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Stock Analysis, IPO, Mutual Funds, Bonds & More

Why are mutual funds silent on dubious credit ratings?

Mutual funds and other institutional investors, who are the consumers of the rating agencies, have been strangely silent, despite having been let down in several egregious cases.

ET CONTRIBUTORS|
Nov 19, 2019, 10.53 AM IST
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By R Balachandran

Credit rating agencies have come under withering criticism in the media for awarding liberal ratings to dubious finance companies. But mutual funds and other institutional investors, who are the consumers of their ratings, have been strangely silent, despite having been let down by the rating agencies in several egregious cases.

“Don’t bite the hand that feeds you”
Globally, and in India, the issuer of the security being rated, pays the fees for the credit rating. A rating agency which develops an image of being conservative in awarding ratings is unlikely to stay in business for long. Whether the US subprime securities in the years leading to the 2008 financial crisis, or the now failed/failing finance companies in the 2018-19 finance company crisis in India, these dubious securities were awarded “AAA” rating by the analysts at ratings agencies. Their “rating rationale” is understandable; the adage “don’t bite the hand that feeds you” would be apt here!

But what about mutual funds and other institutions who use the ratings in their decision-making process? There are some very smart people in the industry, who would be aware of the conflict of interest in rating agencies. Why then rely on them, as one of the inputs in decision making?

A safety mechanism
In the world of banking and financial markets, an early lesson that those who are employed in the industry learn, is the need for a fall-back mechanism, or to put it more crassly, the need for protecting one’s backside, if and when things go wrong.

Credit rating agencies can provide such a safety mechanism. In the event of an investment loss/defalcation by the issuer, and subsequent investigation by any of the myriad Indian regulators/investigative agencies viz. SFIO, SEBI, CBI, Enforcement Directorate or questions by the Board/Trustees, the analysts and management of mutual funds and other investment institutions in the public and private sector, can cite the “AAA” ratings awarded by the credit rating agencies to justify their original investment.

India, a light touch regulatory scenario
Where does this leave the end investor in mutual funds whose investment has seen major erosion in some instances? Unfortunately, they do not appear to have a voice. Their guardian angel, the market regulator, has tweaked some norms, and made the right noises, but there have been no significant financial penalties on errant players. Similarly, banks and insurance companies have at best faced a mere slap on the wrist from their respective regulators, and modest fines/settlements. In contrast, penalties by the regulators and the Justice Department in the US, run into hundreds of millions of dollars, and often into billions. Such contrasting light touch regulation and enforcement in India, in a landscape filled with perpetrators of financial frauds, is perplexing.

Self-fulfilling prophecy
Why are credit rating agencies reluctant to downgrade ratings, despite warning signs of trouble, unless the finance company makes media headlines and the hands of rating agencies are forced? Perhaps they do not wish to set off a vicious cycle by downgrading ratings, which can lead to loan recalls, inability to refinance/raise fresh loans/securities, effectively cutting off the issuer from the financial markets, resulting in a default. If this was the reason for the hesitation in downgrading, it may be somewhat understandable, though it merely postpones the inevitable.

This brings up the more important question, the liberal ratings awarded in the first place. In the absence of an alternative to the current “issuer pays” model, the rating industry is unlikely to self-reform.

In the interim, the ratings now being issued are more likely to reflect the underlying credit worthiness of the borrower. As things settle down, and the credit cycle returns to normalcy, we will again see “AAA” ratings making a resurgence. One can only hope that the professional fund managers and their risk management teams at mutual funds, will take these fancy ratings with more than a pinch of salt and do their own due diligence.

There are a whole host of other investors who may not have a choice except to rely on the “AAA” external credit ratings viz. the government run Employees Provident Fund, PF trusts of public sector and private sector companies, corporate treasuries etc. These investors do not have sufficient infrastructure to undertake independent credit assessment.

Mother of all financial market bailouts?
India’s aging insurance behemoth and possibly the largest investor in the financial markets, relying cosily on the external “AAA” ratings as an input for its debt investments, needs to professionalize its team, and face rigorous audit and vigilance. Else we may see a “mother of all bailouts” in the Indian financial markets in the next decade, eclipsing current bank bailouts and that of UTI. A public listing, and associated transparency may surface problems earlier, and help in cleaning up its act.

(R Balachandran is a fixed income investor and erstwhile corporate banker)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

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