Transparent investment data is crucial as moves are afoot to bypass rating agencies

Investors often ask “when will the financial crisis ever end?” Fortunately, the answer may be “soon”.

The US government is currently examining a research programme that allows savvy investors to bypass some of the pitfalls that contributed to the current financial crisis.

We all know that banks’ concealment of losses contributed to the malaise that Ireland has suffered from disproportionately.

The greed in the finance sector – and the pursuit of short-term return through bonus pay structures – will continue, as it has always done. The challenge is to contain it.

Investors can only make sensible objective decisions if they have access to proper information and transparency.

Let down
In the past they were let down. The credit rating agencies effectively misled investors by failing to blow the whistle on reckless banking.

Auditors, constrained by arcane accounting rules, told investors that banks were profitable when they were effectively bankrupt.

If markets behaved as the text books suggest, the rating agencies would no longer exist.

The banking crisis is only one example of their failure. They also delayed downgrading Enron and before that gave favourable ratings to local authorities that went bankrupt from using toxic structured products.

A paper by the European Central Bank* nevertheless shows how powerful they are.

“Country-specific credit ratings have played a key role in the developments of the spreads for Greece, Ireland, Portugal and Spain.

“It is useful to point out that institutional investors, such as pension funds and insurers, are obliged by law or their own statutes to purchase and hold bonds with a certain minimum rating.

“Moreover, credit ratings are used by regulators to establish banks’ capital requirements.”

Central banks also rely on rating agencies to decide the size of loans they give to commercial banks.

Pension fund trustees should of course be alarmed by this. Regulation is forcing pension fund managers to buy potentially worthless bonds.

Sensible private investors, spared of such regulation, have in my experience steered clear of anything that is triple A rated on the grounds that they are probably overpriced and contain risks that the rating agencies have not highlighted.

Possible solution
Marc Joffe**, a former Moody's executive who currently works with the San Jose State University, has a possible solution.

He has received a grant for a project that allows investors to bypass the credit rating agencies and do for themselves what rating agencies and auditors should do.

Investors want independently verifiable raw data. This allows them to draw their own conclusions and not the information fed to them by rating agencies and auditors – often themselves commissioned by bankers.

Joffe has developed a website that supplies investors with the necessary raw data. Unlike the rating agencies, the model and data used is fully transparent and allows the user to make his own assumptions.

Joffe’s work for the moment is designed for bond investors. Unlike shares, when an investor buys a bond, the income or coupon is usually fixed in advance. The risk of course is that the issuer will default. Most long term investors therefore attempt to make sure that the return on the bond justifies the risk.

Unlike rating agencies, which can walk away from losses, and which want to please the pipers that call the tune (namely bond issuers), investors want a realistic and accurate assessment. Joffe’s’ research is not only confined to US-issued municipal bonds: Italian government bonds are also under his radar.

Flaws in the credit rating system mean that when some municipals default, the adverse publicity causes their healthier counterparts to suffer.

Investor nervousness, according to Joffe, has cost all municipal bond issuers an extra 1.1 per cent in annual interest, as investors seek higher returns to compensate for badly measured risk.

The model does attempt to estimate the probability of default but, unlike the rating agencies, gives investors a better understanding of the risks.

With over $3.7 trillion of municipal bonds in issue, a figure that is growing at 4 per cent per annum, the extra 1.1 per cent is a significant figure.

Joffe’s model looks at four factors:

the percentage of annual interest and pension payments to revenue;

the percentage annual change in total revenue;

the percentage of profit to revenue;

cash reserves.

Apart from Joffe, others are attempting to introduce transparency including the National University of Singapore Risk Management Institute's Credit Risk Initiative.

DIY research
Irish parents are learning to their cost that delegating the upbringing of their children to strangers at crèches doesn't necessarily work. Investors too are beginning to realise that doing the research legwork themselves is a lot safer than depending on strangers.

Now they have an opportunity to do so.

There is no guarantee that Joffe’s initiative will work but it is certainly going in the right direction. Investors want more control over the information they receive. Joffe is not alone.

The National University of Singapore Risk Management Institute’s Credit Risk Initiative is introducing more transparency for corporate bonds.

*iti.ms/11CdcM
**iti.ms/11Cdh3f

Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options