Credit Rating Agency

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CREDIT RATING AGENCY Credit Rating Agency has been defined as [A]n independent company that evaluates the

financial condition of issuers of debt instruments and then assigns a rating that reflects its assessment of the issuer's ability to make the debt payments. Potential investors, customers, employees and business partners rely upon the data and objective analysis of credit rating agencies in determining the overall strength and stability of a company. 1 Since the investors take on the risk of the asset pool rather than the Originator, an external credit rating plays an important role. The rating process would assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework.

A credit rating agency is a potential source of information for market participants who are trying to ascertain the creditworthiness of borrowers. Essentially, rating agencies offer judgments (they prefer the word opinions2) about the quality of bonds issued by corporations, governments (including U.S. state and local governments, as well as sovereign issuers abroad), and mortgage securitizers. These judgments come in the form of letter grades. The best-known scale is that used by Standard & Poors (S&P) and some other rating agencies: AAA, AA, A, BBB, BB, etc., with pluses and minuses as well.3 John Moody is credited with initiating agency bond ratings, in the United States in1909.4 John Moody published the first publicly available bond ratings (mostly concerning railroad bonds) in 1909. Moody's firm was followed by Poor's Publishing Company in 1916, the Standard Statistics Company in 1922,4 and the Fitch Publishing Company in 1924.5 These firms sold their bond

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See Business dictionary http://www.businessdictionary.com/definition/credit-rating-agency.html#ixzz2XbvxMPOR The rating agencies favour that term because it allows them to claim that they are "publishers" and thus enjoy the protections of the First Amendment of the U.S. Constitution (e.g., when the agencies are sued by investors and issuers who claim that they have been injured by the actions of the agencies). 3 Lawrence J. White. 2009. A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry's Role in the Subprime Mortgage Debacle of 2007 2008. Retrieved from http://mercatus.org/publication/brief-history-credit-rating-agencies-how-financial-regulation-entrenched-industrysrole 4 SEE Richard Sylla. 2001. A Historical Primer on the Business of Credit Ratings http://www1.worldbank.org/finance/assets/images/Historical_Primer.pdf

ratings to bond investors in thick rating manuals. In the language of modern corporate strategy, their business model was one of investor pays.5

This relationship between the rating agencies and the U.S. bond markets changed in 1936 when the Office of the Comptroller of the Currency prohibited banks from investing in "speculative investment securities," as determined by recognized rating manuals (i.e., Moody's, Poor's, Standard, and Fitch). Speculative securities were bonds that were below investment grade,6 thereby forcing banks that invested in bonds to hold only those bonds that were rated highly (e.g., BBB or better on the S&P scale) by these four agencies. In effect, regulators had endowed third-party safety judgments with the force of law.7

In the following decades, insurance regulators and then pension fund regulators followed with similar regulatory actions that forced their regulated financial institutions to heed the judgments of a handful of credit rating agencies.8

In 1975, the Securities and Exchange Commission (SEC) issued new rules that crystallized the centrality of the rating agencies. To make capital requirements sensitive to the riskiness of broker-dealers' bond portfolios, the SEC decided to use the ratings on those bonds as the indicators of risk.

However, the SEC worried that references to "recognized rating manuals" were too vague and that a bogus rating firm might arise that would promise "AAA" ratings to those companies that would suitably reward it and "DDD" ratings to those that would not. If a broker-dealer claimed that those ratings were "recognized," the SEC might have difficulties challenging this assertion.

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Lawrence J. White. Op cit. United States Comptroller of the Currency, Purchase of Investment Securities, and Further Defining the Term "Investment Securities" as Used in Section 5136 of the Revised Statutes as Amended by the "Banking Act of 1935," Section II (February 15, 1936). This rule still applies to banks today. This rule did not apply to savings institutions until 1989. Its application to savings institutions in 1989 forced them to sell substantial holdings of "junk bonds" (i.e., below investment grade) at the time, causing a major slump in the junk-bond market. 7 Lawrence J. White. ibid 8 Ibid.

To solve this problem, the SEC designated Moody's, S&P, and Fitch as "Nationally Recognized Statistical Rating Organizations" (NRSROs).7 In effect, the SEC endorsed the ratings of NRSROs for the determination of the broker-dealers' capital requirements. Other financial regulators soon followed suit and deemed the SEC-identified NRSROs as the relevant sources of the ratings required for evaluations of the bond portfolios of their regulated financial institutions.

Over the next 25 years, the SEC designated only four additional firms as NRSROs,8 but mergers among the entrants and with Fitch reduced the number of NRSROs to the original three by the end of 2000. NRSRO designation had become a significant barrier to entry into the bond-rating business because the SEC's support was quite important for potential entrants. Moreover, the SEC neither established criteria for a NRSRO designation nor provided any justification or explanation as to why it "anointed" some firms with the designation and refused to do so for others. Also importantly, in place of the investor pays model established by John Moody in 1909, the agencies converted to an issuer pays model during the early 1970s whereby the entity that is issuing the bonds also pays the rating firm to rate the bonds. This change opened the door to potential conflicts of interest:9 A rating agency might shade its rating upward so as to keep the issuer happy and forestall the issuer's taking its business to a different rating agency. 10

In the bond-information market, experience, brand-name reputation, and economies of scale are important features. The industry was never going to be a commodity business of thousands (or even hundreds) of small-scale producers. In the United States, the Securities and Exchange Commission (SEC) an organisation that regulates which companies are nationally recognised securities rating organisation (NRSRO), has never allowed more than five companies to be recognised at one time since the industry began.11 Moodys investors Service and the Standard & Poors Division of McGraw Hill Companies Inc. and Fitch Ratings Inc are the three major

This conflict of interest will be discussed later under the heading moral hazards. Ibid. 11 John Ryan. 2012. The Negative Impact of Credit Rating Agencies and Better Regulation. Retrieved from http://www.swpberlin.org/fileadmin/contents/products/arbeitspapiere/The_Negative_Impact_of_Credit_Rating_Agencies_KS.pdf
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players.12 Nevertheless, regulators actions surely contributed heavily to the dominance of the three major rating agencies. The SECs belated efforts to allow wider entry into the NRSRO category during the current decade were too little and too late. The entrants could not quickly overcome the advantages of the big threes incumbency.13

Moody John Moody founded the financial holding company, Moodys Corporation, in 1909. Although Moodys provides a number of services, one of their largest divisions is Moodys Investor Services. While Moodys has conducted credit ratings since 1914, they only conducted ratings of government bonds until 1970. Moodys has grown significantly over the years. Presently, Moodys is the second largest of the big three firms.14

Standard and Poor Henry Varnum Poor was a financial analyst with a similar vision to John Knowles Fitch. Like Fitch, Poor was interested in publishing financial statistics, which inspired him to create H.V. and H.W. Poor Company.

Luther Lee Blake was another financial analyst interested in becoming a financial publisher. In order to achieve this dream, Blake founded Standard Statistics in 1906, just a year after Poors death. Standard Statistics and H.V. and H.W. Poor published very similar information. Hence, it made sense for the two companies to consolidate their assets, and they merged in 1941 to form the Standard and Poors Corporation. Today, Standard and Poors not only provides ratings but also offers other financial services, such as investment research, to investors. They are now the largest of the big three rating agencies.15

Fitch
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Ibid. Ibid. See also Kalen Smith. History of Credit Rating Agencies and How They Work retrieved from http://www.moneycrashers.com/credit-rating-agencies-history/ 14 Ibid. 15 Ibid.

The Fitch Publishing Company was founded in 1913 by John Knowles Fitch, a 33-year-old entrepreneur who had just taken over his fathers printing business. Fitch had a unique goal for his company: to publish financial statistics on stocks and bonds. In 1924, Fitch expanded the services of his business by creating a system for rating debt instruments based on the companys ability to repay their obligations. Although Fitchs rating system of grading debt instruments became the standard for other credit rating agencies, Fitch is now the smallest of the big three firms.16

How Credit Rating Agencies Work Debtors want investors to have a good idea of how creditworthy their securities are. Of course, investors are looking for an unbiased idea of a companys ability to repay debt. Therefore, companies will often hire a credit rating agency to rate their debt.

After the company solicits a bid, the credit rating agency will evaluate the institution as carefully as possible. However, there is no magic formula to determine an institutions credit rating; the agency must instead conduct a subjective evaluation of the institutions ability to repay its debts.

When conducting their assessment, the credit rating agencies will look at a number of factors, including the institutions level of debt, its character, a demonstration of its willin gness to repay its debt, and its financial ability to repay its debt. Although many of these factors are based on information found on the institutions balance sheet and income statements, others (such as an attitude towards repaying debt) need to be scrutinized more carefully.

For example, in the recent United States debt ceiling debacle, S&P downgraded the U.S. sovereign debt rating because they felt the political brinkmanship of the federal government was not consistent with the behaviour of a AAA institution. When they assess an institutions credit rating, the agencies will classify the debt as one of the following:

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Kalen Smith. Op cit.

High grade Upper medium grade Lower medium grade Non-investment grade speculative Highly speculative Substantial risks or near default In default

High grade investments are considered the safest debt available. On the other hand, investments that are listed as in default are the riskiest debt instruments, as they have already demonstrated that they are unable to repay their obligations. Hence, investments in default will need to offer a much higher interest rate if they intend to invest money in them.

Advantages of Credit Agencies 1. They Help Good Institutions Get Better Rates Institutions with higher grade credit ratings are able to borrow money at more favorable interest rates. Accordingly, this rewards organizations that are responsible about managing their money and paying off their debt. In turn, they will be able to expand their business at a faster rate, which helps stimulate the economys expansion as well.

2. They Warn Investors of Risky Companies Investors always want to know the level of risk associated with a company. This makes rating agencies very important, as many investors wish to be forewarned of particularly risky investments.

3. They Provide a Fair Risk-Return Ratio Not all investors are opposed to buying risky debt securities. However, they want to know that they are going to be rewarded if they take on a high level of risk. For this reason, credit rating agencies will inform them of the risk levels for every debt instrument and help ensure that they are properly compensated for the level of risk they take on.

4. They Give Institutions an Incentive to Improve A poor credit rating can be a wake-up call for institutions that have taken on too much debt or havent demonstrated that they are willing to be responsible about paying it back. These institutions are often in denial of their credit problems, and need to be alerted of any potential problems from an analyst before they make the necessary changes.17

Disadvantages of Credit Rating Agencies Unfortunately, although credit rating agencies serve a number of purposes, they are not without flaws:

1. Evaluation Is Highly Subjective There are no standard formulas to establish an institutions credit rating; instead, credit rating agencies use their best judgement. Unfortunately, they often end up making inconsistent judgments, and the ratings between different credit rating agencies may vary as well.

For example, there was much talk about the S&P downgrade when the United States lost its AAA credit rating. Regardless of the S&P decision, the other two major credit rating agencies still give the U.S. the highest grade rating possible.

2. There is Moral Hazard inherent in the operations of the rating agencies The credit rating agencies usually provide ratings at the request of the institutions themselves. Although they sometimes conduct unsolicited evaluations on companies and sell the ratings to investors, they usually are paid by the very same companies they are rating.

Obviously, this system can lead to serious conflicts of interest. Since the company pays the rating agency to determine its rating, that agency might be inclined to give the company a more favourable rating so as to retain their business. The Department of Justice has started investigating the credit rating agencies for their role in the mortgage-backed securities that collapsed in 2008.

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See generally Kalen Smith

3. Ratings Arent Always Accurate Although credit rating agencies offer a consistent rating scale, that does not mean that companies are going to be rated accurately. For many years, the credit ratings of these agencies were rarely questioned. However, after rating agencies provided AAA ratings for the worthless mortgagebacked securities that contributed to the recession, investors dont have nearly as much faith in them. Their ratings are still referenced by almost everyone, but their credibility has taken a serious hit.

4. Lack of Competition The financial ratings industry is dominated by Standard and Poors and Moodys, both in the US and worldwide. It constitutes a duopoly, or at best, an oligopoly if Fitch is included, with the leading agencies able to charge issuers substantial fees. Since two ratings are normally needed to issue rated debt the two major firms do not compete with each other.18 High ratings given to low-quality assets, particularly those based on risky mortgages, have been criticised by authorities around the world for contributing to the credit market bubbles that have collapsed in the crisis.19

Lack of Accountability It has been shown that CRAs wield enormous power as gatekeepers to financial markets for companies and as a primary assessment tool for investors. However, while rating decisions are ostensibly based on fixed, documented standards, agencies themselves admit that their evaluations are essentially opinions and cannot be verified in courts.20 The assignment of a certain issuer to a rating category is consequently based on non-verifiable, non-auditable information with the issuer allowed no legal recourse. The CRAs have been severely criticised for their lack of diligence and for their bad decisions during the last few years. The collapse of corporate giants triggered a series of examinations on the role and credibility of the CRAs21. No one has been more wrong than CRAs. They put the insurance giant American International Group (A.I.G.) in the AA category. They rated Lehman Brothers an A just a month before it
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John Ryan . Op cit. Alan Beattie. 2008 Financial Times, Rating bodies broke bond of trust, October 23 2008. Financial Times. Retrirved from http://www.ft.com/cms/s/0/06b5770c-a09b-11dd-80a0-000077b07658.html#axzz2XiZ0ZAqM 20 John Ryan Op. cit
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Sean Egan. Why Ratings Are Failing Us. Newsweek, May 25, 2009

collapsed. The CRAs maintained AAA ratings on thousands of nearly worthless subprimerelated securities. The reason for this continued reliance on ratings is simple: bad regulation.22 As more regulators and institutions rely on ratings, the CRAs have become increasingly reluctant to downgrade. Even a one-notch downgrade of A.I.G. before it hit the crisis would have saddled it with an extra $8 billion of obligations. It is no coincidence that when US government officials were debating the fourth round of A.I.G. bailouts in 2009, they quietly called on the rating agencies to ensure that they would not downgrade the insurer. In a crisis, downgrading debt can be like firing a bullet into a companys heart.23

The answer to all this is for the regulatory tie to be severed, and for investors to pay for ratings as they please and from whoever they please, rather than from a sanctioned handful. It is doubtful that will happen. But these are difficult times. If the authorities want to sort the whole sorry mess out, they will never have a better opportunity27. "Potential conflicts exist regardless of who pays. The key is how well the rating agencies manage the potential conflicts." Mr. McDaniel and the other executives present - Deven Sharma, of Standard and Poor's, and Stephen Joynt, of Fitch Ratings - said their companies were co-operating with reviews of the agencies' performance by the Securities and Exchange Commission and other authorities. But they stressed that many parts of the financial system had underperformed, and said it

was disproportionate to blame the ratings agencies for their role.28

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Jerome Fons & Frank Partnoy Rated F for Failure, New York Times, 16 March 2009

See generally John Ryan Op cit

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