Dagong, The New Chinese Bad Guy Or A Fair Player?
Dagong, whose name translates to ‘impartial and without prejudice’, has in recent years directly and intentionally positioned itself in opposition to the Big Three credit rating agencies: Moody’s, S&P, and Fitch. While Dagong was actually founded in 1994, it had until quite recently been content with only rating local issuances; it has rated about 51,000 issuances by 1,100 mainland companies. Dagong also redefined its rating methodology from the traditional 4-notch rating used in China to the72-notch international standard, a move which drew recognition from several global leaders.
The Global Financial Crisis and Opportunity
It was the 2008/2009 global financial crisis however, that really gave Dagong the opportunity to assert itself on the world stage. In the aftermath of the crisis, much blame was heaped upon the Big Three for inaccurately rating sub-prime mortgage-backed securities and collateralized debt obligations as investment grade. These high ratings allowed such sub-prime securities to be easily marketed and sold to investors, some of which needed these triple-A rated securities to meet regulatory capital requirements, greatly exacerbating the market bubble and subsequent crash.
To illustrate just how severe the ratings inflation was, the Financial Crisis Inquiry Commission estimated that out of all the mortgage-backed securities that Moody’s had rated triple-A in 2006, 73% were downgraded to junk by April 2010. The commission itself directly named the Big Three rating agencies as ‘essential cogs in the wheel of financial destruction’.
It was largely accepted that in order to gain market share, the Big Three agencies had engaged in a race to the bottom and had largely relaxed their rating standards in order to satisfy their customers, which were the issuers themselves. This business model naturally allowed such conflict of interests to arise, further, the agencies earned as much as three times more for grading these mortgage-backed securities compared to traditional corporate bonds, increasing the competitive pressures felt.
With the reputation of the Big Three at an all-time low, Dagong sensed an opportunity and marketed itself in direct opposition to the Big Three, targeting not just cross-border yuan issuances but the ‘G3 credit’ issuances as well, which had traditionally been the Big Three’s turf. Dagong began issuing sovereign ratings in 2010 and famously downgraded the United States’ credit rating 3 days before S&P.
Its chairman, Guan Jianzhong has repeatedly issued statements claiming that the Big Three’s rating methodologies are too ideological, claiming that a country’s GDP per capita and level of openness and privatization, both major factors in the Big Three’s sovereign ratings methodology, are separate from the central government’s debt repayment capability. More recently, Dagong has continued to rate the sovereign rating of Russia at A, one notch above the United States at A-, while out of the Big Three both Moody’s and S&P have downgraded Russia’s sovereign debt rating to below investment grade.
Financial vs. Political Pressure
When it comes to the Big Three, there is no doubt that skewed incentives whereby the issuers themselves are paying the rating agencies contributed to misguided ratings and worsened the effects of the collapse of the housing market. There’s no denying that ratings are big business; for example, Moody’s Corporation reported revenues of $3.5B and an operating income of $1.5B in FY2015 with 67% of revenue and 84% of operating income being derived from its ratings division (among the large agencies, only Moody’s is a separate listed entity that discloses its financials with little dilution by non-ratings businesses).
Moody’s profit margins, which have at times reached over 50 percent of gross margin fits in with the model of an industry with high barriers to entry. This is despite the passing of the Credit Rating Agency Reform Act in 2006, which was intended to break the Big Three’s dominance, with the SEC reporting in 2011 that 97% of all credit ratings continued to be issued by the Big Three, down by just 1% compared to 2007.
While the Big Three’s financial incentives structure continues to pose a question as to the fairness of its ratings, Dagong faces a different question, that of political interference. Dagong’s chairman, who controls 100% of the company, is a member of the Communist Party, raising the question of whether ratings given to Chinese corporates, particularly that of state-owned enterprises are fair as well.
Bloomberg recently claimed that based on its own analysis, 57% of China’s AAA bond issuers have risk levels comparable to that of junk bonds. For instance, in the case of China Railway Materials Co., Dagong only cut its credit rating for the company three days after the company had suspended trading on its $2.6B of notes in order to ‘study debt repayment issues’.
Conclusion: Is There Such A Thing As Fair?
With skewed financial incentives on one end and potential political interference on the other, the question is whether there even is such a thing as a ‘fair player’ when it comes to rating agencies. In fact, the current trend seems to be moving towards a cooperative model; the other two large Chinese credit rating agencies, Chengxin and Lianhe are 49% owned by Moody’s and Fitch, respectively.
This seems in line with the overall globalization trend; nevertheless we note that Dagong seems to be more insistent in its ideological stance as a direct competitor to the Big Three, with Dagong founding the Universal Credit Rating Group, currently consisting of Dagong, USA’s Egan-Jones Ratings, and Russia’s RusRating in order to better challenge the Big Three’s hegemony. Dagong’s chairman also recently issued an open invitation for Korean credit rating agencies to join the group.
It would be interesting to see how this plays out in the future, however one thing that is certain is that the days of investors blindly trusting the rating agencies, Big Three or not, are over, and smart investors should always perform their own due diligence on each rating and take it with a pinch of salt.