Inside the Mind of a Credit Ratings Agency

by Cesar Bacani, 17 August 2010

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topics:
Corporate Finance Risk Management

tags:
credit ratings CTRISKS Dagong Global Credit Rating Michael Wong sovereign debt

It’s been a bit of a mystery to many CFOs just how credit-ratings agencies come up with their judgements on the creditworthiness of corporates and sovereigns. The questions became louder during the global financial crisis, when top-rated companies like Lehman Brothers went bankrupt, and even today, as previously investment-grade Greece suddenly imploded.

Eyebrows were raised again when Dagong Global Credit Rating, a little-known agency established in China in 1994, recently rated China’s foreign-currency debt at triple-A – and gave the foreign currency credit of U.S. a lower double-A. Few took Dagong seriously, but the amount of media attention its action received showed just how unsettled the credit-rating industry had become.

CTRISKS, a Hong Kong-based credit-rating organisation founded in 2007 by City University academic Michael Wong, takes a different approach from Dagong and the international majors such as Moody’s and S&P. It focuses on short-term ratings, typically over one year, of banks and corporates in China, Hong Kong and Taiwan, as well as sovereign ratings.

“Traditionally the capital market demands long-term credit ratings, say three to five years, because investors tend to hold debt securities to maturity,” Wong explains. “However, with the prevalence of credit derivatives that help mitigate credit risk, investors and banks can easily monitor their credit risk on monthly or quarterly basis . . . There is no point for investors to consider long-term credit risk.”

CFO Innovation’s Cesar Bacani spoke to Wong to delve into credit ratings issues in the post-crisis environment. Excerpts:

CTRISKS rates China at the highest rating of CT3A. Is this the same rating you have for the U.S.? Do you think the U.S., in fact, should be rated lower than China, as Dagong Global Credit Rating has done for foreign currency debt?

We still rate the U.S. and many European countries at CT3A, the highest rating our company can offer, which indicates their superior ability to deal with economic stress. The U.S. does not have much foreign currency debt. If the U.S. government needs funds to bail out troubled banks or government-related institutions, it can easily issue USD-denominated debt. Of course, this may weaken market confidence in the U.S. dollar, but the government will not default.

For sovereign ratings, we consider several major inputs. They include GDP per capita, GDP size, economic competitiveness and the soundness of the banking system. We have a model that quantifies all these major factors. So if they are strong in economic size, they are strong in economic competitiveness, strong banking system and also economic growth, usually they can get top-rated.

It is rare for a country to default; the default of a country is mainly related to political issues. But the credit quality [of sovereign debt] will affect the bond price and also the credit spread, so we need to provide the market information about the credit quality [of the sovereign].

Does the sovereign rating have an effect on the corporate ratings? For example, if the sovereign is CT1A, no corporate can be rated higher at say CT2A or CT3A?

That’s true.

Why is this the case?

If the economic prospect is not good, the government will face trouble in many areas, including the banking system and social stability. For example, if the unemployment rate is high, it’s easy to have social unrest.

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