Increasing Transparency

Nathan Williams
05 May 2008

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The collapse of the sub-prime market in the US and the subsequent drying up of liquidity saw credit rating agencies accused by investors and regulators of having a flawed risk assessment model. In many respects, the focus on credit ratings agencies was a red herring thrown up by some to obscure the structural issues which brought about the problems in the first place. The UK Chancellor Alistair Darling said in a message to fellow EU finance ministers last October that there should be a focus on "the role of credit-rating agencies in structured finance, including whether rating agencies should be providing fuller, more transparent information". Although the ratings agencies had and still have a case to answer, they can only provide as much information on securitized assets and leveraged loans that issuers and investors are willing to provide.

Seeing their reputations sullied, they are starting to fight back. Standard & Poor's recently released a report titled a Call For Greater Transparency In The European Leveraged Finance Market, an unambiguous statement on the lack of comprehensive information being provided by leveraged loan issuers. "There are structural problems in the European credit markets which need to be addressed. The market became so aggressive there was no demand for a premium based on credit risk, which has contributed to the lack of liquidity we are now seeing," says Taron Wade, research analyst at Standard & Poor's.

Standard & Poor's has taken steps to address the poor quality of information surrounding leveraged loans by assigning new recovery ratings to all speculative-grade unsecured debt. In Europe, this has seen 150 unsecured debt issues rated for the first time. Although this looks like locking the stable door after the horse has bolted, it is a welcome step on the road to greater transparency which should lead to healthier trading practices. "Investors should be paying greater attention to recover prospects for secured and unsecured debt. With this information they are better equipped to gauge credit risk and open a dialogue with lenders regarding covenants and margins on headroom," says Wade.

The true test of whether rating agencies have taken the criticism on board and applied a more robust analytical approach to downgrading credit worthiness may be yet to come. In mid-summer 2007 leverage hit a median of 6.6x debt to EBITDA according to another Standard & Poor's report with covenant headroom also deteriorating, standing at 26.5% of debt to EBITDA in 2007. The result is that in some cases, lenders on leveraged buyouts will not be party to the true erosion of value in portfolio companies. The risk here is that the debt backing highly-leveraged deals with weak covenants will become rapidly impaired should portfolio companies suffer defaults. Stepping in early and taking a pro-active approach to downgrading leveraged loans in the event of defaults will be imperative for rating agencies if they are to reclaim credibility in the wake of the events of last summer.