That Israeli AAA Bond Rating Should Stand For, 'Ask About It Again’

Institutional investors use the ratings to invest your savings, but new research shows that local firms flag up worsening conditions only after they are already public.

Eytan Avriel
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Maalot CEO Ronit Harel Ben-Ze'ev (right).Credit: Ofer Vaknin
Eytan Avriel

“I understand you,” nods the personal investment adviser to the bank customer facing him. “You want a safe bond with a good yield. Here, I have exactly what you need. It’s a bond with an ‘A’ rating by the Maalot rating agency. This rating is almost the best there is, with a yield of a half percent above the yield on a similar government bond. In other words, there is zero chance of bankruptcy. How much do you want me to buy for you?”

This conversation can be heard every day, in every bank branch, from every investment adviser in every city in Israel. Anyone who’s ever held an investment portfolio has heard this pitch countless times.

And in this above conversation, everything is true. The rating is the one the bond received from analysts at Maalot, and the bond’s yield figures were taken directly from stock market listings.

But no investment adviser ever really tells the whole truth – and sometimes a half-truth can be a lie. This is because another sentence or two are missing from this explanation, in which the adviser states to his client something like, “Before you decide to buy the bond, remember the rating firm receives its money from the very same firm it is rating. You should know that after the initial rating is determined, which may be affected by the level of ‘influence’ of the company being rated, the rating company usually does not update its rating downward – for example, because of a worsening of the company’s financial situation. When the rating does drop, it almost always happens too late, after the company has already gotten into trouble, after the price of the bond in the market has already collapsed – and after you have already lost your money. In reality, the rating is not worth much and the rating agencies do not give you any real value. Have you understood all this? If so, sign here please. This is a document that states you have heard and understood everything I’ve explained so far.”

Rators get paid by ratees

Have we gone a bit overboard here? Have we presented a populist description of reality? This is the place to present new data on the rating agencies from a study being conducted by the Bank of Israel and obtained by TheMarker.

But first, let us give a bit of background on the companies that set these bond ratings – both for corporations and government bonds. In most of the world, two large rating companies operate: Moody’s and Standard and Poor’s, along with another medium-sized firm named Fitch.

In Israel, there are two firms operating in the rating business: Maalot (which is partially owned by S&P) and Midroog (which represents Moody’s). For decades, these two companies have been, de facto, the commissars of bond quality.

Your company received an AAA rating from them? You have a stamp of approval that everyone, including professional institutional investors, accept as the word of God. You didn’t receive a high rating? They won’t buy your bonds – and if they buy anyway, you will be forced to sell them at a low price.

Until not long ago, most Israeli financial institutions refused to touch bonds without a high-enough rating from one of the two companies.

But the structure of these rating firms is quite strange. They are not government regulators or public standards institutes. They are private, profit-making companies – and they make their living from fees and payments they receive from the very same companies whose financial quality they are meant to appraise and rate.

Is this a problem? Of course. In the capital markets, though, this is not an unusual situation. Accountants, internal auditors and directors – including independent directors – are all guardians who are meant to oversee the company, but they also receive their appointments and salaries from these same companies they supervise and audit.

The fall after the fall

As long as the capital markets were relatively calm, no one complained. But at the beginning of the 2000s, companies started collapsing and the regulators started to notice that the rating firms were not warning of such failures. As a result, the authorities in the United States set rules for supervising the agencies.

A few years later came the real debacle of the rating firms: the financial crisis of 2008. Banks and other companies dropped like flies, and portfolios of bonds and complex financial products, which received very high ratings, evaporated and disappeared within a few months.

During the investigations conducted after the fact, it turned out that the formulas and methods used by the rating firms were quite often wrong, and ratees influenced the rators. In some cases, there was even criminal intent: Employees of the rating agencies knew full well they were granting high ratings to bad companies, or to financial engineering defined as “junk.”

Why did they do it? Because for every high rating, the company that supplied the rating received a whole chunk of money. In the chronicles of the financial crises of the last 70 years, which are far from over, it will be written that the rating firms deserved a large part of the blame for the collapse.

Banks may not have fallen here in Israel, but in a series of well-known affairs, the two Israeli rating firms did not issue warnings and did not update their ratings even when the writing was on the wall, even when the stories were spread across the front pages of the newspapers, and even after the price of the bonds in the market had already collapsed.

The rating firms in Israel did not warn of the fall of Nochi Dankner’s IDB group until everything was already over. They lowered the ratings of Africa Israel’s bonds only when the crisis became public, and then dropped them six levels all at once. In practice, we can’t remember even one example in recent years where the rating agencies lowered their ratings and surprised the markets – or when the lowered ratings were not recognized as being completely obvious and coming too late.

Not recognizing financial deterioration

Last week, the Israel Securities Authority finally succeeded – after years of efforts – in having the Knesset pass a new law on the supervision of local rating agencies. The new law, which will take effect only after the finance minister publishes the necessary regulations, includes definitions of what are considered ratings, what is considered a conflict of interest, what supervisory mechanisms the ISA has, and what the rules are for establishing such a firm.

But the new law does not deal with the fundamental conflict of interest. The rating firms can still continue to choose their preferred methods for ratings, and they will still make their money from the payments from the companies they rate.

All these problems can be clearly identified in ongoing research being conducted by Konstantin Kosenko and Joseph Djivre, both from the research department at the Bank of Israel.

They examined all the companies filing for bankruptcy in the past 20 years (up through 2012) in the United States, and looked at their ratings over the five years preceding their collapse. They found that the average rating was BB, and that the rating fell gradually as the company’s situation deteriorated. This is exactly what such a study should have found.

But when you conduct the same study with 75% of the ratings in Israel – including those of Maalot and Midroog – we find something completely different. First, it transpires that the average rating of companies that collapsed here (over the five-year period before the collapse) was about A. This is a rating six levels higher than that found in the study of American firms. This is the first hint that the Israeli rating firms are slanted toward their customers. In Israel, for some reason, most of the companies are much better than those in America – even when they collapse.

The second major finding is even more interesting. While the ratings in the United States drop gradually – after all, the company is nearing bankruptcy – here in Israel the graph is almost a straight line, and then it falls – all at once – only a few months before the end.

This means the Israeli rating firms do not know how to identify the deterioration of the company’s situation, and do not publish updates or downgrades.

Based on our understanding of local tycoons and the business scene, we can describe it this way: For some reason or another, the ratings of companies belonging to influential and important business figures are not downgraded, even though anyone with eyes in their head can clearly see when the situation is deteriorating.

The full study (of which the results presented here are only a small part) will be published in a few months by the central bank, and will deal with a number of different aspects of Israeli debt-restructuring arrangements. As for Israeli rating firms, the results are clear: Their ratings are basically worthless – at least for the period of 2007 through 2013. There is no other way to describe their work in analyzing the quality of debt of companies that basically went bankrupt, after receiving high initial ratings that no one bothered to update.

U.S vs. Israeli rating agencies graphic
Eran Heimer (left), CEO of Midroog.Credit: Ofer Vaknin

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