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Talk about raining on Malaysia's parade. No sooner had Deputy Prime Minister and Finance Minister Anwar Ibrahim packed his bags for a fund-raising road show in the United States and Europe than Moody's Investors Service downgraded the country's sovereign debt by three notches. This left the debt at near junk-bond status, putting Malaysia on a par with Latvia. The always jittery markets tumbled, sending the Kuala Lumpur Stock Exchange Composite Index to a nine-year low. Anwar promptly shelved plans to raise $2 billion in bonds--the proceeds would have helped stabilize the ringgit as interest rates continue to fall--and unpacked his bags. After Standard & Poor's had followed Moody's lead and lowered its own rating of Malaysian debt, Anwar attempted a half-hearted fight-back. "Don't get bothered by the ratings," he told would-be investors. "The question is, who will do the rating on these agencies?" That's a question many Asian finance leaders are asking. After all, Anwar wasn't the only one to suffer a financial headache brought on by rating agencies. The Japanese market shuddered when Moody's announced a review for possible downgrade of Japan's debt rating on July 22. The long-term debt ratings of six Thai banks were similarly placed on review on July 28, as were, two days later, nine Chinese banks. Since the Asian crisis broke more than a year ago, Moody's, which ranks with Standard & Poor's as the oldest and most respected of the ratings agencies, has been under fire. At the onset of the crisis, investors accused Moody's of not warning them of the troubles ahead; more recently, Asian companies and governments have blamed the agency for fuelling the crisis with frequent and often sharp downgrades of sovereign and corporate debts. Why the fuss? Quite simply, when Moody's talks, investors listen: When it trumpets a credit-rating downgrade, the leaders of nations hold press conferences and markets crumple. The traditional reason for that influence is that most market players assume the agency's decisions are based on superior information. Moody's can thus alter the way billions of dollars race among the capitals of the globe in a tireless search for the best trade-off between risk and return. But with the rating agencies in the spotlight as never before, many investors are questioning whether the quality of their decision-making justifies their power. Critics argue that Moody's has neither the manpower nor the access to information to get it right all the time. It is not, they say, an oracle. Indeed, it has often followed markets rather than led them. Moody's officials, who themselves are uncomfortable with their new visibility, say expectations are exaggerated. "We only offer objective information," protests Christopher Mahoney, managing director at Moody's in New York. "We never said we were infallible." Ironically, investors are beginning to fault the rating agencies on much the same grounds as they fault Asia itself; for their lack of disclosure and transparency. For rating-agency watchers, trying to anticipate the decisions that emerge from 99 Church Street, Moody's downtown New York headquarters, is much like awaiting the black smoke that curls from the Vatican's chimneys when a new pope is elected. "The markets feel increasingly that Asia is a place you can't understand," says Steve Taran, managing director and global head of sovereign research at Salomon Smith Barney in Hong Kong--and a former Moody's analyst. "They feel increasingly that the rating agencies are unpredictable, inscrutable and fallible. The agencies have to become less mysterious and more accountable." That's because their importance cannot be overstated. In the world of traditional finance, banks lend money to clients whom they know intimately. But when the players consist of issuers and investors, the two sides may not be familiar with each other. They rely on intermediaries such as Moody's to provide the information that facilitates sound investment decisions. Because investment banks are less likely to be independent in their counsel, investors by default look primarily to the rating agencies for information. This is a critical role that increases markets' efficiency; by providing data, the agencies make it possible for investors to participate in global capital markets. Since the crisis broke, though, the markets have become increasingly disillusioned with the rating agencies' uneven performance. Moody's boasts that it was early in predicting the crisis in Thailand. "The analyst signalled the Thai problems internally in 1996 and we changed our rating in May" 1996, notes Mahoney, "but the markets didn't pay attention to our negative signals." But even Mahoney concedes that the agency dropped the ball when it came to anticipating South Korea's meltdown. "There are cases where the ratings and events have been inconsistent," he says. "For us to move Korea down from a single A to Ba2" in December, 1997, way behind the markets' own moves, "implies a lot of change in a short time frame. Ratings volatility in a downward way does not enhance our credibility." Despite Moody's shortcomings, particularly its late responses early in the crisis, what the agency says still moves markets. Investors may already have soured on a market. But when Moody's pronounces a downgrade, the effect can be dramatic. "There's always a huge reaction, but more out of fear about how others will react," says James Mitchell, head of country research for Thailand at Salomon Smith Barney in Bangkok. "Our own information is better" than ratings agencies', declares the deputy head of China business at one major international bank. "By the time they announce something, it's been a longstanding expectation. But you pay attention because the rating influences the cash flow of a company." And, this executive adds, a ratings change dampens other investors' appetite for the investment--prompting everyone to try to sell it. If Moody's was slow off the mark in recognizing some Asian countries' economic weaknesses, its tardiness may be blamed, in part, on the way rating agencies reach their conclusions. In the past, the most important factor in pronouncing judgment on a country's financial stability was to take a top-down macroeconomic approach. As long as the fundamentals were sound, the risk of sovereign default was considered slight. Trade-surplus numbers and official data on the size of reserves mattered most. An analyst could as easily calculate a rating from a desk in a Wall Street skyscraper as from an Asian capital. No longer. The experience of the Asian crisis has left market-watchers, including Moody's, scrambling to find new ways of evaluating the economic world. "The scale and speed of the capital markets is a new kind of event risk which can produce ratings changes which are difficult to anticipate," says Mahoney. "With the integration of global capital markets, everyone is scouring the globe for vulnerabilities." Moody's learned the hard way the importance of having people at the scene to interpret fast-changing events. The agency had long relied heavily on official figures to arrive at its ratings. But as the late British Prime Minister Benjamin Disraeli once warned: "There are three kinds of lies: lies, damned lies and statistics." Official numbers often belie hidden truths and linkages--and a ratings-agency pundit would have to be on the ground to have a good chance of detecting them. That was the case with the Bank of Thailand. Officially, Thailand's central bank had almost $30 billion in reserves going into July 2, 1997--the day Bangkok abandoned the official exchange rate of the baht to the U.S. dollar, sparking the currency crisis. But some market participants knew what Moody's didn't--that central-bank officials had committed more than half of its reserves in long-dated foreign-exchange trades. Usable reserves, therefore, were only half the official figure upon which Moody's relied to do its calculations. Moreover, linkages that had never before been emphasized in understanding financial crises have played a key role in this one--and go a long way to explaining the depth of the crisis and the speed of transmission to other, seemingly removed markets. How did a currency crisis evolve into a credit crisis--and then a banking-system crisis--in many Asian nations? It has to do with underlying links between the private and public sectors. Many companies borrowed U.S. dollars to expand in recent years. As regional currencies devalued, these leveraged firms were in trouble; the local banks they did business with weakened, too. And because banks hold individual savings, a banking crisis usually requires government support and an infusion of public funds. Those are the obvious linkages. But on a micro level, more obscure linkages also played a critical role. Why did investors quickly shed Brazilian holdings when Indonesia collapsed? One reason came to light: Korean merchant banks with Brazilian paper sold it to compensate for the loss in value of their Indonesian investments. But that sort of linkage is difficult to detect--certainly to an analyst who isn't on the scene. The Asian crisis proved Moody's old methods weren't suited to dynamic global markets. It had too few analysts, too far away: Before the turmoil, a single analyst was responsible for the sovereign ratings of five Southeast Asian countries--in addition to five Middle Eastern countries--and all from New York. What's more, analysts were divided into discrete teams covering sovereign debt, banks or corporations, making it difficult for them to consider factors that link all three. The result? Former Moody's analysts say the banking analysts woke up to the degree of leverage in the region well before the sovereign analysts did. But in the traditional hierarchy, the sovereign analysts were at the top--and they took a dim view of the warnings of the banking analysts below them. This "compartmentalized" structure is changing, Mahoney says. Not only are the groups sharing information and ideas, but they have more people on the ground to analyze events as they unfold. In the last year, the number of analysts in the Hong Kong office has grown to 16 from seven. Mahoney, however, stresses the value of the global perspective that Moody's decision-by-committee brings. An analyst in the field sends his or her ratings recommendations to New York, where a group of experts weighs them before deciding whether to reject or accept them. Sometimes these seasoned committee members pick up on clues that analysts close to the market overlook. "It was the Latin American specialists in New York who picked up on the problems in Asia first," Mahoney explains. "The Asian experts were all focused on high savings and investment rates while the Latin American experts were stressing the short-term debt and widening current-account deficits." Not just rating agencies but other market-watchers are learning to cope. "It's a competence issue," notes Salomon's Taran. "Where disclosure is so limited, we are all learning that top-down analysis doesn't work." That creates a staffing issue--and a profitability issue, he adds, asking: "How much do you invest to get additional information? Do they have enough people and quality people?" To be fair, rating-agency critics often lose sight of the fact that these firms are private-sector, for-profit organizations. That means they must always weigh the cost of hiring more staff against the benefit derived from acquiring more information. For many ambitious individuals, the rating agencies can be viewed as a stepping stone to higher-paying positions in brokerage firms. A rating-agency analyst who makes a particularly controversial call that proves correct may attract lucrative job offers; investment bankers who actively recruit analysts from the rating agencies say the discrepancies in pay can be substantial. Some stellar examples of Moody's alumni include Salomon's Taran, Shinji Okabe, the vice-president of fixed-income research at Goldman Sachs in Tokyo, and Roger Arner, now managing director of J.P. Morgan in New York. Moody's sees this as a good reflection on itself. "It would be terrible if our analysts weren't in demand," a Moody's spokesman in New York says. Indeed, he shrugs off the employee turnover; investment banks can always attract individuals who are motivated purely by money, he says. Keeping talented employees is only part of the challenge. The quality of their decisions, after all, can only be as good as the quality of the information on which they are based. The rating agencies are supposed to have access to better information. But do they? "They absolutely get better information from us than a brokerage analyst would get," says David Carse, deputy chief executive at the Hong Kong Monetary Authority--declining to elaborate. But Moody's analysts themselves privately concede that they aren't always privy to the facts they need. "I can't tell you how many times I've left meetings wondering if the people we've met with are lying or they just don't know," says a very senior Moody's analyst in Hong Kong. "And I always hope they're lying because if they really don't know, it is much scarier." To the markets, such distinctions are key. Many analysts suspect that Moody's must have questioned whether the regulators at Bank Indonesia really knew how much debt the country had racked up. It was obvious to other observers that these officials--who were asking international bankers how much money Indonesian companies owed them--were themselves ignorant of the scope of the problem. But in its sovereign-rating reports, Moody's didn't point out this fatal flaw. Many analysts also believe that the Bank of Korea may have understated to the rating agencies the extent of leverage in the system. Moody's won't discuss such concerns, citing client confidentiality. But that nondisclosure can cover up some failings in the data they collect. A former Moody's analyst disclosed that, while she was employed by the agency, a Southeast Asian bank official had confessed that management had drastically understated its bad-debt figures. But sticking to its confidentiality policy, Moody's never informed the markets; instead, the analyst says, she downgraded the bank, citing other factors such as a deteriorating macro environment. Why, when the agency believes it has been given fraudulent information, does it not blow the whistle? "We are not the police and we feel we are on dicey ground in such circumstances," explains Lucy Collett, in-house counsel for Moody's in New York. "We aren't auditors; we don't think our role is to verify information." Mahoney expands on this point. "We have never visualized ourselves as global financial regulators," he says. "That's not our function. Investors shouldn't presume we have privileged information or access. We are the object of too much expectation. People don't have to talk to us or show us their books." The tide may be turning as those who are rated recognize the value in painting a true financial picture. Mahoney says issuers now impart more information, more freely. That, at least theoretically, should lead to better decision-making. "The issuers understand that lack of information diminishes their credibility," explains Mahoney. "And they need credibility. But that doesn't mean they are now committed to total transparency." Still, the recent spate of decisions reflects continuing controversy. "The impartiality, competence and credibility of rating agencies is increasingly being questioned in Asia," says Mukul Asher, associate professor of economics at the National University of Singapore. "My fear is this may feed the backlash against globalization that's building up. Questions of impartiality have arisen because of the timing of some announcements." But to Moody's analysts, such criticism is seen as just another example of the hubris that got Asia into trouble in the first place. A Moody's analyst complains that the agency didn't stop Malaysia from taking its bonds to the international market: "They would have just had to pay more. And these sovereigns refuse to accept the reality that they aren't top credits. They still can't believe it." Baa, humbug. |