RATINGS UNDER REVIEW
Following intense scrutiny in recent months, credit rating agencies have announced important changes to the services they provide.
By Justin Wood and jasper moiseiwitsch

"The essence of comedy is ti-ming. Timmm-ing. Tiiii-ming," runs the old Steve Martin joke, and these days the major rating agencies - Standard & Poor's, Moody's Investors Service and Fitch - seem to be emulating Martin's mangled syllabication.

A case in point: S&P's May 21 action on eight of Hong Kong's biggest companies. In one day the agency downgraded Swire Pacific, Hongkong Land and Hysan Development, revised to negative the outlooks for Hutchison Whampoa, Kerry Properties, Wharf Holdings and Sun Hung Kai, and put Cheung Kong Holdings on credit watch. With the move, the agency expressed concern about Hong Kong's property market in particular and competitiveness in general - basically, there was something to upset everyone.

And Hong Kong has not been the only site of a rating agency bloodbath. S&P's downgrades of Japanese sovereign notes in June - putting Japan on a rating level below Botswana - drew scorn from Prime Minister Junichiro Koizumi, who noted that Japan's sovereign grade now languished in the region of "certain African countries to which Japan is providing assistance." Portfolio managers charged that Moody's downgrades of Brazilian debt seemed a reaction to market sentiment, not a tried-and-true set of criteria.

If the major agencies seem to be acting impulsively, recent embarrassments provide an ample motive. Following high profile errors of judgment last year - notably the failure to spot the Enron collapse - the major debt rating agencies set about changing the way they do business. Fitful or no, recent measures represent the first steps in a broad reassessment of credit analysis and rating that will play out in Asia over the next few years. CFOs of large companies that seek access to the US dollar debt markets will have to adjust to meet their new demands.

In the Hong Kong sweep, Swire's downgrade was the most controversial. S&P had put the highly profitable and conservatively managed conglomerate on review following the September 11 disaster. That seemed right and reasonable: a good portion of Swire's earnings comes from its subsidiary Cathay Pacific Airways, which, like most of the global airline industry, suffered from the attacks. Nevertheless, S&P confirmed Swire's rating in November. Why S&P then downgraded Swire in March - after Cathay's business registered a strong comeback and even the Hong Kong property sector seemed in recovery - mystified many, not least the Swire CFO.

Swire group finance director Martin Cubbon explains that S&P, following an extensive review post-9/11, asked his company to establish and meet certain benchmarks relating to cashflow, interest cover and gearing. "We have bettered those guidelines in the last year and our projections show that these will improve still further," says Cubbon. "It is evident that S&P has simply moved the goal post presumably because their seniors in New York have a very negative view on the property market in Hong Kong. No amount of a company's specific data which supports an alternative view is going to make any difference," he says. .

A Murky Process

Another, more general, complaint is shared by CFOs and treasurers everywhere. The rating process is opaque, they charge. "Agencies should be clearer about where the pressure points lie between different ratings," grouses Andy Longden, group treasurer of BT Group, the UK telco. In December 2000, for example, BT was rated A by all three of the main rating agencies. By May 2001, however, the company had three different ratings. While Fitch kept it at A and Standard & Poors downgraded it one notch to A-, Moody's cut BT's rating by two notches to Baa1 - a move that cost the company an extra US$50 million a year, thanks to step-up coupons on its bonds. "Our aim was to keep BT's rating at a single A, so when Moody's downgraded us to Baa1 it was a surprise," Longden recalls. "It would have helped if we had known more about where the border between different ratings lay."

The agencies' standard line on this kind of criticism is that their ratings take a long-term view, rather than jumping up and down in response to short-term events. In good times, then, a company's rating might appear too low, while in a downturn it might appear too high, but over the medium term they provide a balanced view.

"We try to look through the cycle," says John Bailey, Standard & Poor's Hong Kong-based director of corporate ratings, of the recent Hong Kong property downgrades. "Back in September [2001] we released a report that said, 'Is this the end of the property-based economy in Hong Kong?' In March we made a press release [outlining further concerns about this sector]. So it's not as if we've just woken up to it. We've been looking at this for a while and we've been very public as to our areas of concern," he says.

The Need for Speed

SNevertheless, a US university study released in June 2001 found that 71 percent of institutional investors (of a sample size of 114) thought credit ratings on corporate bonds lagged behind an issuer's creditworthiness at any given moment. (Interestingly, though, they also polled 100 CFOs, of whom 74 percent believed that ratings were up-to-date.)

The agencies have responded to criticisms across the board by announcing plans to improve the timeliness of their opinions. At Moody's, for example, analysts are reducing the time it takes to come to a decision once they have put a company's credit rating up for review. Moody's will also shorten the review period down from about 90 days to 60 days.

Mike Foley, Moody's senior managing director in Europe, sees implications for CFOs. "Part of the rating review process is meeting the company's management and generally [companies] like to take three to six weeks to prepare for that," observes Foley. "In future, we'll need to meet with companies much more quickly," he says. And, he adds, the same goes for changes to rating outlooks. "Companies often want extensive meetings about a possible change to a rating outlook, but outlooks are time-sensitive and best handled via an immediate teleconference," he says.

Another Moody's move has been to publish a new type of analysis called a liquidity risk assessment (LRA), which assesses an issuer's short-term liquidity arrangements. The LRAs will apply only to the 500 or so commercial paper issuers in the US. Just a US development for now, the action signals a determination by Moody's to avoid being blindsided by an Enron-style meltdown, in which a company rated as a relatively low risk suddenly faces a nightmarish threat to its liquidity after a sudden downgrade.

At S&P, similar moves are afoot. The agency has emerged with a new definition of core earnings. This calls for a new accounting for stock options that includes the dilution they might cause to investors' holdings and more transparency in the use of pension investments, to name two of the significant areas targeted by S&P. These changes will affect US companies only, and S&P has no immediate plans to roll them out to Europe or Asia. However, they represent an enactment of more exacting standards that have been proposed time and again in the public debate over company disclosure. If investors applaud the criteria of the new definition - and the venerated Warren Buffett has already given it a thumbs up - then it is sure to be used as the eventual benchmark for Asia (see box, "Core Headaches").

What's more, S&P says it will be quicker to put companies on credit watch when it thinks that a rating change might be in the pipeline, and quicker to reach a conclusion. On top of that, says Ridpath, analysts will make it clear how big any potential upgrade or downgrade will be.

Too Much Information

But even with such reforms, CFOs might find room for complaint. More frequent agency reviews may mean more bad information more of the time. S&P's March revision of Hutchison Whampoa's outlook, for example, capped a series of reversals that commented on a fairly steady story. Indeed, S&P's outlook history on Hutchison has had more twists than a Mexican telenovela. The agency put Hutchison on credit watch with a negative view in May 2000, and then removed the company from credit watch in August 2000 but kept a negative outlook on the company. In May 2001, it revised Hutchison's outlook to stable and then, finally in March, it dropped its outlook again to negative.

All these revisions were connected to the conglomerate's 3G investments, of which the agency has taken a focused interest. Truly, Hutchison has made an aggressive bet on 3G (see "Sixt Sense," March 2002). The company has well-diversified and profitable holdings. But its telecoms and e-commerce properties comprise about a third of the firm's NAV and its 3G investments, in particular, have recently put the company in a net debt position.

Hutchison's ongoing 3G expenditure will see the company taking on more and more debt in the coming years - this quite rightly qualifies as an agency issue. But this has been a years-long project that is only now on the cusp of a commercial launch. Hutchison has worked hard to explain its plans here to S&P and to stick to financing benchmarks and ratios outlined to the agency. So why has S&P kept changing its view on the conglomerate over the past two years? Linda Bui, Merrill Lynch's Hong Kong-based director of fixed income research, feels that is a fair question. "S&P has been using the same rationale for playing with Hutch's rating outlook all along," say Bui, noting the agency's concerns over Hutchison's global 3G businesses. "But there haven't been any new stories coming out for that. It's kind of strange, because they might as well wait for a few more months, when Hutch actually launches its 3G business before they have this kind of rating action," she says. She adds that Moody's has maintained a steady outlook on Hutchison all the while.

So CFOs clearly don't just want more timely rating actions - they want more timely and more meaningful reviews. Hutchison's Sixt underscores the point by noting that S&P's latest outlook revision hardly affected the spread on Hutchison debt, saying it widened about seven to ten basis points.

Sixt takes particular issue with the outlook designation, which he says carries too much subjectivity. He says the agencies are trusted with so much sensitive company information - beyond what a CFO would give to an analyst or an institutional investor - that it obliges the agency to handle that information with a heightened degree of responsibility, what Sixt describes as a "bright line obligation". Outlooks, which are far-sighted and necessarily opinion-based, can be a misuse of that information.

"They have to be very sensitive to and very careful of not crossing that bright line and becoming a financial opinion enterprise," says Sixt. "I don't mind that as a flag as an opinion. It troubles me that this becomes embedded as an outlook for our ratings. Because it's called an outlook, it's viewed as a rating action," he says.

Just Another Opinion

The agency response to Sixt's comments fall into the category of 'we're just another opinion-making institution'. "The outlook statements do have some subjective element to them; the credit ratings have some subjective element to them," says S&P's Bailey in response to Sixt's statement on outlooks. "At the end of the day what a credit rating is - it's an opinion. It's supposed to be independent, objective opinion. People can take it or leave it," he says.

But aside from Sixt's comment that the agencies have more access and are trusted with more information than your average equity analyst, CFOs might roll their eyes at that defense. Clearly the agencies are more than just another view in the market. US regulations governing the type of securities held by broker-dealers, banks and money market funds are benchmarked against the big-three ratings. Many fund managers are, by charter, only allowed to hold 'investment grade' securities. If an agency downgrades a company below the critical BBB- threshold, fund managers globally will dump investments in that company.

And the agencies operate in an all-but-closed market. In 1975 the US Securities and Exchange Commission (SEC) came up with a special label known as "nationally rated statistical rating organizations", or NRSROs, and conferred this status on the big three. Over the following years, the SEC then bestowed NRSRO status on four more rating firms, but mergers have reduced the number back to the original three.

No new rating agencies have gained NRSRO designation since 1992, although this isn't for want of trying. Several firms have applied, but failed because they say the criteria defining an NRSRO contains catch-22 clauses. For example, a firm can only be an NRSRO if it has staffing levels comparable to existing NRSROs. And yet, growing that big is impossible without first gaining NRSRO status.

Hutchison's Sixt notes that a new Basel proposal to apply, by 2006, ratings across a bank's portfolio will only increase the big three's power, as investors will apply agency gradings as the de facto industry benchmark. "If you make ratings dependencies the criteria for capital allocation, as in the banking industry, then you have further institutionalized whoever you have written into that regulation," says Sixt. "And you make the system dependent on that rating process," he says.

Adds Sixt: "That doesn't encourage competition, that encourages institutionalization. [Regulators] need to give some thought as to how more competition could be developed globally to address the need for solid, reliable financial risk analysis."

Justin Wood is managing editor of CFO Europe. Jasper Moiseiwitsch is contributing editor for CFO Asia.