Credit Ratings in the Chilean Fixed Income Market: Some Empirical Observations

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

Background

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 ?

Data and Findings

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.

Some Unsettling Regulatory Issues

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

Credit Ratings in the Chilean Fixed Income Market: Some Empirical Observations