The news that is gripping South Africa’s financial world: Fitch has downgraded Nasper’s senior unsecured bonds down to junk status.

Naspers is one of South Africa’s top companies. And what I mean by that is: I am often reminded (by the old school investors) that Naspers has, historically, been the best performing stock on the JSE. I couldn’t really find external confirmation of that – but either way, my Recent Finance Graduate Investor hasn’t done too badly off his NPN investment.

Fitch’s official story on the downgrade:

1. So we know that Naspers’ sales went up by 26% from last year (good).
2. But their profits only went up by 1% (less good).
3. And then the directors said this in their report:

   Our goal is to invest in new ventures that will deliver value over the long term. With this in mind, we will continue to invest heavily for organic growth and may also acquire new businesses within our fields of focus.

   Followed by:

   While aggressively investing for the long-term limits short-term earnings and cash flows, we believe this strategy to be sound.

4. And we don’t really like the adverb “aggressively” (bad).
5. It just sounds so aggressive.
6. So we think you’re junk.
7. Haha! Just jokes. We think you’re “speculative” grade credit quality.
8. But if the market calls that “junk” – then we’d just like to point out that this is only our opinion and everyone is free to ignore it.
9. Next time, pay us a better rating fee.
10. Sorry, what?

Ignore me. I highly doubt that any rating agency would revenge-rate – it’s just bad for repeat business. And it doesn’t really speak to professionalism.

That said, all three of the Big Boy ratings agencies did get their calls on all those fun subprime securitisation fantasticalities wildly wrong, with great impact, and with almost no repercussion (because look at all of us still relying on them).

Nasper’s Response

Meloy Horn, Nasper’s spokesperson:

This downgrade will have a limited impact on our financing position and borrowing costs in the near future. Rather frustratingly the Fitch methodology ignores the value of our listed assets, Tencent and Mail.ru stakes valued at $55 billion, which more than adequately covers our $1.5 billion in net debt.

My general sense is, since the Subprime Mortgage Crisis unfolded, the rating agencies have become much more conservative in their evaluations. Especially after people started suing them over their “opinions”.

The Awkward Incentives of Rating Agencies

The theory behind a credit rating agency:

1. The world is filled with people that want to borrow money.
2. The world is also filled with people that have money they would like to lend.
3. Normally, there would be a bank in the middle.
4. But sometimes, the people involved get too large. Or their organisations get too large. And the amount of money that they need gets too large.
5. No bank wants the risk of lending all its depositor money to a country or a giant corporate.
6. So these large organisations and countries will borrow from people directly (through the sale of bonds).
7. If this borrowing/lending story had happened with a bank as a middleman, the lending process would have been managed by the credit risk division, who would have done background checks and testing in order to determine risk profiles and what interest rate to offer and so on.
8. But if the bank is no longer there – then there’s no longer a credit division to do the background work.
9. So investors are left to do it themselves.
10. The trouble with investors doing it all themselves: limited time (and if we’re honest, limited know-how).
11. So the credit ratings agencies grew in to fill the void as kind of a public credit risk division.
12. They would do the background work, and then they would issue credit ratings.
13. Governments – governments near fell over themselves to restrict pension funds and provident funds and medical aid funds to investments of a certain credit quality (as released by these ratings agencies).
14. This was for our own protection.

So far, so good.

Next question: who pays these ratings agencies to come in and do a credit rating?

Answer: the borrowers.

Madness.

In most scenarios, the borrower wants to lend as much as possible, as cheaply as possible. The better the credit rating, the better able they are to do that. And they’re the ones taking care of the fee note for the rating agency.

If the rating agency delivers a rating that the client dislikes, then they may find themselves out of a client.

The only real mitigation: if the rating agency gets the rating wrong, then they may find themselves getting sued. Or, worse, they might find themselves irrelevant. They’ll know this when their revised credit ratings get ignored by the market.

When Credit Rating Agencies Are Really A Problem

If a credit rating agency is overzealous, then you get this:

1. A company has a bit of a cash flow crunch owing to something slightly unusual that is a bit of a once-off event.
2. The rating agency gets wind of it, and drops their credit rating down by two notches.
3. Suddenly, that company is facing rising borrowing costs.
4. So their ability to repay becomes slightly less certain than it was before.
5. The rating agency gets wind of that (again), and drops the credit rating a bit more.
6. Up go the borrowing costs.
7. Down goes the ability to repay.
8. Rinse and repeat.
9. Liquidation.

Of course the example is somewhat extreme – but it can happen. Especially where you have countries that do a lot of debt-rolling.

The Catch-22

I guess that, like almost all credit risk people, the agencies are really there to be hated. If they rate too optimistically, then they’re in the pocket of the borrower and can’t be trusted. If they rate too conservatively, then they risk their rating becoming self-fulfilling.

Because of that, some people would like them to be more regulated – in order to make the playing field fair, and their ratings more consistent, and so on.

But perhaps the real problem is that our current regulatory environment forces pension funds and provident funds and the like to treat these opinions as though they’re fact? Because telling a pension fund “you can only invest in investment grade securities as determined by reference to the credit ratings released by Fitch” is not really giving the pension fund any leeway to say “Oh – but we disagree with that rating because they didn’t take into account listed investments.”

It’s just a thought. Impractical though it might be.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.