Debt Rating, Timeliness, and Market Efficiency: Is History Being Repeated?

 

Many years ago, debt rating agencies (and investors) were caught short when the issuers of highly-rated Washington Public Power Supply (WPPS) bonds defaulted on their obligations. (This event came to be known as the "Whoops" debacle, for obvious reasons.) At the time, numerous articles questioned the timeliness of debt rating changes and the ability of the rating agencies to foresee issuers' financial difficulties. Some suggested that, in an efficient market, debt ratings (or, at least, rating changes) were largely superfluous, because the information to be conveyed was already impounded in market prices.

This issue again comes to the fore with an article in the January 26th issue of Barron's entitled "Costly Lessons: The Debt Raters Know What's Wrong in Korea; Too Bad They Didn't Six Months Ago."

Between October, 1997 and January, 1998, the value of the Korean won fell over 45% relative to the U.S. dollar. However, the graphic accompanying the article suggests that "the rating agencies didn't begin their downgrading [of Korean sovereign debt] until the debacle was well under way."

Why the (alleged) delay? The author of the article suggests that, while several of the more traditional indicators continued to appear healthy well into the decline in the market value of Korean debt, several less-widely followed indicators did not. The rating agencies, in turn, claim to have revised their surveillance activities.

Apart from the facts of the event, how might you use this in class?

First, follow your discussion of the debt rating process with a question about what the role of debt rating agencies is in efficient financial markets. Are ratings likely to be more useful for small or large firms? For "Blue-chips" or for less well-known firms? In times of rising markets or in times of declining markets? (This is also a good way to introduce Barron's Confidence Index.)

Then, either take them on a virtual tour of the rating company sites, or make an internet-based homework assignment. Some appropriate URLs are:

Moodys -- www.moodys.com

Standard and Poors -- http://www.ratings.standardpoor.com/oldindex.htm

Fitch's -- http://www.fitchinv.com/overview.htm

These sites do a good job of explaining the ratings and the process, and also provide up-to-date news items. Good luck!

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