Role in capital markets[edit]

Credit rating agencies assess the relative credit risk of specific debt

securities or structured finance instruments and borrowing entities
(issuers of debt),[51] and in some cases the creditworthiness of
governments and their securities.[52][53] By serving as
information intermediaries, CRAs theoretically reduce information
costs, increase the pool of potential borrowers, and promote liquid
markets.[54][55][56] These functions may increase the supply of
available risk capital in the market and promote economic growth. [51]
[56]

Ratings use in bond market[edit]

Further information:  Credit rating
Credit rating agencies provide assessments about the creditworthiness
of bonds issued by corporations, governments, and packagers of asset-
backed securities.[57][58] In market practice, a significant bond issuance
generally has a rating from one or two of the Big Three agencies. [59]
CRAs theoretically provide investors with an independent evaluation
and assessment of debt securities' creditworthiness.[60] However, in
recent decades the paying customers of CRAs have primarily not been
buyers of securities but their issuers, raising the issue of conflict of
interest (see below).[61]
In addition, rating agencies have been liable—at least in US courts—for
any losses incurred by the inaccuracy of their ratings only if it is
proven that they knew the ratings were false or exhibited "reckless
disregard for the truth".[12][62][63] Otherwise, ratings are simply an
expression of the agencies' informed opinions,[64] protected as "free
speech" under the First Amendment.[65][66] As one rating agency
disclaimer read:
The ratings ... are and must be construed solely as, statements of
opinion and not statements of fact or recommendations to purchase,
sell, or hold any securities.[67]
Under an amendment to the 2010 Dodd-Frank Act, this protection has
been removed, but how the law will be implemented remains to be
determined by rules made by the SEC and decisions by courts. [68][69][70]
[71]

To determine a bond's rating, a credit rating agency analyzes the

accounts of the issuer and the legal agreements attached to the bond [72]
[73]
 to produce what is effectively a forecast of the bond's chance
of default, expected loss, or a similar metric.[72] The metrics vary
somewhat between the agencies. S&P's ratings reflect default
probability, while ratings by Moody's reflect expected investor losses
in the case of default.[74][75] For corporate obligations, Fitch's ratings
incorporate a measure of investor loss in the event of default, but its
ratings on structured, project, and public finance obligations narrowly
measure default risk.[76] The process and criteria for rating a
convertible bond are similar, although different enough that bonds and
convertible bonds issued by the same entity may still receive different
ratings.[77] Some bank loans may receive ratings to assist in
wider syndication and attract institutional investors.[73]
The relative risks—the rating grades—are usually expressed through
some variation of an alphabetical combination of lower- and uppercase
letters, with either plus or minus signs or numbers added to further
fine-tune the rating.[78][79]
Further information:  Bond credit rating § Credit rating tiers
Fitch and S&P use (from the most creditworthy to the least) AAA, AA,
A, and BBB for investment-grade long-term credit risk and BB, CCC, CC,
C, and D for "speculative" long-term credit risk. Moody's long-term
designators are Aaa, Aa, A, and Baa for investment grade and Ba, B, Caa,
Ca, and C for speculative grade.[78][79] Fitch and S&P use pluses and
minuses (e.g., AA+ and AA-), and Moody's uses numbers (e.g., Aa1 and
Aa3) to add further gradations.[78][79]

Estimated spreads and

default rates by rating grade

Basis
point Default
Rating
spread rate[83][84]
[80][81][82]

AAA/Aaa 43 0.18%

AA/Aa2 73 0.28%

A 99 n/a
BBB/Baa2 166 2.11%

BB/Ba2 299 8.82%

B/B2 404 31.24%

CCC 724 n/a

Sources: Basis spread is

between US treasuries
and rated bonds
over a 16-year period;[23][81]
Default rate over a
5-year period, from a study
by Moody's investment service[83][84]

Agencies do not attach a hard number of probability of default to each

grade, preferring descriptive definitions, such as "the obligor's capacity
to meet its financial commitment on the obligation is extremely
strong," (from a Standard and Poor's definition of a AAA-rated bond)
or "less vulnerable to non-payment than other speculative issues" (for
a BB-rated bond).[85] However, some studies have estimated the
average risk and reward of bonds by rating. One study by Moody's [83]
[84]
 claimed that over a "5-year time horizon", bonds that were given its
highest rating (Aaa) had a "cumulative default rate" of just 0.18%, the
next highest (Aa2) 0.28%, the next (Baa2) 2.11%, 8.82% for the next
(Ba2), and 31.24% for the lowest it studied (B2). (See "Default rate" in
"Estimated spreads and default rates by rating grade" table to right.)
Over a longer time horizon, it stated, "the order is by and large, but not
exactly, preserved".[86]
Another study in the Journal of Finance calculated the additional
interest rate or "spread" that corporate bonds pay over that of
"riskless" US Treasury bonds, according to the bonds rating. (See
"Basis point spread" in the table to right.) Looking at rated bonds from
1973 through 1989, the authors found a AAA-rated bond paid only 43
"basis points" (or 43/100ths of a percentage point) more than a
Treasury bond (so that it would yield 3.43% if the Treasury bond
yielded 3.00%). A CCC-rated "junk" (or speculative) bond, on the other
hand, paid over 4% more than a Treasury bond on average (7.04% if
the Treasury bond yielded 3.00%) over that period.[23][81]
The market also follows the benefits from ratings that result from
government regulations (see below), which often prohibit financial
institutions from purchasing securities rated below a certain level. For
example, in the United States, in accordance with two 1989
regulations, pension funds are prohibited from investing in asset-
backed securities rated below A,[87] and savings and loan
associations from investing in securities rated below BBB.[88]
CRAs provide "surveillance" (ongoing review of securities after their
initial rating) and may change a security's rating if they feel its
creditworthiness has changed. CRAs typically signal in advance their
intention to consider rating changes.[78][89] Fitch, Moody's, and S&P all
use negative "outlook" notifications to indicate the potential for a
downgrade within the next two years (one year in the case of
speculative-grade credits). Negative "watch" notifications are used to
indicate that a downgrade is likely within the next 90 days. [78][89]
Accuracy and responsiveness[edit]
Further information:  Credit rating agencies and the subprime crisis
Critics maintain that this rating, outlooking, and watching of securities
has not worked nearly as smoothly as agencies suggest. They point to
near-defaults, defaults, and financial disasters not detected by the
rating agencies' post-issuance surveillance, or ratings of troubled debt
securities not downgraded until just before (or even after) bankruptcy.
[90]
 These include the 1970 Penn Central bankruptcy, the 1975 New
York City fiscal crisis, the 1994 Orange County default,
the Asian and Russian financial crises, the 1998 collapse of the Long-
Term Capital Management hedge fund, the
2001 Enron and WorldCom bankruptcies, and especially the 2007–
8 subprime mortgage crisis.[90][91][92][93][94]
In the 2001 Enron accounting scandal, the company's ratings remained
at investment grade until four days before bankruptcy—though
Enron's stock had been in sharp decline for several months [95][96]—
when "the outlines of its fraudulent practices" were first revealed.
[97]
 Critics complained that "not a single analyst at either Moody's of
S&P lost his job as a result of missing the Enron fraud" and
"management stayed the same".[98] During the subprime crisis, when
hundreds of billion of dollars' worth [46] of triple-A-rated mortgage-
backed securities were abruptly downgraded from triple-A to "junk"
status within two years of issue,[47] the CRAs' ratings were
characterized by critics as "catastrophically misleading" [99] and
"provided little or no value".[69][100] Ratings of preferred stocks also
fared poorly. Despite over a year of rising mortgage deliquencies,
[101]
 Moody's continued to rate Freddie Mac's preferred stock triple-A
until mid-2008, when it was downgraded to one tick above the junk
bond level.[102][103] Some empirical studies have also found that rather
than a downgrade lowering the market price and raising the interest
rates of corporate bonds, the cause and effect are reversed. Expanding
yield spreads (i.e., declining value and quality) of corporate bonds
precedes downgrades by agencies, suggesting it is the market that
alerts the CRAs of trouble and not vice versa.[104][105]
In February 2018, an investigation by the Australian Securities and
Investments Commission found a serious lack of detail and rigour in
many of the ratings issued by agencies. ASIC examined six agencies,
including the Australian arms of Fitch, Moody's and S&P Global Ratings
(the other agencies were Best Asia-Pacific, Australia Ratings and
Equifax Australia). It said agencies had often paid lip service to
compliance. In one case, an agency had issued an annual compliance
report only a single page in length, with scant discussion of
methodology. In another case, a chief executive officer of a company
had signed off on a report as though a board member. Also, overseas
staff of ratings agencies had assigned credit ratings despite lacking the
necessary accreditation.[106][107][108]
Explanations of flaws[edit]
Defenders of credit rating agencies complain of the market's lack of
appreciation. Argues Robert Clow, "When a company or sovereign
nation pays its debt on time, the market barely takes momentary
notice ... but let a country or corporation unexpectedly miss a payment
or threaten default, and bondholders, lawyers and even regulators are
quick to rush the field to protest the credit analyst's lapse." [109] Others
say that bonds assigned a low credit rating by rating agencies have
been shown to default more frequently than bonds that receive a high
credit rating, suggesting that ratings still serve as a useful indicator of
credit risk.[68]
A number of explanations of the rating agencies' inaccurate ratings and
forecasts have been offered, especially in the wake of the subprime
crisis:[92][94]

 The methodologies employed by agencies to rate and monitor

securities may be inherently flawed.[110] For instance, a 2008 report
 by the Financial Stability Forum singled out methodological
shortcomings—especially inadequate historical data—as a
contributing cause in the underestimating of the risk in structured
finance products by the CRAs before the subprime mortgage crisis.
[111]

 The ratings process relies on subjective judgments. This means

that governments, for example, that are being rated can often
inform and influence credit rating analysts during the review
process[112]
 The rating agencies' interest in pleasing the issuers of securities,
who are their paying customers and benefit from high ratings,
creates a conflict with their interest in providing accurate ratings of
securities for investors buying the securities.[113] Issuers of
securities benefit from higher ratings in that many of their
customers—retail banks, pension funds, money market
funds, insurance companies—are prohibited by law or otherwise
restrained from buying securities below a certain rating. [88]
 The rating agencies may have been significantly understaffed
during the subprime boom and thus unable to properly assess
every debt instrument.[114]
 Agency analysts may be underpaid relative to similar positions
at investment banks and Wall Street firms, resulting in a migration
of credit rating analysts and the analysts' inside knowledge of
rating procedures to higher-paying jobs at the banks and firms that
issue the securities being rated, and thereby facilitating the
manipulation of ratings by issuers.[103]
 The functional use of ratings as regulatory mechanisms may
inflate their reputation for accuracy.[115]
Excessive power[edit]
Conversely, the complaint has been made that agencies have too much
power over issuers and that downgrades can even force troubled
companies into bankruptcy. The lowering of a credit score by a CRA
can create a vicious cycle and a self-fulfilling prophecy: not only do
interest rates on securities rise, but other contracts with financial
institutions may also be affected adversely, causing an increase in
financing costs and an ensuing decrease in creditworthiness. Large
loans to companies often contain a clause that makes the loan due in
full if the company's credit rating is lowered beyond a certain point
(usually from investment grade to "speculative"). The purpose of these
"ratings triggers" is to ensure that the loan-making bank is able to lay
claim to a weak company's assets before the company
declares bankruptcy and a receiver is appointed to divide up the claims
against the company. The effect of such ratings triggers, however, can
be devastating: under a worst-case scenario, once the company's debt
is downgraded by a CRA, the company's loans become due in full; if the
company is incapable of paying all of these loans in full at once, it is
forced into bankruptcy (a so-called death spiral). These ratings triggers
were instrumental in the collapse of Enron. Since that time, major
agencies have put extra effort into detecting them and discouraging
their use, and the US SEC requires that public companies in the United
States disclose their existence.
Reform laws[edit]
The 2010 Dodd–Frank Wall Street Reform and Consumer Protection
Act[116] mandated improvements to the regulation of credit rating
agencies and addressed several issues relating to the accuracy of credit
ratings specifically.[68][71] Under Dodd-Frank rules, agencies must
publicly disclose how their ratings have performed over time and must
provide additional information in their analyses so investors can make
better decisions.[68][71] An amendment to the act also specifies that
ratings are not protected by the First Amendment as free speech but
are "fundamentally commercial in character and should be subject to
the same standards of liability and oversight as apply to auditors,
securities analysts and investment bankers."[69][68] Implementation of
this amendment has proven difficult due to conflict between the SEC
and the rating agencies.[71][70] The Economist magazine credits the free
speech defence at least in part for the fact that "41 legal actions
targeting S&P have been dropped or dismissed" since the crisis. [117]
In the European Union, there is no specific legislation governing
contracts between issuers and credit rating agencies.[70] General rules
of contract law apply in full, although it is difficult to hold agencies
liable for breach of contract.[70] In 2012, an Australian federal court
held Standard & Poor's liable for inaccurate ratings.[70]
Ratings use in structured finance[edit]
Further information:  Structured finance
Credit rating agencies play a key role in structured financial
transactions such as asset-backed securities (ABS), residential
mortgage-backed securities (RMBS), commercial mortgage-backed
securities (CMBS), collateralized debt obligations (CDOs), "synthetic
CDOs", or derivatives.[118]
Credit ratings for structured finance instruments may be distinguished
from ratings for other debt securities in several important ways. [119]
 These securities are more complex and an accurate prognoses of
repayment more difficult than with other debt ratings.[119][120] This is
because they are formed by pooling debt — usually consumer
credit assets, such as mortgages, credit card or auto loans — and
structured by "slicing" the pool into multiple "tranches", each with a
different priority of payment. Tranches are often likened to buckets
capturing cascading water, where the water of monthly or quarterly
repayment flows down to the next bucket (tranche) only if the one
above has been filled with its full share and is overflowing. The
higher-up the bucket in the income stream, the lower its risk, the
higher its credit rating, and lower its interest payment. [121] This
means the higher-level tranches have more credit worthiness than
would a conventional unstructured, untranched bond with the
same repayment income stream, and allows rating agencies to rate
the tranches triple A or other high grades. Such securities are then
eligible for purchase by pension funds and money market
funds restricted to higher-rated debt, and for use by banks wanting
to reduce costly capital requirements.[122][123][124]
 CRAs are not only paid for giving ratings to structured securities,
but may be paid for advice on how to structure tranches [119][125] and
sometimes the underlying assets that secure the debt[125][126] to
achieve ratings the issuer desires. This involves back and forth
interaction and analysis between the sponsor of the trust that
issues the security and the rating agency.[119][125] During this process,
the sponsor may submit proposed structures to the agency for
analysis and feedback until the sponsor is satisfied with the ratings
of the different tranches.[125][126]
 Credit rating agencies employ varying methodologies to rate
structured finance products, but generally focus on the type of pool
of financial assets underlying the security and the proposed capital
structure of the trust.[125] This approach often involves
a quantitative assessment in accordance with mathematical models,
and may thus introduce a degree of model risk.[119][127] However,
bank models of risk assessment have proven less reliable than
credit rating agency models, even in the base of large banks with
sophisticated risk management procedures.[128]
Aside from investors mentioned above—who are subject to ratings-
based constraints in buying securities—some investors simply prefer
that a structured finance product be rated by a credit rating agency.
[125]
 And not all structured finance products receive a credit rating
agency rating.[125] Ratings for complicated or risky CDOs are unusual
and some issuers create structured products relying solely on internal
analytics to assess credit risk.[125]
Subprime mortgage boom and crisis[edit]
Further information:  Credit rating agencies and the subprime crisis
The Financial Crisis Inquiry Commission[129] has described the Big
Three rating agencies as "key players in the process" of
mortgage securitization,[31] providing reassurance of the soundness of
the securities to money manager investors with "no history in the
mortgage business".[130]
Credit rating agencies began issuing ratings for mortgage-backed
securities (MBS) in the mid-1970s. In subsequent years, the ratings
were applied to securities backed by other types of assets. [125] During
the first years of the twenty-first century, demand for highly rated
fixed income securities was high.[131] Growth was particularly strong
and profitable in the structured finance industry during the 2001-2006
subprime mortgage boom, and business with finance industry
accounted for almost all of the revenue growth at at least one of the
CRAs (Moody's).[132]
From 2000 to 2007, Moody's rated nearly 45,000 mortgage-related
securities as triple-A. In contrast only six (private sector) companies in
the United States were given that top rating.[133]
Rating agencies were even more important in rating collateralized debt
obligations (CDOs). These securities mortgage/asset backed security
tranches lower in the "waterfall" of repayment that could not be rated
triple-A, but for whom buyers had to found or the rest of the pool of
mortgages and other assets could not be securitized. Rating agencies
solved the problem by rating 70%[134] to 80%[135] of the CDO tranches
triple-A. Still another innovative structured product most of whose
tranches were also given high ratings was the "synthetic CDO".
Cheaper and easier to create than ordinary "cash" CDOs, they paid
insurance premium-like payments from credit default
swap "insurance", instead of interest and principal payments from
house mortgages. If the insured or "referenced" CDOs defaulted,
investors lost their investment, which was paid out much like an
insurance claim.[136]
Conflict of interest[edit]
However when it was discovered that the mortgages had been sold to
buyers who could not pay them, massive numbers of securities were
downgraded, the securitization "seized up" and the Great
Recession ensued.[137][138]
Critics blamed this underestimation of the risk of the securities on the
conflict between two interests the CRAs have—rating securities
accurately, and serving their customers, the security issuers [139] who
need high ratings to sell to investors subject to ratings-based
constraints, such as pension funds and life insurance companies.[123]
[124]
 While this conflict had existed for years, the combination of CRA
focus on market share and earnings growth, [140] the importance of
structured finance to CRA profits, [141] and pressure from issuers who
began to `shop around` for the best ratings brought the conflict to a
head between 2000 and 2007.[142][143][144][145]
A small number of arrangers of structured finance products—
primarily investment banks—drive a large amount of business to the
ratings agencies, and thus have a much greater potential to exert
undue influence on a rating agency than a single corporate debt issuer.
[146]

A 2013 Swiss Finance Institute study of structured debt ratings

from S&P, Moody's, and Fitch found that agencies provide better
ratings for the structured products of issuers that provide them with
more overall bilateral rating business.[147][148] This effect was found to
be particularly pronounced in the run-up to the subprime mortgage
crisis.[147][148] Alternative accounts of the agencies' inaccurate ratings
before the crisis downplay the conflict of interest factor and focus
instead on the agencies' overconfidence in rating securities, which
stemmed from faith in their methodologies and past successes with
subprime securitizations.[149][150]
In the wake of the global financial crisis, various legal requirements
were introduced to increase the transparency of structured finance
ratings. The European Union now requires credit rating agencies to use
an additional symbol with ratings for structured finance instruments in
order to distinguish them from other rating categories.[119]
Ratings use in sovereign debt[edit]
Further information:  Sovereign credit rating
Further information:  List of countries by credit rating
Credit rating agencies also issue credit ratings
for sovereign borrowers, including national governments,
states, municipalities, and sovereign-supported international entities.
[151]
 Sovereign borrowers are the largest debt borrowers in many
financial markets.[151] Governments from both advanced economies and
emerging markets borrow money by issuing government bonds and
selling them to private investors, either overseas or domestically.
[152]
 Governments from emerging and developing markets may also
choose to borrow from other government and international
organizations, such as the World Bank and the International Monetary
Fund.[152]
Sovereign credit ratings represent an assessment by a rating agency of
a sovereign's ability and willingness to repay its debt. [153] The rating
methodologies used to assess sovereign credit ratings are broadly
similar to those used for corporate credit ratings, although the
borrower's willingness to repay receives extra emphasis since national
governments may be eligible for debt immunity under international
law, thus complicating repayment obligations. [151][152] In addition, credit
assessments reflect not only the long-term perceived default risk, but
also short- or immediate-term political and economic developments.
[154]
 Differences in sovereign ratings between agencies may reflect
varying qualitative evaluations of the investment environment. [155]
National governments may solicit credit ratings to generate investor
interest and improve access to the international capital markets. [154]
[155]
 Developing countries often depend on strong sovereign credit
ratings to access funding in international bond markets. [154] Once
ratings for a sovereign have been initiated, the rating agency will
continue to monitor for relevant developments and adjust its credit
opinion accordingly.[154]
A 2010 International Monetary Fund study concluded that ratings
were a reasonably good indicator of sovereign-default risk.[54]
[156]
 However, credit rating agencies were criticized for failing to
predict the 1997 Asian financial crisis and for downgrading countries
in the midst of that turmoil.[153] Similar criticisms emerged after recent
credit downgrades to Greece, Ireland, Portugal, and Spain, [153] although
credit ratings agencies had begun to downgrade
peripheral Eurozone countries well before the Eurozone crisis began.
[156]

Conflict of interest in assigning sovereign ratings[edit]

As part of the Sarbanes–Oxley Act of 2002, Congress ordered the U.S.
SEC to develop a report, titled "Report on the Role and Function of
Credit Rating Agencies in the Operation of the Securities
Markets"[157] detailing how credit ratings are used in U.S. regulation
and the policy issues this use raises. Partly as a result of this report, in
June 2003, the SEC published a "concept release" called "Rating
Agencies and the Use of Credit Ratings under the Federal Securities
Laws"[158] that sought public comment on many of the issues raised in
its report. Public comments on this concept release have also been
published on the SEC's website.[159]
In December 2004, the International Organization of Securities
Commissions (IOSCO) published a Code of Conduct[160] for CRAs that,
among other things, is designed to address the types of conflicts of
interest that CRAs face. All of the major CRAs have agreed to sign on to
this Code of Conduct and it has been praised by regulators ranging
from the European Commission to the US SEC.[citation needed]
Use by government regulators[edit]
Further information:  Nationally recognized statistical rating
organization
Further information:  Basel III
Regulatory authorities and legislative bodies in the United States and
other jurisdictions rely on credit rating agencies' assessments of a
broad range of debt issuers, and thereby attach a regulatory function
to their ratings.[161][162] This regulatory role is a derivative function in
that the agencies do not publish ratings for that purpose. [161] Governing
bodies at both the national and international level have woven credit
ratings into minimum capital requirements for banks, allowable
investment alternatives for many institutional investors, and similar
restrictive regulations for insurance companies and other financial
market participants.[163][164]
The use of credit ratings by regulatory agencies is not a new
phenomenon.[161] In the 1930s, regulators in the United States used
credit rating agency ratings to prohibit banks from investing in bonds
that were deemed to be below investment grade.[92] In the following
decades, state regulators outlined a similar role for agency ratings in
restricting insurance company investments.[92][161] From 1975 to 2006,
the U.S. Securities and Exchange Commission (SEC) recognized the
largest and most credible agencies as Nationally Recognized Statistical
Rating Organizations, and relied on such agencies exclusively for
distinguishing between grades of creditworthiness in various
regulations under federal securities laws.[161][165] The Credit Rating
Agency Reform Act of 2006 created a voluntary registration system for
CRAs that met a certain minimum criteria, and provided the SEC with
broader oversight authority.[166]
The practice of using credit rating agency ratings for regulatory
purposes has since expanded globally.[161] Today, financial market
regulations in many countries contain extensive references to ratings.
[161][167]
 The Basel III accord, a global bank capital standardization effort,
relies on credit ratings to calculate minimum capital standards and
minimum liquidity ratios.[161]
The extensive use of credit ratings for regulatory purposes can have a
number of unintended effects.[161] Because regulated market
participants must follow minimum investment grade provisions,
ratings changes across the investment/non-investment grade
boundary may lead to strong market price fluctuations and potentially
cause systemic reactions.[161] The regulatory function granted to credit
rating agencies may also adversely affect their original market
information function of providing credit opinions.[161][168]
Against this background and in the wake of criticism of credit rating
agencies following the subprime mortgage crisis, legislators in the
United States and other jurisdictions have commenced to reduce rating
reliance in laws and regulations. [92][169] The 2010 Dodd–Frank
Act removes statutory references to credit rating agencies, and calls for
federal regulators to review and modify existing regulations to avoid
relying on credit ratings as the sole assessment of creditworthiness. [