All I CARE about is Virginity

This isn’t the first time a credit rater got screwed. And it won’t be the last.

Part of the reason, I feel, is that credit raters don’t rate companies. They rate paper.

Look. You are either a virgin. Or you’re not. There is no such thing as 73% virgin, is there?

The same logic applies to credit ratings. You are either creditworthy, or you’re not. Says who? Ben Graham.

If any obligation of an enterprise deserves to qualify as a creditworthy investment, then all its obligations must do so. Stated conversely, if a company’s junior bonds are not safe, its first-mortgage bonds are not a creditworthy either. For, if the second mortgage is unsafe, the company itself is weak, and generally speaking there can be no creditworthy obligations of a weak enterprise.

I have always found it irritating to see the whole panoply of gibberish like “AAA” “BBB” “CCC” “D+” “C-” blah blah blah…

Why can’t there be a single credit rating for a borrower instead of that?

You might think I am being naïve here much like the friend of a fishing tackle producer, who when he saw all those flashy green and purple lures asked him, “Do fish take these?”

“Charlie?” he said, “I don’t sell these lures to fish.”

I would rather be naïve and right, than be just wrong.


22 thoughts on “All I CARE about is Virginity

  1. vinayagarwal says:

    There is huge wisdom to be learnt from what Charlie says – “All commissioned salesman have a tendency to serve the transaction instead of the truth- I put consultants in the same category, sometimes even lawyers.”


  2. Reni George says:

    Dear Sir
    You have aptly said either you are a virgin or not.Its just Hoopla created by rating agencies to rate just the paper,it looks somewhat as if they are rating my son’s third grade craft and drawing exam A+,A-,C+,AA,AA+.They can just keep it simple,can we give the money or not.

    Reni George

  3. Taha Merchant says:

    Yes Professor, the Emperor is indeed naked 🙂

    All analyst, whether credit analysts or equity analysts, ultimately hit a common wall. And that is the wall that separates us from knowledge about the future. That wall is exceedingly high and utterly impervious. That is the reality.

    But most people in the financial industry do not perceive it as such. Maybe because its convenient for their pockets, or maybe because they haven’t given it enough thought, they perceive this wall as easily scalable. What is only required is some fancy degrees from some fancy colleges, along with a few years of experience, and the wall starts looking smaller and smaller.

    The resultant arrogance with respect to our grasp of the future, which is the ethos in the financial industry, is its biggest nemesis. So many intelligent minds spend all their time trying to come up with precise (to the decimal point) estimates of a company’s performance for the next quarter or the next year or so, and base their bets on that very estimate coming true.

    The very idea that having such a nuanced view of the future is possible is what leads to the “panoply of gibberish like “AAA” “BBB” “CCC” “D+” “C-” in the case of credit analysis. And so, even a company leveraged to the hilt can be awarded a AAA if its future projections are good enough.

    According to Ben Graham on the other hand, an “Analysis of the Future Should Be Penetrating Rather than Prophetic”. If a thorough analysis of a co’s past performance and the present finances (a highly leveraged co would be out without further thought) of a company did not raise any red flags, and if the company could be “counted on to remain in business and to participate about as before in good times and bad” due to the nature of its business position, that was all that should have been needed. And that was all that could be had of the future.

    If an investment demanded (by virtue of its price, low interest coverage etc) one to answer questions any tougher than that, then it was out.

    For the few in the industry who may realize all this, they choose to look the other way. So that as you have pointed out, they can continue to sell an ever higher variety of lures to the unsuspecting.

  4. extirpator1 says:

    Dear Professor,
    I understand your point when you say that if the junior lenders are not safe, senior lenders wouldn’t be either. But would a rating at least not be helpful in understanding probability of default?

    • Well, if you read Chapter 6 to 13 (2nd edition), of Ben Graham’s Security Analysis and follow the principles of credit analysis he lays down, you don’t need credit ratings.

      You must also understand that (1) credit raters are paid by debt issuers not debt buyers which, at least at a subconscious level, triggers incentive-caused bias as in “whose bread I eat, his song I sing”; (2) like other human beings, they experience envy which will make them accept dubious clients who if they were refused, would otherwise go to a competitor; (3) they are prone to manipulation by seasoned crooks who are experts at parting fools from their money; (4) they are prone to fall for “social proof” wherein they will justify, like in many other professions, wrong behaviour because “everyone is doing it” (5) during boom times, they get over-optimistic, like most people, and have a tendency to blindly extrapolate recent, good fundamental performance; (6) at a subconscious level they hate being disliked and are very slow in downgrading an instrument because they wish to avoid hate mails and calls from issuers; (7) once they have given a high rating to an issue and made it public, and then something negative happens, they feel the pressure to remain consistent with their prior, announced opinions and are slow to change their views in light of new facts that destroys the basis of their earlier opinions; and (8) like most human beings they have a tendency to underweigh of even shove under the carpet, any information which disconfirms their prior beliefs and actively look for and overweigh evidence that supports those beliefs.

      In addition, you should understand that when you buy a bond at a full price, there is no upside to it (unless you are making bets on the direction of interest rates, which by the way is a bad idea anyway) and lot of downside if something goes wrong with the issuer. No bond in your portfolio will deliver a profit that will offset losses in other bonds. This is not the way it works in equities where losses on a few bad calls may be offset by a few good, or lucky, ones. You can’t get lucky in bonds. So, you have to be extra careful in what you buy.

      You really are on your own. But Ben Graham will help you. If you let him. Otherwise, don’t invest in bonds directly. Invest in bond mutual funds which do not bet on the direction of interest rates and never deliver “exceptional” performance which is more than the going rate of interest for very high quality credit, because that exceptional performance is likely to be a lucky outcome of a gambler taking risks with your money.

      • Dear Professor Bakshi,

        Don’t several of these behavioural pitfalls apply with equal force to sell-side equity research analysts / market commentators?

        I guess the antidote to these ills is a huge dose of ‘intellectual honesty’ or the willingness to question oneself, which is out of the picture because of the way both credit rating and sell side research professions (if that word can be used here) are organised?

  5. AAA, BBB and all other rating nomenclatures are indeed worthless and are plaguing the investment community. It definitely makes sense to have ratings with Binary nature. A company should either be credit worthy or not. Period.

  6. ankitsanmati says:

    The ratings are broadly given to the company itself and it becomes paper specific only when there are special terms and conditions attached to the paper which can act as credit enhancers or otherwise.

    As far as different categories of ratings are concerned, its just based on the probability of having a binary system is not only rubbish but also impractical. Different categories indicate different risk levels and thus the returns. It all boils down to investor appetite.

    Yeah there are flaws in the rating process and some highly rated companies do default causing problems for the investors, therefore the investors should not completely rely on these ratings for investments. If you read the disclaimers carefully, the rating agencies do mention that the ratings should not be treated as recommendations to buy, sell or hold the rated debt instruments.

    P.S. – The bias in the comment above is because I am a credit rating analyst 🙂

  7. Sir, Should I equate them to astrologers? Probability is used and leveraged to make a living by many of the guys- is it not with guys too?

  8. Sir i had one follow up question. A company will be creditworthy for a given level of debt (taking into account its cashflows under conservative assumptions) but any other tranche on top of that would be equity in nature and hence becomes non-creditworthy. there are naive or unscrupulous lenders out in the market who are willing to provide that extra debt, which essentially is equity risk. in such circumstance should we not say that creditworthiness will be at teh level of tranche and not at the level of enterprise. we might argue that if the management and owners are burdening the company with unsustainable level of debt then the whole company is probably not creditworthy. But it might just be that managers are overoptimistic rather than unscrupulous and careful analysis suggests that for a given level of debt the company is indeed creditworthy. so cant there be situations where one tranche is indeed a creditworthy obligation while the other is not. For example in the European LBO market, just after Lehman crisis, the price of senior debt fell well below the face value while careful analysis would suggest that there was sufficient margin of safety in that debt but the junior debt in the company was more like part of the equity cushion for the senior debt. the pricing anomaly ulitimately got removed by April 2009 when markets recovered sharply.

    • Those are very good observations Sandeep. Graham’s framework is meant for the lay investor who wants safety of principal and a satisfactory return. When you buy bonds of high credit quality at well below face value, you are not the lay investor Graham is talking about. That part, which you are referring to, is covered elsewhere in Security Analysis (See Part III of Security Analysis titled “Senior Securities with Speculative Features”).

      There are sometimes huge inefficiencies created in pricing of various securities within a capital structure. Those opportunities are not meant for lay investors but for professional ones. And the professional investors don’t really need credit ratings to help them make money in such opportunities.

  9. Achin Jain says:

    The rating is just the assessment of the accounting process that a company follows. And right category of item is classified in right category and place. And if the process is aligned with the set of guidelines set by different regulating agencies. I don’t think any credit agency or accounting agency verifies the actual values or details shared in the financial paper that is shared with them by the company officials.
    Example – Satyam or just recent example of Robert Vadra and Corporation bank stand off.

  10. Dear Sir

    For a moment let’s assume that by regulation its made mandatory to have only two rating for any corporate bond AAA credit worthy or D not credit worthy. Now the implication of this will be many companies which are not credit worthy which I means absolute safe like any blue chip company but is not as risky as Kingfisher, they wont be able to get any finance. This will result in a big collapse of lot of corporate which depend on debt eg. all NBFCs – none of which might be eligible to get AAA rating. I agree that from investor perspective investing in any bond does not make sense even if there is slightly risk of default as higher rate cannot compensate for risk. In general, most of the companies will lie somewhere in between AAA and D and rating will at least give some way (even if vaguely) to adjust the interest rate to incorporate risk of default. If for a moment we say that we do not need credit rating and corporates can simply follow standard procedure and arrive at their own rating, but even this can result in lot of unintended consequences.
    I fully agree with you that under current system of credit rating, rating agencies are biased to issue favorable rating. But the same is the case with Auditors, Corporate hospitals, Big 4 which issue due diligence or valuation report or even the equity research house. I don’t know what is the way to correct this biased but completely abolishing all rating may not be solution.

  11. Anil, I don’t think making it mandatory to have only two credit ratings will solve the problem. Investors have to realise that the raters have huge reasons which prevent them from being totally objective and honest about their work. Those reasons are same reasons which influence any professional including auditors and doctors.

    I am looking at the problem from the investor’s viewpoint. He should not rely on ratings to help him determine the credit quality of an issuer.

  12. gdok says:

    Dear sir,
    Dont you think ratings perform the role of attracting the right kind of investor?
    A junk bond investor knows that he has high risk-reward payoff while the investment grade buyer knows he should neither expect exceptional profit nor complete default!

    If it can be proved that investment grade (I-G) rated companies have the same or higher default rate (say within 1-2 quarters or years of being rated as I-G) vs the junk rated companies… then probably we should all dump ratings.
    I found an article which says that default rate progressively increases as ratings decrease over the first 10 years after issuance.

    May be in emerging markets, accounting standards are not good enough or environment is too unpredictable for ratings to carry as much meaning as they do in US context, at least to go by the study results above.

    Warm regards.

    • Gourav,

      Read these articles which are required reading for my students when it comes to understanding the realities of the ratings business.

      I have no doubt in believing that default experiences are co-related with ratings. The riskier the ratings, the higher the subsequent default experience. However, a bond investor who is looking for safety of his principal and fulfilment of promise of interest payments, should not want to take any significant credit risk. Why? Because he is paying a full price and has no upside for taking that risk. For him, having a higher probability of default is not offset by higher yields being offered. Even if that relationship holds most of the time, when it breaks down, it creates huge portfolio losses.

      During bad economic recessions, when borrowers ability to repay loans raised is found deficient, all but the highest grade bonds fall in price. So the fellow who bought the “slightly inferior” bonds and was offered a slightly higher yield to offset that extra risk of default ends up seeing a large fall in the price of his bonds. Graham’s advice is very clear: for most bond investors there is no real trade-off between yield and default risk.

  13. The biggest irony is that large institutional investors like pension funds, insurance companies and the likes who are handling large chunks of money and are considered to be ‘knowledgeable sophisticated’ investors are required to depend on ratings for their investment decisions. For example many of them are not allowed to buy securities which are rated lower than a particular rating grade (say B+ or B-). Few days back it was in the news that FIIs will have to sell out of India if India’s credit rating is downgraded to ‘junk’ status because many of them are not allowed to stay invested in such countries. Similarly our pension fund behemoth EPFO is allowed buy only those securities which are rated by at least two rating agencies and it can switch out of its positions only if the securities are downgraded by at least two rating agencies (which leads to buying rich and selling cheap). Don’t know if there are any reforms in the new pension bill.

  14. Trupti Gupta says:

    Dear Sir,

    While I don’t dispute your points on the obvious conflict of interest and incentive triggered bias that you mentioned about the rating agencies etc, I would like you to know that I beleive that the rating agencies may be not at all that bad and the ratings are not completely uselss or misleading. I work for a leading financial institution of the country and work as a credit analyst out here. My organisation has developed a rating scale which incorporates almost all the key aspects regarding the specific borrower, the industry in which operates and the particular business/proposal we are funding (including the quality of the promoter, financial strength of the group, ability to service debt, corporate covernance, peer comparison industry related aspects etc and perform a robust rating internally which more often than not matches with that of the external rating agencies of repute (we consider them so). For each proposal that we look at we do our internal assessment of the companies, rate them and decide the going ahead with the same or not. We have compared our ratings with those issued by the external rating agencies for the said instruments, finding no significant difference between the two.

    If we trying to say that a investment in a debt instrument is for safety of prinicipal and return and hence ideally either there is a risk of default or none, instead of varying probabilities of default (as indicated by the different level of ratings), which is the basis of an investor to make his investing decision, I have a disagreement. The ‘almost risk free instruments’, i.e. Govt debt and the top-notch corporates of the country are rated at the highest scale and junk instruments indicate a high possibility of default. The other instruments are benchmarked against these in terms of the risk of default and the investors who wish to invest in the same should be aware of risk (quasi equity) that they are taking for their preference of a a higher return (higher than the AAA rated instruments). Ratings serve the purpose of this benchmarking.

    I hope I not am construed to have been suffering from any kind of a bias as I am neither a credit analyst with a rating agency nor someone who will not suffer because of misleading ratings.

    • Trupti,I don’t have an issue with what you wrote. I just feel there is too much complexity in modern credit analysis which isn’t needed for people who are financially literate. They can simply use the Graham-and-Dodd framework. But for those who aren’t financially literate and also for those who may be financially literate but have no time or have a need to cover their asses in the event something goes wrong with a borrower, modern credit ratings play a very useful role. So from a societal viewpoint, clearly credit rating agencies have a role to play – despite the fact that have goofed up quite a lot. In that respect, I have an observations: Credit raters of instruments issued by companies having listed stocks should carefully monitor the stock price of the issuer. That’s because a sharp drop in market price caused by the actions derived from the “wisdom of the crowds” or “wisdom of insiders” often offers an early warning signal of impending problems. Graham incorporated this thinking very firmly in his system of credit analysis – something I find lacking in modern credit analysis (at least when measured by the frequency of downgrade to near junk status well after the stock has declined by more than 50%).

      You stated that investors who wish to invest in lower grade instruments should be aware of the quasi equity risk they take. Graham argues that investors should not invest in lower grade instruments at all. And if that’s the case, and if they are financially literate, the analysis is binary— either the firm is creditworthy or its not.

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