Credit rating agency
A credit rating agency (CRA, also called a Ratings Service) is a company that assigns credit ratings — rating of the debtor's ability to pay back the debt making timely interest payments and the likelihood of default. An agency may rate the issuers of debt obligations, the debt instruments and in some cases, the servicers of the underlying debt. Credit rating agencies are not to be confused with credit bureaus, aka consumer credit reporting agencies, which rate individuals for credit-worthiness, giving them credit scores.
Debt instruments the agencies rate may include government bonds, corporate bonds, CDs (certificates of deposit), municipal bonds, preferred stock, and collateralized securities, such as mortgage-backed securities and CDOs (collateralized debt obligations).
The issuers of the obligations/securities may be companies, special purpose entities, state and local governments, non-profit organizations, or sovereign nations. A credit rating permits (or makes much more easy) the trading of securities on a secondary market. A credit rating affects the interest rate applied to the particular security being issued, with higher ratings leading to lower interest rates.
The value of such security ratings has been widely questioned. Before and during the 2007–09 financial crisis tens of thousands of "tranches" of mortgage-backed collateralized debt obligations (CDOs) in the United States were issued with the highest rating by the agencies — "triple-A" — but later write-downs at financial institutions of CDOs (triple A and lower rated) totaled over $500 billion. Ratings downgrades during the European sovereign debt crisis of 2010–12 have been blamed by EU officials for accelerating the crisis.
Credit rating is a highly concentrated industry with the two largest CRAs — Moody's Investors Service, Standard & Poor's — having 80% market share globally, and the "Big Three" credit rating agencies — Moody's, S&P and Fitch Ratings — controlling approximately 95% of the ratings business.
Other agencies include DBRS, A. M. Best (U.S.), Baycorp Advantage (Australia), Dun & Bradstreet, ICRA Limited (India), Egan-Jones Rating Company (U.S.), Global Credit Ratings Co. (South Africa), Levin and Goldstein (Zambia), Agusto & Co. (Nigeria), Japan Credit Rating Agency, Ltd. (Japan)., Muros Ratings (Russia alternative rating agency), Rapid Ratings International (U.S.), Credit Rating Information and Services Limited(Bangladesh) and Public Sector Credit Solutions (U.S.).
Below are the credit worthiness grades used by the "Big Three" agencies for long and short term debt issues. Higher grades are intended to represent a lower probability of default. For example one study reportedly shows that over a "5-year time horizon" for bonds rated by Moody's, "the Aaa cumulative default rate was 0.18%, the Aa2 0.28%, rising to 2.11% for Baa2, 8.82% for Ba2 and 31.24% for B2. The order is by and large, but not exactly, preserved over longer time horizons."
|A1||A+||A-1||A+||F1||Upper medium grade|
|Baa1||BBB+||BBB+||Lower medium grade|
|Ba1||Not prime||BB+||B||BB+||B||Non-investment grade
|Caa3||CCC-||In default with little
prospect for recovery
Ratings — in the case of Moody's (the largest and oldest rating agency) — are based on models and the judgement of the rating committee. For example, in the case of ratings by Moody's of Mortgage-backed Securities, models "incorporated firm- and security-specific factors, market factors, regulatory and legal factors, and macroeconomic trends." At least in the US, rating agencies are not liable for misstatements in securities registration as courts have ruled ratings are opinions protected by the First Amendment. One rating agency disclaimer reads:
The ratings ... are and must be construed soley as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities
Uses of ratings
Credit ratings are used by parties looking for measurements of relative credit risk — investors, issuers, investment banks, broker-dealers, and governments. When a rating agency's ratings are accurate, the range of investment alternatives grows, leading to a more efficient 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 may open the capital markets to borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities.
By bond issuers
Because many investors won't buy an unrated bonds a significant bond issuance almost always has at least one rating from a respected CRA — generally two — to avoid being under-subscribed or being offered a price too low for the issuer's purposes. Since around the 1970s, the "Big Three" and most other rating agencies have used the "issuers pays" business model, where the agency is paid for its rating by the issuer — not the buyer — of a security and the rating is made publicly available.
In structured finance
Credit rating agencies play a key role in structured financial transactions — a term for mortgage-backed securities, special purpose entities (aka off-balance-sheet vehicles), derivatives, and similar products — which became a significant part of rating agencies business leading up to the 2006-2008 "subprime crisis". In the words of the to the Financial Crisis Inquiry Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States:
Rating agencies were essential to the smooth functioning of the mortgage-backed securities market. Issuers needed them to approve the structure of their deals; banks needed their ratings to determine the amount of capital to hold; repo markets needed their ratings to determine loan terms; some investors could buy only securities with a triple-A rating; and the rating agencies' judgement was baked into collateral agreements and other financial contracts.
The agencies gave top ratings on debt pools that "included $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes between 2002 and 2007". In the case of one of the Big Three — Moody's — structured finance went from from 28% of that company's revenue in 1998 to almost 50% in 2007, and "accounted for pretty much all of Moody's growth."
Ratings are vital to "private-label" asset-backed securities (ABS), like subprime mortgage-backed securities (MBS), whose "financial engineering" make them "harder to understand and to price than individual loans".
These securities pool debt and then "slice" them into "tranches" each given a different priority in the debt repayment stream of income — 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. Buckets higher up the income stream have higher credit ratings and pay lower interest.
The pooling of debt has the advantage of diversification (Mortgages from many different areas of the country in a mortgage-backed security for example are less affected by a regional housing bust than a regional bank). The "tranching" has the advantage of offering investors different levels of risk and return, each to their taste. Specifically it gives the top buckets — "super senior" tranches — more credit worthiness than would a conventional unstructured, untranched bond with the same repayment income stream. This allowed rating agencies to rate the tranches triple A, making them eligible for purchase by pension funds and money market funds restricted to top rated debt, and for use by banks wanting to reduce costly capital requirements.
According to the Financial Crisis Inquiry Report, the complexity "transformed" the Big Three credit rating agencies "into key players in the process, positioned between the issuers and the investors of securities"
"Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors. Investment banks therefore paid handsome fees to the rating agencies to obtain the desired ratings."
According to the CEO of a servicer of the securitization industry, Jim Callahan of PentAlpha,
“The rating agencies were important tools to do that because you know the people that we were selling these bonds to had never really had any history in the mortgage business. ... They were looking for an independent party to develop an opinion,”
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.
There has been criticism in the wake of large losses in the collateralized debt obligation (CDO) market that occurred despite being assigned top ratings by the CRAs. For instance, losses on $340.7 million worth of CDOs issued by Credit Suisse Group added up to about $125 million, despite being rated AAA or Aaa by Standard & Poor's, Moody's Investors Service and Fitch Group
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 an ostensibly 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.
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.
Rating agencies state that rather than being a considered judgement of the volatility of a security and the wisdom of investing in it, their ratings are opinions and because of the "personhood" of corporations — protected free speech. This argument has been effective in American courts, and since the crisis, "41 legal actions targeting S&P have been dropped or dismissed".
Ratings use by government regulators
According to authors Herwig Langohr, Patricia Langohr, in recent years, regulators have "woven" credit ratings "into everything from allowable investment alternatives for many institutional investors to required capital for most global banking firms."
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. Higher rated securities (such as U.S. government bonds or short-term commercial paper from very stable companies) judged less risky and thus requiring less reserves or protection against a "run on the bank".
The structure of the Basel II agreements meant that CDOs capital requirement rose 'exponentially'. For example under Basel II, a AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation. For a number of reasons (frequently having to do with inadequate staff expertise and the costs that risk management programs entail), many institutional investors relied solely on the ratings agencies rather than conducting their own analysis of the risks these instruments posed. (As an example of the complexity involved in analyzing some CDOs, the Aquarius CDO structure has 51 issues behind the cash CDO component of the structure and another 129 issues that serve as reference entities for $1.4 billion in CDS contracts for a total of 180. In a sample of just 40 of these, they had on average 6500 loans at origination. Projecting that number to all 180 issues implies that the Aquarius CDO has exposure to about 1.2 million loans.) Pimco founder William Gross urged investors to ignore rating agency judgments, describing the agencies as "an idiot savant with a full command of the mathematics, but no idea of how to apply them."
Rating agencies bestowed with regulatory power must be vetted under both Basel II and SEC regulations. The Basel II guidelines, state bank regulators should look for "objectivity," "independence," "transparency,", etc. in credit ratings/rating agency they approve. To further define how these terms will be used in practice, Banking regulators from a number of jurisdictions like Europe and Pakistan have since issued their own discussion papers.
In the United States, the Securities and Exchange Commission (SEC) modified its minimum capital requirements in 1975 for broker-dealers to base their requirements on credit ratings by a “nationally recognized statistical rating organization” (NRSRO); which at the time, was one of the big three — Moody’s, S&P, or Fitch.
Credit ratings also apply to banking regulations in the US where since 2001, banks have been permitted to hold less capital for higher-rated securities. (BBB rated securities require five times as much capital as AAA and AA rated securities, while BB securities require ten times more capital, etc.)
Credit ratings applied to what investments some investors could buy.
- The SEC restricts money market funds to purchasing “securities that have received credit ratings from any two NRSROs ... in one of the two highest short-term rating categories or comparable unrated securities".
- The US Department of Labor restricts pension fund investments to securities rated A or higher.
- the Secondary Mortgage Market Enhancement Act of 1984 made credit ratings crucial for the structured finance and the mortgage market. It permitted federal- and state-chartered financial institutions to invest in mortgage-related securities if the securities had high ratings from at least one rating agency. According to Lewis Ranieri, “the language of the original bill ... requires a rating. ... It put them [the rating agencies] in the business forevermore. It became one of the biggest, if not the biggest, business.” According to former Moody’s managing director Eric Kolchinsky, the law meant “the rating agencies were given a blank check.”
- insurance regulators used credit ratings to ascertain the strength of the reserves held by insurance companies.
But while sundry regulations required use of NRSRO rating agencies by many firms and institutions, once approved as a NRSRO agency by the SEC, the CRA's themselves "faced no further regulation" from the SEC for more than 30 years — from 1975 to 2006, when the SEC got limited authority to oversee NRSROs in the Credit Rating Agency Reform Act.
(Originally NRSRO recognition was granted through a "No Action Letter" sent by the SEC staff. The action not taken being enforcement action against a regulated entity — such as an investment bank or broker-dealer — relying on the rating agency's ratings if the SEC staff researched those ratings and and found them widely used and considered "reliable and credible." These "No Action" letters were made public, making the NRSRO recognition public.)
The Credit Rating Agency Reform Act went into effect in the Summer of 2007 — after withstanding a court challenge from Standard & Poor's — and replaced the "No Action Letter" with NRSRO recognition by the SEC Commission (not SEC staff). The act required NRSROs to register with, and be regulated by, the SEC, to have policies preventing misuse of nonpublic information, the disclosure of conflicts of interest, and prohibitions against "unfair practices".
Some regulatory power of credit ratings is scheduled to loosen and regulations on rating agencies tighten following the passage of 2010 Dodd–Frank law. The law calls for "every federal agency to review existing regulations that require the use of an assessment of the credit-worthiness of the security or money market instrument ... [and] to remove any reference to, or requirement of reliance on credit ratings; and substitute with a standard of credit worthiness as the agency shall determine as appropriate for such regulations."
In the wake of the financial crisis of 2007–2010, the Financial Crisis Inquiry Report called the "failures" of the Big Three rating agencies "essential cogs in the wheel of financial destruction." SEC Commissioner Kathleen Casey complained the ratings of the large rating agencies were "catastrophically misleading" yet the agencies "enjoyed their most profitable years ever during the past decade" while doing so.
In their book on the crisis — All the Devils Are Here — journalists Bethany McLean, and Joe Nocera, criticized rating agencies for continuing "to slap their triple-A [ratings]s on subprime securities even as the underwriting deteriorated -- and as the housing boom turned into an outright bubble" in 2005, 2006, 2007. McLean and Nocera blamed the practice on "an erosion of standards, a willful suspension of skepticism, a hunger for big fees and market share, and an inability to stand up to" investment banks issuing the securities. The February 5th 2013 issue of Economist stated "it is beyond argument that ratings agencies did a horrendous job evaluating mortgage-tied securities before the financial crisis hit."
More generally, some of the criticisms credit rating agencies have been subject to include:
- Failure to downgrade securities promptly and laxness
Critics have complained that credit rating agencies often times do not downgrade companies ratings until after or just before bankruptcy. While agencies have charts and studies demonstrating that their ratings are accurate a very high percentage of the time, according to journalists McLean and Nocera, the rating agencies
missed the near default of New York City, the bankruptcy of Orange County, and the Asian and Russian meltdowns. They failed to catch Penn Central in the 1970s and Long-Term Capital Management in the 1990s. They often downgraded companies just days before bankruptcy -- too late to help investors. Nor was this anything new: one study showed that 78% of the municipal bonds rated double A or triple-A in 1929 defaulted during the Great Depression. 
In the case of Enron, though its stock had been in "precipitous decline" since October 2001 and credit rating agencies had been aware of the company's problems for months, its rating remained at investment grade until four days before the company went bankrupt on December 2, 2001.  In the aftermath, "not a single analyst at either Moody's of S&P lost his job as a result of missing the Enron fraud". Management remained unchanged and Moody's stock price underwent no long term damage. McLean, and Nocera quote one insider as saying `Enron taught them how small the consequences of a bad reputation were.`
Freddie Mac's preferred stock was awarded the top rating by Moody's until Warren Buffett talked about Freddie on CNBC. The next day Moody's downgraded Freddie to one tick above junk bonds. Some empirical studies have documented that rather than a downgrade by a CRA leading to lower net worth and higher interest rates of corporate bonds, yield spreads of corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, casting doubt on 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 spreads when calculating the risk in their portfolio.
- Cosy relationships with securities issuers
Originally rating agencies sold their service as a subscription to bond/debt buyers who wanted to know how safe the bonds they were considering buying were. In the 1970s first Fitch and then Moody's and S&P abandoned that model in favor of charging bond issuers directly. More revenue was earned this way because many investors wouldn't buy an unrated bond so issuers wanted to be rated, while subscriptions were "always going to be optional" for bond buyers because information about ratings changes from the larger CRAs could spread so quickly (by word of mouth, email, etc.), . However the new model meant that the rating agencies "were potentially beholden to the same people whose bonds they were rating", possibly opening themselves to undue influence or the vulnerability of being misled.
In the structured finance boom of the mid-2000, high ratings of securities were vital because larger group of investors — money market funds and pension funds — were forbidden by their bylaws to buy securities not rated a triple-A. An incestuous relationship between financial institutions and the credit agencies developed such that, banks began to leverage the credit ratings off one another and 'shop' around amongst the three big credit agencies until they found the best ratings for their CDOs. Often they would add and remove loans of various quality until they met the minimum standards for a desired rating, usually, AAA rating. Often the fees on such ratings were $300,000–500,000, but ran up to $1 million. Subpoena emails later revealed issuers openly threatened to take their business to another rating agency if the agency's ratings were not high enough. These triple-A ratings were highly inaccurate and later downgraded costing investors billions.
- Inaccurate ratings of structured products
Credit Rating Agencies have made errors of judgment in rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. The actual method by which Moody's rates CDOs has also come under scrutiny. If default models are biased to include arbitrary default data and "Ratings Factors are biased low compared to the true level of expected defaults, the Moody’s [method] will not generate an appropriate level of average defaults in its default distribution process. As a result, the perceived default probability of rated tranches from a high yield CDO will be incorrectly biased downward, providing a false sense of confidence to rating agencies and investors."
Little has been done by rating agencies to address these shortcomings indicating a lack of incentive for quality ratings of credit in the modern CRA industry. This has led to problems for several banks whose capital requirements depend on the rating of the structured assets they hold, as well as large losses in the banking industry.
AAA rated mortgage securities trading at only 80 cents on the dollar, implying a greater than 20% chance of default, and 8.9% of AAA rated structured CDOs are being considered for downgrade by Fitch, which expects most to downgrade to an average of BBB to BB-. These levels of reassessment are surprising for AAA rated bonds, which have the same rating class as US government bonds. Most rating agencies do not draw a distinction between AAA on structured finance and AAA on corporate or government bonds (though their ratings releases typically describe the type of security being rated).
Many banks, such as AIG, made the mistake of not holding enough capital in reserve in the event of downgrades to their CDO portfolio. The structure of the Basel II agreements meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios vulnerable to multiple downgrades, essentially precipitating a large margin call.
- Threatening to downgrade to solicit business
While often accused of being too close to company management of their existing clients, CRAs have also been accused of engaging in heavy-handed "blackmail" tactics in order to solicit business from new clients, and lowering ratings for those firms . For instance, Moody's published an "unsolicited" rating of Hannover Re, with a subsequent letter to the insurance firm indicating that "it looked forward to the day Hannover would be willing to pay". When Hannover management refused, Moody's continued to give Hannover Re ratings, which were downgraded over successive years, all while making payment requests that the insurer rebuffed. In 2004, Moody's cut Hannover's debt to junk status, and even though the insurer's other rating agencies gave it strong marks, shareholders were shocked by the downgrade and Hannover lost $175 million USD in market capitalization.
- Downgrading that leads to a vicious cycle of less credit worthiness
The lowering of a credit score by a CRA can create a vicious cycle and self-fulfilling prophecy, 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"). 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.
- Conflict of interest in assigning sovereign credit ratings
It has also been suggested that the credit agencies are conflicted in assigning sovereign credit ratings since they have a political incentive to show they do not need stricter regulation by being overly critical in their assessment of governments they regulate.
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" 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" 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.
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.
Oligopoly produced by regulation
Agencies are sometimes accused of being oligopolists, 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). In 2003, the US SEC submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.
Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses, and its high profit margins (which at times have been greater than 50 percent of gross margin) can be construed as consistent with the type of returns one might expect in an industry which has high barriers to entry.
According to professor Frank Partnoy, the regulation of CRAs by the SEC and Federal Reserve Bank has eliminated competition between CRAs and practically forced market participants to use the services of the three big agencies, Standard and Poor's, Moody's and Fitch.
SEC Commissioner Kathleen Casey has said that these CRAs have acted much like Fannie Mae, Freddie Mac and other companies that dominate the market because of government actions. When the CRAs gave ratings that were "catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade."
To solve this problem, Ms. Casey (and other such as NYU professor Lawrence White) have proposed removing the NRSRO rules completely. Professor Frank Partnoy suggests that the regulators use the results of the credit risk swap markets rather than the ratings of NRSROs.
The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.
Regulatory reliance on credit ratings
Think-tanks such as the World Pensions Council have argued that European powers such as France and Germany pushed dogmatically and naively for the adoption of the so-called “Basel II recommendations”, adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD), effective since 2008. In essence, they forced European banks, and, more importantly, the European Central Bank itself when gauging the solvency of financial institutions, to rely more than ever on standardized assessments of credit risk marketed by two private US agencies—Moody’s and Standard & Poor's, thus using public policy and ultimately taxpayers’ money to strengthen an anti-competitive duopolistic industry.
The Big Three
The three largest credit rating agencies—Standard & Poor's, Moody's Investor Service, and Fitch Ratings—are collectively referred to as the "Big Three" due to their substantial market share. According to the most recent U.S. Securities and Exchange Commission (SEC) report, the agencies together account for approximately 96% of all credit ratings. As of December 2012, S&P is the largest of the three, with 1.2 million outstanding ratings and 1,416 analysts and supervisors. Moody's is the second largest agency, with 1 million outstanding ratings and 1,252 analysts and supervisors. Fitch is the smallest of the Big Three, with approximately 350,000 outstanding ratings, and is sometimes used as an alternative to S&P and Moody’s. Fitch's ratings on corporate obligations 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.
The credit rating industry has always been characterized by industry concentration. Since the establishment of the first agency in 1909, there have never been more than four credit rating agencies with significant market share. The situation for international financial markets is similar, as the same three rating agencies have significant share in that market as well. Why this concentrated market structure has developed is a matter of theoretical dispute. One widely-cited opinion is that the Big Three's historical reputation within the financial industry creates a high barrier of entry for new entrants. Following the enactment of the Credit Rating Agency Reform Act of 2006, seven additional rating agencies have attained recognition from the SEC as Nationally Recognized Statistical Rating Organizations (NRSROs). While these other agencies remain niche players, some have gained market share following the 2008 financial crisis, and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group.
Credit rating agencies generate revenue from a variety of activities related to the production and distribution of credit ratings. The sources of the revenue are generally the issuer of the securities or the investor. Most agencies operate under one or a combination of business models: the subscription model and the issuer-pays model. However, agencies may offer additional services using a combination of business models.
Under the subscription model, the credit rating agency does not make its ratings freely available to the market, so investors pay a subscription fee for access to ratings. This revenue provides the main source of agency income, although agencies may also provide other types of services. Under the issuer-pays model, agencies charge issuers a fee for providing credit rating assessments. This revenue stream allows issuer-pays credit rating agencies to make their ratings freely available to the broader market, especially via the Internet.
The subscription approach was the prevailing business model until the early 1970s, when Moody's, Fitch, and finally Standard & Poor's adopted the issuer-pays model. Several factors contributed to this transition, including increased investor demand for credit ratings, and widespread use of information sharing technology—such as fax machines and photocopiers—which allowed investors to freely share agencies’ reports and undermined demand for subscriptions. Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer-pays model, only Egan-Jones maintains an investor subscription service. Smaller, regional credit rating agencies may use either model. For example, China's oldest rating agency, Chengxin Credit Management Co., uses the issuer-pays model, while ratings from the Beijing-based Dagong Global Credit Rating are unsolicited.
Critics argue that the issuer-pays model creates a potential conflict of interest because the agencies are paid by the organizations whose debt they rate. However, the subscription model is also seen to have disadvantages, as it restricts the ratings' availability to paying investors. Issuer-pays CRAs have argued that subscription-models can also be subject to conflicts of interest due to pressures from investors with strong preferences on product ratings. In 2010 Lace Financials, a subscriber-pays agency later acquired by Kroll Ratings, was fined by the SEC for violating securities rules to the benefit of its largest subscriber.
A 2009 World Bank report proposed a "hybrid" approach in which issuers who pay for ratings are required to seek additional scores from subscriber-based third parties. Other proposed alternatives include a "public-sector" model in which national governments fund the rating costs, and an "exchange-pays" model, in which stock and bond exchanges pay for the ratings. Crowd-sourced, collaborative models such as Wikirating have been suggested as an alternative to both the subscription and issuer-pays models, although it is a recent development as of the 2010, and not yet widely used.
- A debt instrument is any type of documented financial obligation. A debt instrument makes it possible to transfer the ownership of debt so it can be traded. (source: wisegeek.com)
- For example, in the US, a state government which shares the credit responsibility for a Municipal bond issued by a municipal government entities but under the control of that state government entity. (source:Campbell R. Harvey's Hypertextual Finance Glossary)
- Alessi, Christopher. "The Credit Rating Controversy. Campaign 2012". Council on Foreign Relations. Retrieved 29 May 2013.
- McLean, Bethany and Joe Nocera. All the Devils Are Here, the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010 (p.111)
- from the beginning of the credit crisis to 2009
- Barnett-Hart, Anna Katherine. "The Story of the CDO Market Meltdown: An Empirical Analysis". March 19, 2009. Harvard Kennedy School. Retrieved 28 May 2013. "Overall, my findings suggest that the problems in the CDO market were caused by a combination of poorly constructed CDOs, irresponsible underwriting practices, and flawed credit rating procedures."
- "Credit Rating Agencies—NRSROs". U.S. Securities and Exchange Commission. 25 September 2008. Retrieved 2009-04-30.
- "List of Credit Rating Companies". Bangladesh Securities and Exchange Commission. 2 September 2008. Retrieved 2007-03-12.
- Crisl History
- Cantor, R., Hamilton, D.T., Kim, F., and Ou, S., 2007 Corporate default and recovery rates. 1920-2006, Special Comment: Moody's investor Service, June Report 102071, 1-48 page 24
- cited by authors Herwig Langohr and Patricia Langohr
- Langohr, Herwig; Patricia Langohr (2010). The Rating Agencies and Their Credit Ratings: What They Are, How They Work. Wiley. p. 48.
- Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.120
- McLean, and Nocera. All the Devils Are Here, 2010 (p.112)
- Maclean, Bethany; Joe Nocera (2010). All the Devils Are Here, the Hidden History of the Financial Crisis'. Portfolio, Penguin,. p. 117. "Investors like having two agencies rate a deal, but nobody cared about having all three involved ..."
- MacLean and Nocera, All the Devils Are Here, p.111
- Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.118
- Smith, Elliot Blair (September 24, 2008). "Bringing Down Wall Street as Ratings Let Loose Subprime Scourge". Blooomberg.
- McLean, and Nocera. All the Devils Are Here, 2010 (p.124)
- see also:Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.118, quote: the rating of structured finance products ... made up close to half of Moody's rating revenues in 2005, 2006, 2007.
- The Financial Crisis Inquiry Report. National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. pp. 43–44. "Purchasers of the safer tranches got a higher rate of return than ultra-safe Treasury notes without much extra risk—at least in theory. However, the financial engineering behind these investments made them harder to understand and to price than individual loans. To determine likely returns, investors had to calculate the statistical probabilities that certain kinds of mortgages might default, and to estimate the revenues that would be lost because of those defaults. Then investors had to determine the effect of the losses on the payments to different tranches. This complexity transformed the three leading credit rating agencies—Moody’s, Standard & Poor’s (S&P), and Fitch—into key players in the process, positioned between the issuers and the investors of securities."
- Here's how a CDO works| Upstart Business Journal| December 5, 2007
- Financial Crisis Inquiry Report, p.43
- MacLean, and Nocera. All the Devils Are Here, 2010 (p.111)
- The Financial Crisis Inquiry Report. National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. 44. "Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors. Investment banks therefore paid handsome fees to the rating agencies to obtain the desired ratings. “The rating agencies were important tools to do that because you know the people that we were selling these bonds to had never really had any history in the mortgage business. ... They were looking for an independent party to develop an opinion,” Jim Callahan told the FCIC; Callahan is CEO of PentAlpha, which services the securitization industry, and years ago he worked on some of the earliest securitizations"
- The Financial Crisis Inquiry Report. National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. xxv.
- Tomlinson, Richard; Evans, David (1 June 2007). "CDOs mask huge subprime losses, abetted by credit rating agencies". International Herald Tribune.
- "Free speech or knowing misrepresentation?". The Economist. 5 February 2013,.
- The Rating Agencies and Their Credit Ratings: What They Are, How They Work ... By Herwig Langohr, Patricia Langohr, Wiley, 2008, p.ix
- "Buffett and the Ratings Cartel". The Wall Street Journal. 2 June 2010. Retrieved 21 June 2010.
- "Part 2: The First Pillar—Minimum Capital Requirements" (pdf). Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. Bank for International Settlements. November 2005. Retrieved April 18, 2013. More than one of
- Consultation Paper on the recognition of External Credit Assessment Institutions| The Committee of European Banking Supervisors Discussion Paper| Web.archive.org
- Eligibility Criteria for recognition of External Credit Assessment Institutions| State Bank of Pakistan ECAI Criteria, SBP.org.pk
- Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.119
- Andrew J. Donohue, director, Division of Investment Management, SEC, “Speech by SEC Staff: Opening Remarks before the Commission Open Meeting,” Washington, DC, June 25, 2008. See also Lawrence J. White, “Markets: The Credit Rating Agencies,” Journal of Economic Perspectives 24, no. 2 (Spring 2010): 214.
- Lewis Ranieri, interview by FCIC, July 30, 2010
- Eric Kolchinsky, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the Investment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings Process, June 2, 2010, transcript, pp. 19–20
- Definition of Nationally Recognized Statistical Rating Organization| ACTION: Proposed rule. SEC
- Leone, Marie (2 October 2006). "Bush Signs Rating Agency Reform Act". CFO (Magazine). Retrieved 9 May 2009.
- Jonathan S. Sack and Stephen M. Juris (2007). "Rating Agencies: Civil Liability Past and Future" (PDF). New York Law Journal 238 (88). Retrieved 9 May 2009.
- Credit Rating Agencies| SEC spotlight
- the ten-member commission appointed by the United States government with the goal of investigating the causes of the financial crisis of 2007–2010
- CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION
- A Triple-A Idea—Ending the rating oligopoly, Wall Street Journal, April 15, 2009
- TE (5 February 2013). "Free speech or knowing misrepresentation?". The Economist.
- McLean, and Nocera. All the Devils Are Here, 2010 (p.113-4)
- Borrus, Amy (8 April 2002). "The Credit-Raters: How They Work and How They Might Work Better". BusinessWeek.
- Wyatt, Edward (8 February 2002). "Credit Agencies Waited Months to Voice Doubt About Enron" (– Scholar search).[dead link]
- McLean, and Nocera. All the Devils Are Here, 2010 (p.120)
- Associated Press (August 22, 2008). "Freddie Mac courts investors, Buffett passes". International Herald Tribune via Internet Archive. Retrieved August 6, 2011.
- See, variously, Kliger, D. and O. Sarig (2000), The Information Value of Bond Ratings, Journal of Finance, December: 2879-2902 and Galil, Koresh (2003). The quality of corporate credit rating: An empirical investigation. EFMA 2003 Helsinki Meetings. European Financial Management Association.
- Partnoy, Frank (2006). "How and why credit rating agencies are not like other gatekeepers". In R. E. Litan & Y. Fuchita. Financial gatekeepers: Can they protect investors?. Brookings Institution. p. 13. SSRN 900257.
- McLean, and Nocera. All the Devils Are Here, 2010 (p.111)
- Wayne, Leslie (15 July 2009). "Calpers Sues Over Ratings of Securities". The New York Times.
- Nocera; McLean (2010). All the Devils Are Here. Penguin,. "[Example from page 118] "UBS banker Rovert Morelli, upon hearing that S&P might be revising its RMSBS ratings, sent an e-mail to an S&P analyst. `Heard your ratings could be 5 notches back of moddys [sic] equivalent, Gonna kill you resi biz. May force us to do moddyfitch only ...`""
- Wadden IV, William "Biv" (2002). "Interpreting Moody’s Historical Default Rate Data".
- Norris, Floyd (2 November 2007). "Being Kept in the Dark on Wall Street". The New York Times. Retrieved 30 April 2010.
- Buiter, Willem (21 September 2007). "Basel II: back to the drawing board?". The Financial Times.
- Kerr, Duncan (15 October 2007). "Banks learn to reprice risk in post-crisis credit market". Financial News (eFinancialNews Limited). Retrieved 29 June 2012.
- "Fitch Completes Review of All Fitch-Rated SF CDOs; Places $36.8B on Rating Watch Negative". Fitch Ratings. Retrieved 10 May 2009.
- "Credit markets | CDOh no! | Economist.com". Economist.com<!. 8 November 2007. Retrieved 10 May 2009.
- Klein, Alec (24 November 2004). "Credit Raters' Power Leads to Abuses, Some Borrowers Say". The Washington Post.
- "Will Financial Reform Negatively Bias U.S. Sovereign Credit Ratings?". Thoughtsworththinking.net. May 21, 2010.
- "Measuring the measurers". The Economist. 31 May 2007.
- Teather, David (28 January 2003). "SEC seeks rating sector clean-up | Business". London: The Guardian. Retrieved 10 May 2009.
- « Dagong, the new Chinese bad guy or a fair player ? », SACR, 21 mars 2012.
- AAA Oligopoly, The Wall Street Journal, FEBRUARY 26, 2008
- M. Nicolas J. Firzli, "A Critique of the Basel Committee on Banking Supervision" Revue Analyse Financière, Nov. 10 2011/Q2 2012, p. 64
- H. Kent Baker; Gerald S. Martin (2011). "Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice". Wiley. ISBN 0470569522.
- "Annual Report on Nationally Recognized Statistical Rating Organizations" (pdf). U.S. Securities and Exchange Commission. December 2012.
- Jeannette Neumann (16 November 2012). "SEC says credit rating industry remains plagued by weak oversight". Financial News.
- Klein, Alec (23 November 2004). "Smoothing the Way for Debt Markets". The Washington Post.
- Gerard Caprio (2012). "Handbook of Key Global Financial Markets, Institutions, and Infrastructure". Academic Press. p. 386. ISBN 0123978734.
- Marie Leone (2 October 2006). "Bush Signs Rating Agency Reform Act". CFO.com. Retrieved 13 May, 2013.
- "Credit Rating Agencies—NRSROs". U.S. Securities and Exchange Commission. 12 May 2011. Retrieved 13 May 2013.
- Arturo Cifuentes (4 March 2013). "Get technical to fix rating agencies". Financial Times. Retrieved 13 May 2013.
- Yali N'diaye (26 February 2013). "Analysis: Can The US Rating Landscape Really Change?". Market News International.
- Simon Rabinovitch (24 October 2012). "New credit rating agency to align with common interests of human society". Financial Times. Retrieved 13 May 2013.
- "Securities and Exchange Commission: Action Needed to Improve Rating Agency Registration Program and Performance-related Disclosures" (pdf). United States Government Accountability Office. 2010. pp. 60–61.
- Gerard Caprio (2012). Handbook of Key Global Financial Markets, Institutions, and Infrastructure. Academic Press. ISBN 0123978734.
- Lianna Brinded (38 November 2007). "Moody's to boost investor confidence with new data feed". Financial News.
- Pragyan Deb; Gareth Murphy (2009). "Credit Rating Agencies: An Alternative Model" (PDF). London School of Economics.
- "General Principles for Credit Reporting" (PDF). World Bank. September 2011. "In some countries, credit rating agencies are starting to provide other types of services, including credit reporting services."
- Stephen Foley (14 January 2013). "Issuer payment: model resistant to reform". Financial Times.
- "Issuer-pays model ensures ratings are available to the entire market". The Economic Times. 6 May 2010.
- John (Xuefeng) Jiang; Mary Harris Stanford; Yuan Xie (2012). "Does it matter who pays for bond ratings? Historical evidence" (PDF). Journal of Financial Economics.
- Katie Hunt (31 October 2012). "China ratings firms challenge US dominance". BBC.
- Norbert Gaillard (2011). A Century of Sovereign Ratings. Springer. p. 90. ISBN 146140522X.
- Gwynneth Anderson (April 2011). "New raters enter the Fray". Treasury & Risk.
- Damien Fennell; Andrei Medvedev (November 2011). "An economic analysis of credit rating agency business models and ratings accuracy" (PDF). Financial Services Authority. p. 19.
- Jeannette Neumann; Aaron Lucchetti (6 September 2010). "Ratings Firm is Fined in Misstate Case". The Wall Street Journal.
- Jonathan Katz; Emanuel Salinas; Constantinos Stephanou (October 2009). "Credit Rating Agencies: No Easy Regulatory Solutions" (pdf). The World Bank Group.
- "Report of the Committee on Comprehensive Regulation for Credit Rating Agencies" (pdf). Securities and Exchange Board of India. December 2009.
- John Greenwood (28 January 2012). "Wiki joins rating game". Financial Post.
- Yali N'Diaye (26 November 2012). "Crowd Sourced Rating Firms Join Forces;Target SEC Registration". MNI. Deutsche Boerse Group.
- 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.
- On the limits of the current 'Issuer-pays' business model, see Kenneth C. Kettering, Securization and its discontents: The Dynamics of Financial Product Development, 29 CDZLR 1553, 60 (2008).
- For a renewed approach of CRAs business model, see Vincent Fabié, A Rescue Plan for rating Agencies, Blue Sky—New Ideas for the Obama Administration ideas.berkeleylawblogs.org.
- Frank J. Fabozzi and Dennis Vink (2009). "On securitization and over-reliance on credit ratings". Yale International Center for Finance.
- For a theoretical analysis of the impact of regulation on rating agencies' business model, see Rating Agencies in the Face of Regulation—Rating Inflation and Regulatory Arbitrage, by Opp, Christian C., Opp, Marcus M. and Harris, Milton (2010).
- Analysts and ratings = chapter 14 in Stocks and Exchange – the only Book you need , Ladis Konecny , 2013, ISBN 9783848220656
- "Spotlight on Nationally Recognized Statistical Rating Organizations (NRSROs)", Securities and Exchange Commission
- Securities Industry and Financial Markets Association, SIFMA
- The Risk in Credit Ratings by Markus Krebsz, Scottish Financial Risk Academy
- 5 Reasons Why S&P's Downgrade of US Debt is Flawed