Scrutiny on rating agencies

By M Shanmugam (The Edge)

THE world has seen its second financial crisis in 12 years causing the role of various financial intermediaries to change. But nothing has changed for rating agencies and how their role is looked upon in the financial system.

For instance, in the current financial crisis that peaked in the third quarter last year with the collapse of Lehman Brothers, the way investment banks operate has changed. Big names such as Merrill Lynch were swallowed by Bank of America while others became commercial banks with the US government pumping in huge capital. With the capital infusion, came accountability on the way staff is rewarded and in the latest development, there is a move to scrutinise the financial products of investment banks.

The 1997/98 currency crisis changed the way Asian tiger economies managed their balance sheet. It instilled discipline in their budget spending as currencies of countries with an over-extended balance sheet came under attack. This in turn affected highly geared companies in the Asian tiger economies such as South Korea, Indonesia, Thailand and Malaysia.

However, the role and relevance of rating agencies never changed despite the financial turmoil. Their opinions come under fire when bonds they rated defaulted. But when fund-raising resumed, opinions of rating agencies are sought after as they are the official criteria that determine large investment funds decision on what papers investors can invest in and what they cannot.

But can a rating agency give an opinion that goes wrong and get away with it?

That is the fundamental question in the suit filed by one of the world’s largest pension fund, California Public Employees' Retirement Scheme System (Calpers) against Standard & Poor's and Fitch Rating. Calpers is suing the rating agencies for what it claims as "wildly inaccurate risk assessments" in relation to rating reports on US$1 billion (RM3.51 billion) worth of papers that were tied to structured investments products.

The papers defaulted as the structured products lost value due to the collapse of the US housing market.

Nearer home, four papers amounting to more than RM2.5 billion issued by special purpose vehicles (SPVs) to raise fund for the controversial Port Klang Free Zone (PKFZ) project have come under scrutiny.

The SPVs are owned by Kuala Dimensi Sdn Bhd (KDSB), the main contractor for the PKFZ project that has hogged the limelight for the wrong reasons. The project, that was initially budgeted at less than RM3 billion, received government funding to the tune of RM4.6 billion.

But the cost to the Port Klang Authority (PKA), the owner of the PKFZ project, is estimated to be between RM8 billion and could go as high as RM12.5 billion due to interest expenditure.

All four papers were rated by Malaysia Rating Agency (MARC) and given top-notch triple A rating, an indication of its low risk. MARC gave the rating based on an implicit guarantee of the PKA in meeting the debt obligations in letters signed by two former transport ministers.

But both the ex-ministers have stated that the letters they had signed cannot be construed as guarantees.

On top of that, there are other issues that have surfaced. They are:

1. Letters of guarantee from the government can only be issued by the Treasury and;
2. Bonds backed by the government are normally issued by government-owned entities and cannot be issued by third parties. In this case, according to the Public Accounts Committee (PAC), the debt papers should have been issued directly by the PKA and not KDSB.

Why were the parties responsible for issuing the papers, including the investment banks and MARC, not aware of such regulations?

In its opinion on the debt papers, the rating agency primarily premised the AAA rating on the government guarantee. But was there any scrutiny whether the transport ministry or the PKA can issue letters that tantamount to a guarantee? Was there a risk assessment whether such letters carry weight?

MARC, since the developments of the PKFZ fiasco, has downgraded the papers but maintained the ratings because of the government guarantee. But does it really matter now? Wouldn't bond holders suffer if the government decides not to honour payments?

So far, the Ministry of Finance (MoF) has been meeting obligations in relation to the four bond issues related to the PKFZ project.

But there is a claim by the PKA that it had been over-billed by between RM500 million to RM1 billion. What happens if there is a delay in settling the dispute?

Irrespective of what happens, the opinions of rating agencies have so far been viewed as essential in helping investors arrive at a decision in relation to debt issues. This is on the premise that the agencies themselves are said to have some insightful information that is not available to the public eye.

But what happens when vital information that premises the rating agency's opinion is flawed? Who pays for the lapses in such instances? At the moment, it is only the bond holders. But over time, the relevance of opinions by rating agencies will suffer.