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Executives Defend Credit Rating Methodologies

It's not especially fun to be a credit rating agency just now. The economy is coming off a recession, business headlines are still littered with revelations of surprising high-profile accounting frauds, both the telecom and power marketing industries are in dire straits, and default rates on high-yield debt are at unprecedented levels. Rating agencies failed to predict all this turmoil, and as a consequence have come under an enormous amount of criticism and scrutiny. Critics complain on one hand that the agencies fell down on the job by failing to predict the collapse of fallen angels such as Enron. Yet, on the other hand, the agencies are now overcompensating and being too tough on other companies struggling through a difficult economic environment.

While not denying they missed problems at Enron, the ratings agencies are quick to point out that everyone else did, too, from Enron's board of directors to Wall Street equity analysts to the company's underwriters and its external auditors. If more corporations are seeing their credit ratings downgraded since Enron, the rating agencies add, that is more a reflection of deteriorating financial strength at those companies than any scheme on the part of the agencies to downgrade more aggressively. "We have not changed our methodology," says Christopher Mahoney, chairman of the credit policy committee for Moody's Investors Service. "We believe that ratings should provide a stable signal of relative credit risk using the traditional techniques of fundamental financial analysis." Robert Grossman, group managing director and chief credit officer for Fitch Ratings, adds that current trends in ratings activity actually mirror just what happened after the last significant economic downturn in 1991.

Grossman concedes; credit ratings in general are down. At the end of 2000, for example, about 42% of the companies followed by Fitch carried a Single A rating; today, only about 33% do. By contrast, 29% of the companies Fitch follows now carry a Triple B rating, up from about 22%. Triple B is the lowest of all investment grade ratings, one step above "junk" or high-yield status. Meanwhile, Fitch issued 150 credit downgrades during the third quarter of this year through September 25, but only 37 upgrades?a pattern that has held true in each of the last four quarters. Of course, the financial strength of many corporations has deteriorated during that time, too. In looking at 174 companies with a Single A rating as of December 31, 1999, Grossman found that the median company in that group had a higher debt-to-EBITDA ratio two years later (2.33x versus 1.80x), a higher total-debt-to-market-capitalization ratio (34% versus 29%), and a lower cash-flow-to-total-debt ratio (5% versus 7%). The cash flow ratios reflect cash flow after dividends and capital expenditures.

While insisting they've made no wholesale changes to the way they rate corporate creditworthiness, both Mahoney and Grossman say their firms have taken measures designed to make them more effective credit watchdogs. Moody's, for example,

• Has created a "chief credit officer" for its corporate finance group;

• Introduced new quantitative tools for use by its analysts; intensified its focus on issuers' liquidity alternatives in the event of a credit shock;

• Conducted a rigorous post-mortem analysis of all investment-grade defaults since Enron;

• Undertaken a "rating trigger survey" to systematically identify rating triggers in corporations' financial and operating agreements;

• Conducted intensive reviews of certain volatile market sectors, such as telecom, merchant energy, technology and retail; and

• Begun reducing the number of companies it requires each of its analysts to follow.

While arguing that even these sorts of changes won't guarantee that credit rating agencies will catch future Enrons before they happen, Mahoney says there are red flags that analysts can and will watch for at companies they follow: aggressive accounting, arrogant management, negative free cash flow, opaque financial disclosures, excessive complexity in a company's business model or financial reporting, and serial acquisitions. "Obviously, there are good companies that have some of these qualities," Mahoney notes. "Nonetheless, I think if we had considered these prior to Enron, we could have done a better job."

In the meantime, both Mahoney and Grossman report their companies continue to pay foremost attention to a company's free cash flow when determining how to rate its creditworthiness. "In the rating agency world, cash is still king," Grossman points out. "That's still the single most important metric we follow."

"Post-Enron, we have placed greater emphasis on liquidity risk, and on the relationship between an issuer's free cash flow and its indebtedness," concurs Mahoney. "We are penalizing negative free cash flow, after capital expenditures to a greater degree than before. Insofar as a troubled issuer has negative pro forma free cash flow and requires continued access to the capital market, we will not necessarily uphold its rating in order to help it stay afloat."

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