A new world order

Credit Management, May 2002 by Banyard, Peter

Peter Banyard examines Fitch's reasons for changing its ratings criteria. He then goes on to look at consumer credit, and considers that most uncommon of traits, common sense.

It's usually a bit of a shaker whenever someone announces a new world order. Usually the best reaction is to beef up the defence budget and install nuclear bunkers ahead of the possibility of being forced to conform to the NWO. I am not sure that this is quite appropriate when Fitch Ratings declares that a NWO is taking shape. After all, Fitch is meant to be on our side in the credit business and it does not deploy any armoured divisions or carrier groups. However, in the wake of the Enron surprise, the agency has raked over its ratings criteria and concluded that things have got to change. The language used is polite but the list of changed commercial practices is a pretty damning indictment of a financial industry that is now lost to honour. If that last phrase sounds a bit Victorian it may be because flaky business practice has become acceptable.

Beginning with 'laddering', which is one matter Fitch does not deal with and which has just come to the surface, the list of dubious practices is a long one. The laddering itself is a device to ramp up a stock's price following an initial public offering. The underwriting brokers cut secret deals with big investors and allocate them stock at the offer price so long as they agree to chase that price up by buying more stock at increasing price levels. When those investors sell to the mugs who are not in the secret, it is alleged that they split their profits with the underwriters. Some of the firms and individuals being investigated in connection with the first two cases, Buy.com and drugstore.com, are household names. No case has yet come to court so we can still hope that these are mere wild allegations, just a bad dream.

Indeed it might beggar belief that such people would stoop to that sort of deception from simple greed, or it might not. It is becoming clear that the idea of having a good business model and working hard and purposefully enough to build it up is too slow an option for modern financial operators. The result has been the invention or misuse of a number of financial stratagems in a manner specifically designed to deceive. Fitch's list alone includes loans that fly off balance sheet to mutual funds and even synthetic structures. This amounts to a conscious attempt to defeat serious credit analysis and is coupled to the changing nature of the capital markets. Credit provision has shifted from commercial banks into the capital markets and bonds are no longer principally long-term interest bearing assets, but instruments that are pooled into transactions and tranched for risk appetite.

Fitch has much else to say about the difficulty of producing new analytical methods to deal with this market evolution. Part of the problem is that credit rating is built into commercial agreements and that makes these agreements very sensitive to any change in ratings. It becomes an invidious business if a reasonable credit downgrade amounts to ruining a company. Fitch will be making a number of changes in the way that companies are analysed and I dare say that similar things are happening at the other major agencies. In the end a credit rating is going to be a much more detailed and slightly more ambiguous report that is going to take careful study.

It may seem that few of us are affected professionally by these capital market changes. We are, most of us, affected personally as the list of financial sector failures lengthens. We all know now about the problems of the pensions industry and the closely allied difficulties of the life insurance industry. Other savings vehicles like split capital trusts are believed to be in such parlous condition that they are openly referred to as the `walking dead'. This was not something that the ratings warned us about and that is probably because everyone failed to spot a change in the markets which has made for increased price volatility and less availability of strong asset-backed securities: in other words low risk investments. There has also been an ethical shift.

The best illustration I can give is the case of Dublin listed pharmaceutical company Elan. The share price has suffered over an aborted clinical trial but also over reservations that three of the board, including the chief executive, were recruited from the firm that audits Elan's accounts. Elan has riposted that there is nothing wrong in that, and that is true enough. All the same, the post-- Enron climate has made for unease over any possible cosiness in the business relationship between auditor and client. I can see that we are all going to be rather more fastidious about these things from now onwards; and we have good reason for that. The bursting of the bubble has thrown up rather too many cases of a dubious collusion between professionals and their clients. Elan may be the innocent victim of a new rigour in these matters, but I still welcome the change.