18/04 What is a rating agency?

School reportA high score from a credit rating agency means cheaper borrowing – a low mark carries a heavy price

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AAA, Ba3, Ca, CCC… they look like some kind of hyper-active school report.
They are, indeed, a marking system, and one that is designed to inform interested parties.
The letter formations are given to large-scale borrowers, whether companies or governments, and tell the buyers of this debt how likely they are to be able to get it back.
The score card also affects the amount that should be charged by way of return on that borrowing.
These letters have been all over the coverage of the financial impact of the crisis besetting the eurozone.
A change to the score means a change to the amount a borrower must pay its debt-holders, something that can make it more expensive to borrow as investors demand a higher rate of return for taking on more risky debt.
But while the borrowers in the news – the governments of Greece, Ireland, Portugal, and now even the mighty US – are household names, the ones that have such an impact on their fortunes are not.

CREDIT-RATING AGENCIES

  • Private-sector firms that assigns credit ratings for issuers of debt
  • A credit rating takes into account the debt issuer’s ability to pay back its loan
  • That in turn affects the interest rate applied to the security (eg a bond) being issued
  • A credit downgrade can make it more expensive for a government to borrow money
They are credit-rating agencies, which exist to assess the credit-worthiness of bond issuers – companies or, as in this case, countries who borrow money by issuing IOUs known asbonds.
But who are they? Do we need them and how do they work out whether to give the top-of-the-class AAA or a lower grade, such as CCC, which – sticking with the schools analogy – means the issuer is probably planning on bunking off?

Poor and Moody

Standard & Poor’s (S&P), as the oldest, comes first. It was begun in 1860 by Henry Poor, who wrote a history of the finances of railroads and canals in the United States as a guide for investors.
The ‘Standard’ part came into being in 1906, when the Standard Statistics Bureau was set up to examine finances of non-railroad companies.
The two businesses joined forces in the 1940s.
Moody’s was started in 1909 by John Moody, who published an analysis of the tangled and uncertain world of railway finances, grading the value of its stocks and bonds.
These are now mighty concerns – Moody’s operating income was $688m in 2010 and Standard & Poor’s made $762m.
They each have 40% apiece of the business of rating major companies and countries.
Fitch, with another eponymous founder, John Fitch, was set up in 1913 and is a smaller version of the other two.
There are hosts of other ratings agencies, whose names rarely appear even within the darker corners of the financial pages – so why are these three businesses the ones everyone watches?

Track Record

Part of the answer lies with the Securities and Exchange Commission (SEC), the US financial watchdog.
In 1975, it acknowledged these three as Nationally Recognized Statistical Rating Organizations (NRSRO).

Start Quote

The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment – or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue”

Standard & Poor’s

An endorsement from an NRSRO makes life quicker and easier for countries and financial institutions wishing to issue bonds – it basically tells investors a firm has a track record and how likely it is to be able to pay back the money.
Further impetus for NRSROs comes from the fact that certain regulated investment funds are required by the SEC to hold only those bonds that have a very high rating from accredited agencies.
An insurance company’s strength is also judged by the ratings applied to the investment reserves it holds.
A downgrade of an issuers’ rating pushes down the value of a bond and raises its interest rate.
It can mean regulated funds must now sell these bonds.
But this can cause a vicious cycle.
A big sell-off adds in market forces – more sellers than buyers – reducing the price further. That means a yet higher interest rate must be paid – and that puts an even bigger strain on the borrower.
Although the SEC has 10 NRSROs on its approved list, including a Canadian agency and two Japanese ones, the big three – Standard & Poor’s, Moody’s and Fitch – remain the industry standard-bearers.
This is partly because they make their ratings available freely to investors – making their money from charging the organisations who want their bonds rated.

Heavy criticism

So much for their size. What of their actual methods?
Standard & Poor’s said it based its judgments on a range of financial and business attributes that might influence the repayment, some of which may depend on the issuer of the bond (ie the borrower).
In a statement, S&P gave a long list of indicators it may use, including “economic, regulatory and geopolitical influences, management and corporate governance attributes, and competitive position”.
That seems to cover everything. But since the credit crisis that began in 2007, these agencies have come in for heavy criticism – and even hostility.

SCORE CARD

  • Rating agencies use different systems involving a long list of letters
  • A top mark is AAA or AAa
  • Down to BBB or Baa3 is also safe
  • BB or Ba1 down to C is speculative – or “junk”
  • Other less sequential numbers are applied to the worst kind of bond
After all, stacks of mortgage-backed securities – the investments that were backed by mortgages that were either never going to be paid back or were even fraudulent – were given the very best grade by the three supposed experts in rating the likelihood of the money being paid back.
Similar dramatic swings have been taking place in the ratings applied to government-backed – rather than private property-supported debt. One day a country’s bond is graded a safe top rating and the next given a mark that suggests investors’ money is not safe.
Many observers believe that if the rating on the UK’s government bonds – or gilts – was downgraded by just one notch from AAA to AA it would put up the cost of official borrowing by around half of one per cent.
That would mean a big rise in the annual interest bill which has to be met by taxpayers.
When asked why it changes ratings, S&P responded: “The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment – or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue.”
It indeed appears a dark art – but one whose influence has a more measurable effect.

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About Uy Do

Banking System Analyst, former NTT data Global Marketing Dept Senior Analyst, Banking System Risk Specialist, HR Specialist
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