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This investigation explores the role of credit ratings in the Chilean fixed income market, highlighting how institutional investors depend on these ratings for their investment strategies. The study questions the value of requiring two ratings from different agencies, given their high degree of agreement. It analyzes the methodologies of leading agencies like Moody's, Fitch, and Standard & Poor's, discussing potential regulatory implications resulting from the subprime crisis. The findings prompt a reevaluation of the credit ratings framework and its impact on market risk assessments.
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Credit Ratings in the Chilean Fixed Income Market: Some Empirical Observations A. Cifuentes, V. Charlin and E. Bone Centro de Regulación y Estabilidad Macrofinanciera, CREM Faculty of Economics and Business University of CHILE Santiago, CHILE January 2014
Fixed income markets are highly regulated • What institutional investors can and cannot buy is dictated by the credit ratings • A bond issuer has to obtain two ratings before it can market a security • It has become widely accepted --and demonstrated-- that the rating agencies played a significant role in the subprime crisis • * * * • Is it reasonable to have a regulatory framework based on ratings? • Are ratings (as they are defined now) proper metrics to assess credit risk? • Should the rating agencies that played a role in the crisis be allowed to operate in Chile? Questions ?
The goal of this investigation is to shed some light into an aspect that so far has received little attention • We seek to explore whether the ratings given by the three leading rating agencies in the Chilean market are indeed different • A casual observer would probably notice a high degree of "agreement" in terms of the ratings • This issue is relevant for at least two reasons • If two ratings are required, but they are always the same, does the second rating offer an investor/regulator any additional value? • Given the fact that many subjective elements come into play when issuing a rating--not to mention that the agencies proclaim to have different methods and benchmarks--one often wonders: should there be a high level of agreement?
This market is dominated by three rating agencies (Moody's, Fitch, and Standard and Poor's) • The ratings reflect credit risk (ability and willingness to pay); they do not capture market risk, liquidity risk, or the possibility of fraud • Standard and Poor's (S&P) and Fitch base their ratings on a "probability of default" concept • Moody's claims to give ratings based on an "expected loss" concept • If P is the default probability, then the expected loss (EL) associated with such default is • EL= P(1-α) • where α denotes the recovery rate
Suppose I buy a bond that will pay $ 100 in a year Let us assume that p (probability of default) is high, say, 90% [1] The S&P rating should be “low” [2] But the Moody’s rating (based on the expected loss concept, EL) could be “anything” depending on the recovery rate EL = p (1 – α) If α = 10% then, the EL = 0.9 x 0.9 = 81% If α = 99.9% then, the EL = 0.9 x 0.001 = 0.09% Based on this: Should we expect a high degree of agreement in the ratings?
Ratings Categories and Symbols Default Probability Expected Loss Can we say that AAA = Aaa? Or that A+ = A1? Or that BBB+ = Baa1 ?
Exhibit 4. Values of kappa and its corresponding 95%-confidence intervals for both structured products and corporates.
Exhibit 5. Values of weighted kappa and its corresponding 95%-confidence intervals for both structured products and corporates.
The results are clear: the level of agreement for both, corporates and structured products, is extraordinary • One possible explanation is that predicting the capacity of a company to pay its debts is a remarkably objective endeavor • Another alternative is that the agencies after years of competing with one another have learned to "calibrate" their methods not to outdo each other • Whatever the explanation, we prefer to leave up to the reader the task of deriving his/her own conclusions • One thing, however, is obvious: the benefits of having two agencies analyzing each transaction when we know that the outcome will be, most of the time, a close agreement, seems dubious
Finally, a deeper reflection: • The findings of this effort are just one additional piece of evidence--in a long list of exhibits--to think about reframing completely and from scratch the entire credit ratings concept • Whether the findings of this study are a peculiarity of the Chilean market, or they reflect an overall global trend, is something we intend to address in the near future • Next project: Mexico & Brazil
