Credit Rating Agency

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A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations. In most cases, these issuers are companies, cities, non-profit organizations, or national governments issuing debt-like securities that can be traded on a secondary market. A credit rating measures credit worthiness, the ability to pay back a loan, and affects the interest rate applied to loans. (A company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.)

Interest rates are not the same for everyone, but instead are based on risk-based pricing, a form of price discrimination based on the different expected costs of different borrowers, as set out in their credit rating. There exist more than 100 rating agencies worldwide.

Credit rating agencies for corporations For more information, see Bond credit rating.

Agencies that assign credit ratings for corporations include:

A. M. Best (U.S.)
Baycorp Advantage (Australia)
Dominion Bond Rating Service (Canada)
Fitch Ratings (U.S.)
Moody's (U.S.)
Standard & Poor's (U.S.)
Pacific Credit Rating (Peru)

Uses of ratings by credit rating agencies Credit ratings are used by investors, issuers, investment banks, broker-dealers, and by governments. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk; this generally increases the efficiency of the market, lowering costs for both borrowers and lenders. This in turn increases the total supply of risk capital in the economy, leading to stronger growth. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals and universities.

Ratings use by bond issuers

Issuers rely on credit ratings as an independent verification of their own credit-worthiness. In most cases, a significant bond issuance must have at least one rating from a respected CRA for the issuance to be successful (without such a rating, the issuance may be undersubscribed or the price offered by investors too low for the issuer's purposes). Recent studies by the Bond Market Association note that many institutional investors now prefer that a debt issuance have at least three ratings. Issuers also use credit ratings in certain structured finance transactions. For example, a company with a very high credit rating wishing to undertake a particularly risky research project could create a legally separate entity with certain assets that would own and conduct the research work. This "special purpose entity" would then assume all of the research risk and issue its own debt securities to finance the research. The SPE's credit rating likely would be very low and the issuer would have to pay a high rate of return on the bonds issued. However, this risk would not lower the parent company's overall credit rating because the SPE would be a legally separate entity. Conversely, a company with a low credit rating might be able to borrow on better terms if it were to form an SPE and transfer significant assets to that subsidiary and issue secured debt securities. That way, if the venture were to fail, the lenders would have recourse to the assets owned by the SPE. This would lower the interest rate the SPE would need to pay as part of the debt offering.

The same issuer also may have different credit ratings for different bonds. This difference results from the bond's structure, how it is secured debt, and the degree to which the bond is subordinated bonds to other debt. Many larger CRAs offer "credit rating advisory services" that essentially advise an issuer on how to structure its bond offerings and SPEs so as to achieve a given credit rating for a certain debt tranche. This creates a potential conflict of interest, of course, as the CRA may feel obligated to provide the issuer with that given rating if the issuer followed its advice on structuring the offering. Some CRAs avoid this conflict by refusing to rate debt offerings for which its advisory services were sought.

Ratings use by investment banks and broker-dealers

Investment banks and broker-dealers also use credit ratings in calculating their own risk portfolio (finance) (i.e., the collective risk of all of their investments). Larger banks and broker-dealers conduct their own risk calculations, but rely on CRA ratings as a "check" (and double-check or triple-check) against their own analyses.

Ratings use by government regulators

Regulators use credit ratings as well, or permit these ratings to be used for regulatory purposes. For example, under the Basel II agreement of the Basel Committee on Banking Supervision, banking regulators can allow banks to use credit ratings from certain approved CRAs (called "ECAIs" or "External Credit Assessment Institutions") when calculating their net capital reserve requirements. In the United States, the Securities and Exchange Commission (SEC) permits investment banks and broker-dealers to use credit ratings from "Nationally Recognized Statistical Rating Organizations" (or "NRSROs") for similar purposes. The idea is that banks and other financial institutions should not need to keep in reserve the same amount of capital to protect the institution against (for example) a run on the bank, if the financial institution is heavily invested in highly liquid and very "safe" securities (such as U.S. government bonds or short-term commercial paper from very stable companies).

CRA ratings are also used for other regulatory purposes as well. The U.S. SEC, for example, permits certain bond issuers to use a shorten prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimic the safety and liquidity of a bank savings deposit, but without FDIC insurance) comprise only securities with a very high rating from an NRSRO. Likewise, insurance regulators use credit ratings to ascertain the strength of the reserves held by insurance companies.

It is important to note that under both Basel II and SEC regulations, not just any CRA's ratings can be used for regulatory purposes. (If this were the case, it would present an obvious moral hazard, since an issuer, insurance company, or investment bank would have a strong incentive to seek out a CRA with the most lax standards, with potentially dire consequences for overall financial stability.) Rather, there is a vetting process, of varying sorts. The Basel II guidelines (paragraph 91, et al), for example, describe certain criteria that bank regulators should look to when permitting the ratings from a particular CRA to be used. These include "objectivity," "independence," "transparency," and others. Banking regulators from a number of jurisdictions have since issued their own discussion papers on this subject, to further define how these terms will be used in practice. (See The Committee of European Banking Supervisors Discussion Paper, or the State Bank of Pakistan ECAI Criteria.)

In the United States, since 1975, NRSRO recognition has been granted through a "No Action Letter" sent by the SEC staff. Following this approach, if a CRA (or investment bank or broker-dealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determines that this is the case, it sends a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff will not recommend enforcement action against that entity. These "No Action" letters are made public and can be relied upon by other regulated entities, not just the entity making the original request. The SEC has since sought to further define the criteria it uses when making this assessment, and in March 2005 published a proposed regulation to this effect.

On September 29, 2006, U.S. President George W. Bush signed into law the "

The rating agencies respond that their advice constitutes only a "point in time" analysis, that they make clear that they never promise or guarantee a certain rating to a tranche, and that they also make clear that any change in circumstance regarding the risk factors of a particular tranche will invalidate their analysis and result in a different credit rating. In addition, some CRAs do not rate bond issuances upon which they have offered such advice.

Complicating matters, particularly where structured finance transactions are concerned, the rating agencies state that their ratings are opinions regarding the likelihood that a given debt security will fail to be serviced over a given period of time, and not an opinion on the volatility of that security and certainly not the wisdom of investing in that security. In the past, most highly rated (AAA or Aaa) debt securities were characterized low volatility and high liquidity -- in other words, the price of a highly rated bond did not fluctuate greatly day-to-day, and sellers of such securities could easily find buyers. However, where structured transactions that involve the bundling of hundreds or thousands of similar (and similarly rated) securities tend to concentrate similar risk in such a way that even a slight change on a chance of default can have an enormous effect on the price of the bundled security. This means that even though a rating agency could be correct in its opinion that the chance of default of a structured product is very low, even a slight change in the market's perception of the risk of that product can have a disproportionate effect on the product's market price, with the result that a ostensibly AAA or Aaa-rated security can collapse in price even without there being any default (or significant chance of default). This possibility raises significant regulatory issues because the use of ratings in securities and banking regulation (as noted above) assumes that high ratings correspond with low volatility and high liquidity.

Criticism Credit rating agencies have been subject to the following criticisms:

Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months.{{Citation

| last = Borrus | first = Amy | author-link = | last2 = | first2 = | author2-link = | title = The Credit-Raters: How They Work and How They Might Work Better | newspaper = BusinessWeek | pages = | year = 2002 | date = 2002-04-08 | url = http://www.businessweek.com/magazine/content/02_14/b3777054.htm{{Citation | last = Wyatt | first = Edward | author-link = | last2 = | first2 = | author2-link = | title = Credit Agencies Waited Months to Voice Doubt About Enron | newspaper = | pages = | year = 2002 | date = 2002-02-08 | url = http://bodurtha.georgetown.edu/enron/Credit%20Agencies%20Waited%20Months%20to%20Voice%20Doubt%20About%20Enron.htm--> Some finance scholars{{Fact|date=June 2007--> have documented in empirical studies that yield spreads of corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that the market often leads a downgrade and questioning the informational value of credit ratings. This has led to suggestions that, rather than rely on CRA ratings in financial regulation, financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use [credit spread (bond) when calculating the risk in their [Portfolio (finance).

Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled. These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. Furthermore, because information about ratings changes from the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings. This has led to accusations that these CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. At the same time, more generally, the largest agencies (Moody's and Standard & Poor's) are often seen as agents of globalization and/or "Anglo-American" market forces, that drive companies to consider how a proposed activity might effect their credit rating, possibly at the expense of employees, the environment, or long-term research and development. These accusations are not entirely consistent: on one hand, the larger CRAs are accused of being too cosy with the companies they rate, and on the other hand they are accused of being too focused on a company's "bottom line" and unwilling to listen to a company's explanations for its actions.

The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. In some cases, large loans to companies contain a clause that makes the loan due in full if the companies' credit rating is lowered beyond a certain point (usually a "speculative" or "junk bond" rating). The purpose of these "ratings triggers" is to ensure that the 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; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called "Death spiral financing"). These rating triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting these triggers and discouraging their use, and the U.S. Securities and Exchange Commission requires that public companies in the United States disclose their existence.

Agencies are sometimes accused of being oligopolists {{Citation

| last = | first = | author-link = | last2 = | first2 = | author2-link = | title = Measuring the measurers | newspaper = The Economist | pages = | year = 2007 | date = 2007-05-31 | url = http://www.economist.com/finance/displaystory.cfm?story_id=9267952--> , because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses. The high profit on Moody's revenues (>50% gross margin), which are consistent with the high barriers to entry, do nothing to allay market fears of monopoly pricing.

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 Marketsdetailing 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 that sought public comment on many of the issues raised in its report. Public commentson this concept release have also been published on the SEC's website.

In December 2004, the International Organization of Securities Commissions (IOSCO) published a Code of Conduct 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 U.S. Securities and Exchange Commission.

Bibliography

On the history and origins of credit agencies, see Born Losers: A History of Failure in America, by Scott A. Sandage (Harvard University Press, 2005), chapters 4-6.
On contemporary dynamics, see Timothy J. Sinclair, The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness (Ithaca, NY: Cornell University Press, 2005).
For a description of what CRAs do in the corporate context, see IOSCO Report on the Activities of Credit Rating Agencies and IOSCO Statement of Principles Regarding the Activities of Credit Rating Agencies

References

See also

Credit bureau
Credit history
Adverse credit history
Credit card
Credit score
Fair Credit Reporting Act
Identity theft

External links

Klein, Alec. (2004) "Credit Raters Exert International Influence" Washington Post
Davies, Paul J. (2007) "How S&P put the triple A into CPDO" Financial Times

A. M. Best (U.S.)
Baycorp Advantage (Australia)
Dominion Bond Rating Service (Canada)
Fitch Ratings (U.S.)
Moody's (U.S.)
Standard & Poor's (U.S.)
Pacific Credit Rating (Peru)

Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months.{{Citation

Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled. These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. Furthermore, because information about ratings changes from the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings. This has led to accusations that these CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. At the same time, more generally, the largest agencies (Moody's and Standard & Poor's) are often seen as agents of globalization and/or "Anglo-American" market forces, that drive companies to consider how a proposed activity might effect their credit rating, possibly at the expense of employees, the environment, or long-term research and development. These accusations are not entirely consistent: on one hand, the larger CRAs are accused of being too cosy with the companies they rate, and on the other hand they are accused of being too focused on a company's "bottom line" and unwilling to listen to a company's explanations for its actions.

The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. In some cases, large loans to companies contain a clause that makes the loan due in full if the companies' credit rating is lowered beyond a certain point (usually a "speculative" or "junk bond" rating). The purpose of these "ratings triggers" is to ensure that the 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; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called "Death spiral financing"). These rating triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting these triggers and discouraging their use, and the U.S. Securities and Exchange Commission requires that public companies in the United States disclose their existence.

Agencies are sometimes accused of being oligopolists {{Citation

On the history and origins of credit agencies, see Born Losers: A History of Failure in America, by Scott A. Sandage (Harvard University Press, 2005), chapters 4-6.
On contemporary dynamics, see Timothy J. Sinclair, The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness (Ithaca, NY: Cornell University Press, 2005).
For a description of what CRAs do in the corporate context, see IOSCO Report on the Activities of Credit Rating Agencies and IOSCO Statement of Principles Regarding the Activities of Credit Rating Agencies

References

See also

Credit bureau
Credit history
Adverse credit history
Credit card
Credit score
Fair Credit Reporting Act
Identity theft

External links

Klein, Alec. (2004) "Credit Raters Exert International Influence" Washington Post
Davies, Paul J. (2007) "How S&P put the triple A into CPDO" Financial Times

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