Raters face season of discontent

Abu Dhabi: Almost three years to the day Dubai Holding Commercial Operating Group (Dhcog) accepted its first Standard & Poor's rating, the relationship ended last month on a sour note.

By last month, Dhcog's creditworthiness in S&P's view had fallen from an initial rating of A+, just two notches below the sovereign rating of the Abu Dhabi Government, to a B grade, considered a ‘speculative' or ‘high-yield' rating.

Dhcog said S&P did not understand its business model. S&P said Dhcog was not meeting its disclosure requirements. And they went separate ways.

It was not the first split between a rating agency and an issuer in the Gulf Co-operation Council (GCC). In fact, 2009 saw the rating industry's top three agencies — Moody's, S&P and Fitch — lose nine clients based in the Gulf over similar disputes. S&P accounted for six withdrawals, including the Abu Dhabi Government utilities provider Taqa, Dhcog and the country's largest bank, Emirates NBD.

With a combined 402 corporate, sovereign, bank and structured finance ratings in the Gulf and thousands of ratings globally, the nine withdrawals did not pose a significant threat to the earnings of the three agencies. But, they embody the growing discontent of regional debt issuers with their falling ratings, at a time when their financial standing is weakening, often due to circumstances beyond their control. The rating agencies have also misunderstood and misgauged government support for some companies.

Last year saw the highest-ever recorded figure for bond and sukuk issuances in GCC countries at $73.2 billion (Dh268.6 billion), led by the sovereign issues of Dubai and Qatar, according to a January report by NCB Capital, an affiliate of the Saudi National Commercial Bank.

Since analysts estimate international investors make up about two-thirds of buyers, it is likely the raters will be around for a long while to come.

Complaints and accusations against the rating companies have not been limited to debt issuers. Investors are not particularly happy with the ratings agencies either.

They point to AAA-rated US mortgage-backed securities that collapsed as a result of the subprime crisis and to the agencies' A ratings for Lehman Brothers, which turned into D, for default, overnight on September 15, 2008 when the company filed for bankruptcy protection.

"The rating agencies got it wrong," said Tudor Allin-Khan, chief economist at HC Securities in Dubai. "They got it wrong because the world was growing and risk appetite was increasing."

"We believe the downfall of Lehman reflected escalating fears that led to a loss of confidence, ultimately becoming a real threat to Lehman's viability in a way that fundamental credit analysis could not have anticipated," S&P said in its research note on September 24, 2008.

No other avenue

Like it or not, companies and governments have no choice but to obtain credit ratings to access international debt markets. There exists no other avenue for measuring a borrower's creditworthiness. "You can criticise them but there is no alternative," said Mohieddine Kronfol, head of debt asset management at Algebra Capital.

In 2007, Dhcog used the S&P rating along strong evaluations by Moody's and Fitch to successfully sell $2.5 billion worth of bonds to investors from the UK, Germany, France and the Middle East.

"The investors showed strong interest in the Dubai story and the role of Dubai Holding in contributing to the economic growth of Dubai," Fadel Al Ali, Dubai Holding chief financial and operating officer, said in a statement after the company's bonds were five times oversubscribed by investors.

In severing its ties with S&P, Dhcog accused the agency of not having the right expertise, not understanding its business and its relationship with its sovereign backer, essentially the same arguments put forward by Taqa.

Emirates NBD did not point the finger at S&P but said it is sticking with Moody's, Fitch and Capital Intelligence, raters "who either have a presence in or long-standing coverage of the UAE, to provide independent monitoring and rating of its financial strength".

"It's not an issue of expertise," said Jan Willem Plantagie, S&P Middle East regional head. "When we assigned the rating, the company had the choice to accept the rating or not. All these companies have accepted the rating at the time. Therefore, if we did not have the expertise at the time, they would not have accepted the ratings."

But, since the onset of the financial crisis in the US, ratings agencies have come under increased scrutiny for their failures to predict the collapse of investment banks and structured finance products.

"What happened in 2008 was the underlying data, the housing data, deteriorated in a way that had never been seen in the past," said Philipp Lotter, head of corporate finance at Moody's Middle East Ltd. "What we saw was a paradigm shift in our assumptions."

In the West, it has meant tighter regulation with the Europeans banning rating agencies from providing advisory services in April, 2009. In September, the US Securities and Exchange Commission adopted new rules requiring more disclosure from the agencies and banks seeking structured finance ratings, asking them to disclose preliminary assessments to discourage "shopping" for the best rating. Some analysts question the integrity of the agencies' business models, which rely on the entities they rate for revenues. The agencies maintain they practice strict separation between analytical and commercial departments.

Transparency

With almost every withdrawal in the Gulf, rating agencies have complained about the lack of transparency and disclosure by the entities they rated or the governments that back them.

Transparency of government decision-making was also a criticism by the International Monetary Fund in its January forecast revision for UAE. "In Europe you have legislation which clearly sets out how and when governments can support entities," said S&P's Plantagie. "You have budgetary mechanisms. For instance in the UK, you have an emergency fund that can be used overnight to provide cash to entities. Here you have nothing."

Others say the problem lies in the virtual monopolisation of the market by the top three players. Capital Intelligence, the nearest competitor, was only established in 1985 and holds just 400 ratings globally, compared with the tens of thousands of ratings by the top three companies. A.M. Best, although more than a century old, has specialised in insurance sector rating and only started rating banks in 2006.

"There needs to be greater competition within the ratings industry. When you only have three bodies holding large market share, it's very difficult to get an independent opinion," said HC's Allin-Khan. "The investment banking world had this in 2000 after the dotcom boom. I've worked in this industry since then and have seen it become more independent."

Lotter said: "Ultimately, we're an industry that's facing huge regulatory change. A lot of that is very positive and we're adapting to those demands."

A-B-C of credit rating

A credit rating represents the opinion of its sponsor regarding the relative ability of the company being rated to pay back its debt.

Companies and governments seek credit ratings in order to borrow money from international markets, usually through the issuance of bonds. A high rating (AAA to BBB- from Fitch and S&P or Aaa to Baa3 from Moody's) is referred to as "investment grade," carrying reduced risk of default. This gives the bond issuer the ability to borrow at reduced interest rates compared to others with lower credit ratings.

The riskier category of ratings is referred to as "speculative grade" or "high yield," because it represents a higher probability of the borrower not meeting the full debt obligation on time and, therefore, pays higher interest to investors.

Companies and governments pay the credit rating agencies to rate them as well as the individual financing instruments they may be using. The agencies maintain their commercial and analytical departments are strictly separated to avoid conflict of interest.

The global ratings industry is dominated by three companies: Moody's, Standard and Poor's and Fitch. Smaller players such as Capital Intelligence and A.M. Best continue to grow in some regional markets such as the Middle East. Ratings are based on analysis of the full financial position of an entity including its cash flow, outstanding debt, previous repayment history, government support and vulnerability to external economic circumstances.