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Robert Cole recently spoke at an ACCA UK lecture Can We Trust Ratings? His views are shared here.

Debt rating agencies have enormous power over companies and the cost of their capital. But since ratings are paid for by companies, and the forecasting they must do is notoriously difficult, investors must question the independence and accuracy of the research.

My basic thesis is that credit rating agencies occupy an extremely awkward position in the financial fabric of the market-led economy. It is a position that poses problems for credit rating agencies themselves, and creates difficulties for companies, investors, and the economy as a whole.

Paying the piper and calling the tune
For a company to obtain a credit rating it usually has to pay one or more credit rating agencies a fee to undertake the required work. I do not want to suggest that all credit analysts offer views that are always skewed in favour of the firms that pay for the research.

Indeed, I am content to assume that the vast majority of credit rating researchers put the commercial relationships aside when coming to conclusions about the firm and its debt.

But there must be a risk that, at least on the odd occasion, the existence of a commercial relationship between the researcher and the researched means that the credit raters are too generous and companies will have unreasonable expectations of influence.

It is also possible that in an attempt to demonstrate impartiality a credit rating agency will deviate too far the other way. The agency may be unduly harsh on a company or its prospects, in an attempt to demonstrate credentials of independence.

A couple of months ago I was invited to lunch by the chief executive of a well-known and established FTSE 100 company. To spare the blushes of all concerned I shall keep the names of those involved to myself. But I was intrigued to learn of the relationship between the FTSE 100 firm and its credit rating agency.

The FTSE 100 firm in question had a substantial – although apparently sustainable – burden of debt. At the time of my lunch it was eager to be able to take on more debt. Coincidentally, or perhaps not, it also felt hard done by in a recent rating exercise and in response it invited the analysts into the company. It put its arguments forward and presented evidence backing the notion that its credit rating should be improved.

As a result of the meetings, according to my chief executive contact, the credit rating was improved. I am not criticising the company for wanting to put its case to the raters. Nor am I criticising the credit rating agency for changing its tune if, as I assume was the case, clarification of the facts merited a reappraisal. But there must at least be a risk that the existence of a commercial relationship between the two contributed to the credit rating upgrade. After all, nothing actually changed at the FTSE 100 company over the period of reappraisal.

Credit raters cannot afford to be wrong
It seems to me that the status given to the leading credit rating agencies means that they cannot afford to be wrong. And yet it is quite impossible for anyone in this line of business to be accurate in anything like a consistent fashion.

I am reminded of the story told to me by a Stock Exchange compliance officer. It was his practice to assume that any trader who was right about price movement more than 60% of the time was crooked. I am not suggesting that credit raters do anything but act with honour. However, their position means they need to be right all of the time, not just 60% of the time. And this is, surely, an unreasonable expectation.

Literature is littered with aphorisms that point to the inevitable inaccuracy of forecasting. My personal favourite is a line attributed to Nils Bohr, the Danish Nobel Laureate in Physics. He said, memorably, that “Prediction is very difficult, especially if it’s about the future”.

Many more sayings point to the difficulty of trying to make accurate predictions. Yet this is exactly what credit raters, thanks to the status they enjoy, have to do. In the process, it seems to me, they find themselves stuck in that awful position between a rock and a hard place.  

Bear in mind here that a company can only raise debt in the bond markets if it has a credit rating. For companies that wish to use bond finance – and there are many good reasons why many companies do want to borrow in this way – a credit rating is not an optional extra. It is a requirement.

Consider also that the amount of money a company can raise through the bond markets is linked to its credit rating. In addition, the cost of servicing the debt is related to the credit rating. Broadly speaking, the lower the rating the less a company can borrow and the higher the interest cost attached.

Inevitably credit rating agencies will make mistakes and this can lead to real problems – of wealth destruction, unemployment, and economic weakness.

Consider the telecoms companies keen to expand towards the end of the 1990s. Helped by over-optimistic views espoused by credit rating agencies, too many firms were allowed to raise very large amounts of money at reasonable rates of interest. As a result huge overcapacity, and an unsustainable bubble, was created in parts of the telecoms network.

Roll forward a few years and the credit rating agencies can be seen to occupy a position that is still powerful – perhaps too powerful – considering the inevitable flaws in any exercise that involves forecasting. Who is to say the credit rating agencies have not now become too pessimistic about the prospects for the telecoms industry?

In marking down the ratings, credit rating agencies can raise the cost of servicing debt – depending on the particular terms of the bondholder agreements – in a way that may prove unjustified by the course of events. As a result of the actions of credit rating agencies financing may even be pulled away altogether. If that is the case companies could go to the wall, investors could lose their cash, employees could lose their jobs and the provision of services that add to the quality of life – economically and socially – could be destroyed. 

Solutions
I do not mean to lay all the problems of the commercial world at the feet of credit rating agencies. Everyone – journalists included – has some blame to bear. But the role of credit rating agencies needs, at the very least, closer examination.

So what of solutions? Credit raters should sever the link with their current paymasters in order to enhance their own credibility, as well as their credit ratings of other companies. Credit ratings, in the same way as share price recommendations, are designed to serve investors and work best as an aid to the investment community. If the investment community wants to be best served by the rating agencies they have to be prepared to foot the bill for the work done.

Investors must also take a realistic view of the value of the work. It is bound to be wrong – when measured in any but the most flexible terms – a lot of the time. But as Henri Poincare, the French mathematician and physicist, wrote in his book The Foundations of Science: “It is far better to foresee even without certainty than not to foresee at all.” Released of the burdensome and pressurising obligation to be right, the quality of research might also improve.

If the availability of finance, and the price of the debt, is left to purer forms of market forces, helped by truly independent research, there may be a better chance that companies will raise the “right” amount of debt, at the “right” price.

Robert Cole – Deputy Business Editor, The Times, and Chief Writer on the Tempus investment column

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