Relying on credit ratings?
This month we continue our introductory series on credit ratings, which has become a very topical subject in the last few months. The rating agencies are being heavily criticised for not foreseeing the rapid deterioration in credit quality of, amongst many others, Enron. But, is this criticism fair?
The whipping boys
No doubt, the investment community (particularly those caught holding Enron debt) will think so. They need someone to take the blame. But what can we reasonably expect the rating agencies to do?
The ratings agencies are only as good as the information they receive. GIGO as the IT boys used to say – garbage in, garbage out. So, when analysts are only able to access poor information that masquerades as the truth, what do we expect?
If the management of a company takes full advantage of techniques of financial engineering, aided and abetted by their investment bank advisers and auditors, how can we expect the credit agency analysts to detect what is really going on? After all, in most cases the reporting rules are not being broken and the arrangements appear satisfactory.
Unable to see the unforeseeable
But there is a second issue here and that is that the weakness in financial performance we are seeing in many companies demonstrates that business has risk associated with it. No amount of analysis will eliminate this, nor will balance sheet manipulation. There are genuinely unforeseeable events that change the financial health of companies (and whole industries) for better or worse.
Perhaps we should just remind ourselves that, even at the short end of the market, any investment in any form of security gives a very real exposure to the issuer. No amount of analysis is going to eliminate that risk entirely. Anyone placing too much faith in the credit analysts will be disappointed.