China Holds Debt Rating Agency Responsible

Credit ratings agencies' track record of adequately warning creditors has been less than stellar in many instances.

A China court is making one of these agencies pay.

Here's an excerpt from a Jan. 4 South China Morning Post article:

A Chinese court ruled that a local ratings firm should help compensate some creditors for a construction firm's 1.4 billion yuan (US$216 million) bond defaults three years ago, a first in the country as Beijing raises pressure on agencies to improve their due diligence.

Dagong Global Credit Rating is responsible for repaying up to 10 per cent of at least 494 million yuan of combined debt claims to more than 400 individual bondholders of Wuyang Construction Group...

Wuyang Construction's legal representative and actual controller Chen Zhizhang, underwriter Tebon Securities, as well as an accounting company and a legal firm are also collectively responsible, the court said, citing their failures to conduct due diligence properly.

Beijing has tightened oversight of the country's bond market following a surge of defaults since November, imposing short-term bans on new business on two other rating agencies and launching probes into several banks, accounting firms and a large brokerage for alleged irregularities related to bond sales.

The Hangzhou court's ruling also sets the precedent for bond underwriters, accounting and law firms to be financially responsible for bondholders' losses, potentially offering a new road map for handling such cases in the future.

"This verdict should be the first of its kind in China. It substantially raises the cost of fraudulence and inadequate due diligence in the bond market," said Yang Hao, a fixed income analyst at Nanjing Securities Co. "Financial intermediaries will become more prudent in the future and investors may also actively explore this approach to seeking compensation."

The 2020 edition of Robert Prechter's Conquer the Crash provides an example of why credit ratings agencies should not be relied upon for timely financial warnings. The book offers a quote from the February 28, 2008 Elliott Wave Financial Forecast:

The stock prices of MBIA and Ambac have declined over 90% from their respective peaks last year. Through the entire run up to the highs and subsequent decline, S&P and Moody's, two of the main ratings agencies, maintained a AAA rating on each company. Despite the crushing decline in the share price, ratings agencies this week "affirmed" their AAA status on both companies, maintaining the charade of financial stability. We are quite sure it will fail. For one thing, government-endorsed agencies' assessments of risk came to replace free-market-based assessments. This was not much of a problem on the way up, because the upward trajectory of prices kept even the most rickety promises afloat. But the recent change toward increasing pessimism means that a long-term attack on agencies and their ratings is on, and it will do for the decline what complacency did for the advance. Don't be surprised if affirmations of corporate health accompany short-term peaks and the inevitable downgrades near the bottom are erroneously seen as contributing to the carnage.

The 2020 edition of Conquer the Crash continues:

One year later, all these expectations had come to pass: Government-sanctioned firms' ratings were outed as too positive, unsuspecting holders of weak debt suffered huge losses, the services came under fire for ineptitude and cronyism, and they eventually downgraded many issues, when it was way too late.