their influence on markets – the good, the bad and the ugly. 

The good. In a study looking at the impact of rating changes made by Moody’s from 1983 to 2009 on stock market performance of (developed and emerging) countries 12 months before and after a ratings change, the results were interesting. Two key observations were made.

One, out of 71 upgrades and 25 downgrades made, aggregate results showed that stock markets of upgraded countries outperformed their respective market index in the 12 months before the rating change (13.8 per cent). Likewise, stocks in downgraded countries aggregately underperformed the market index before the event.

In other words, market-adjusted their prices in response to new information faster than ratings agencies could adjust their ratings. Two, in the 12 months following a ratings change, relative performance was virtually identical for the upgraded and downgraded countries (3.87 versus 3.7 per cent).

Takeaway: Ratings don’t move markets. Quit paying too attention here, as some do.

The bad. Lenders in the international market rely heavily on credit ratings to determine the pricing of sovereign debt, with private sector borrowing from these markets in turn relying on the government’s pricing profile.

Unfortunately, despite this huge responsibility, credit ratings are simply a matter of opinion. They often depend on who you ask.

Plus they’re often in a state of flux. For instance, six months earlier before the Moody’s gloomy warning, S&P Global gave the country a stable outlook based on strong external position and monetary policy flexibility. Takeaway: do your own analysis.

The ugly. Lest we forget, Moody’s, S&P Global and Fitch all contributed to the 2008 financial crisis. How? They all inflated ratings on toxic mortgage securities.

As housing prices began to tumble that year, Moody’s for instance was forced to downgrade over 80 per cent of the all mortgage bonds it had rated AAAA.

It’s unsurprising that the Financial Crisis Inquiry Commission in 2011 concluded that the crisis could not have happened without the rating agencies.

Let’s also remember that rating agencies rated Enron’s debt as “investment grade” just days before it filed the largest claim for bankruptcy protection in history.

Takeaway: ratings are given by human beings. Always take them with a pinch of masala. The bottom line is that ratings are not a sure thing. One should look to the markets for signals about the fiscal health and prospects of a country.