Credit rating agency

A credit rating agency provides independent assessments, in the form of credit ratings, of the probability of default of companies, governments and the providers of of a wide range of financial instruments. Credit ratings have a major impact on the availability and cost of credit for borrowers. Following the discovery of shortcomings in 2008, revisions to the methods of regulating the agencies are under consideration.

"There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful"
      (Thomas L. Friedman, in an interview with Jim Lehrer on Newshour, PBS television, Feb. 13, 1996).

Introduction: credit ratings and rating agencies

The term "credit" is used in this context in its sense of trustworthiness, and refers to the extent to which its subject can be trusted to be willing and able to comply with the terms of a financial contract. Assessments of individual creditworthiness (usually stated as "credit scores") are not undertaken by organisations known as credit rating agencies, and are not further referred to in this article.

Credit rating agencies assess the creditworthiness of the issuers of debt instruments, including bonds issued by corporations and governments and mortgages and their derivatives, and they express their findings as alphabetically-coded "rating" categories such as AAA, AA, and BB. Credit ratings have been presented by the issuing agencies as statements of opinion, implying the absence of any legally-enforceable commitment to their reliability.

The major credit rating agencies are located in the United States and are regulated by the United States Securities and Exchange Commission They undertake "solicited ratings" for a fee at the request of the issuers of debt instruments, basing their assessments upon data supplied to them by the issuers. They also undertake unsolicitated assessments at their own expense, using published data. Their credit ratings are freely available to investors.

The rôle of the agencies

As the light-hearted opening quotation implies, the credit rating agencies exert a powerful influence upon the financial system. Views differ concerning the source of that power, however. According to a spokesman of the United States Department of the Treasury it arises from the fact that rating agencies solve a basic market failure by providing information about the borrower that a lender would otherwise be unable to obtain. Especially in the capital markets, where a lender is likely purchasing just a small portion of the borrower’s debt in the form of a bond or asset-backed security – it can be inefficient, difficult and costly for a lender to get all the information they need to evaluate the credit worthiness of the borrower. In the absence of credit ratings, lenders would not lend as much as they could, and borrowers would have to offer higher rates to offset uncertainty. . But, according to an eminent Professor of Law, they do not so much provide the market with information, so much as reflect the information that it already has; and they are not widely respected among sophisticated market participants. Several studies have indicated that that the market anticipates ratings changes . (The fact that ratings are correlated with actual default experience – does not alter that conclusion because ratings can be both correlated with default and have little informational value ) . Professor Partnoy believes that their influence stems almost entirely from their rõle in the regulatory system. Since 1973 credit ratings have been incorporated into hundreds of regulatory decisions, including decisions affecting securities, pensions, banking, real estate, and insurance. Some businesses are not permitted to hold assets rated below stipulated grade, and others are required to maintain reserve ratios that depend upon the ratings of their assets. Large numbers of businesses are consequently dependent upon recognised credit ratings to enable them to raise money on terms that they can afford . There is evidence that all types of rating announcements – outlooks, reviews and rating changes, whether positive or negative – have a significant impact on the risk premiums that are embodied in the interest rates on bonds (as reflected in the prices of credit default swaps) .

Rating performance

The rating agencies claim that their ratings have, on the whole been reliable, but there have been several dramatic exceptions.

A report to a Senate Committee on the 2001 collapse of the Enron Corporation commented that

"The credit rating agencies... failed to warn the public of Enron’s precarious situation until a mere four days before Enron declared bankruptcy. Until that time, the rating agencies gave Enron an "investment grade" rating, which indicated that Enron was creditworthy and its bonds were a safe investment .. because they did not exercise the proper diligence [and]...did not sufficiently consider factors affecting the long-term health of the company" .

- and other failures that have been reported, include the failure to anticipate the 2002 collapse of Worldcom .

During 2007 and 2008 the Standard and Poor agency downgraded more than two-thirds of its investment-grade ratings, and the Moodys agency downgraded over 5,000 mortgage-backed securities, precipitating the subprime mortgage crisis and contributing to the crash of 2008. Those failures were referred to by the chairman of a Congressional Committee as a "story of colossal failure" , and the President of Standard and Poor acknowledged that "the historical data we used and the assumptions we made significantly underestimated the severity of what has actually occurred". A former Director of Moodys has attributed their misconduct to a drive to retain market share in face of attempts by the major banks to play each agency off against the others - a tactic knows as "ratings shopping". (The originate and distribute policy that had been adopted by the banks would have given them a strong incentive to get good ratings for their CDOs that they were attempting to sell.) And Standard and Poor's technical shortcomings were attributed by a former senior executive to its use of outdated models . Errors have also been attributed to their acknowledged failure to verify the data provided to them by their clients .

a further analysis of the rating agencies' credit rating errors is available on the addendum subpage

Regulation of the agencies

There is general agreement that the existing provisions for the regulation of the agencies are inadequate, and several proposals are before the United States Congress. The features of the present situation that are under review include:

• the embodiment of credit rating requirements in legislation;
• the rating agencies' immunity from legal action for negligence;
• the absence of a duty to exert "due diligence" in verifying data supplied by applicants for rating;
• the conflict of interest arising from the fact that ratings are paid for by the rated businesses.
• the practice of "ratings shopping";
• limitations upon the powers of the Securities and Exchange Commission (including provisions that bar the Securities and Exchange Commission from concerning itself with the methodology and substance of ratings);
• the conditions required by that Commission for their designation of agencies as "Nationally Recognized Statistical Rating Organizations" (NRSROs), including:-
• the lack of transparency of the data and methods of analysis used by the agencies; and,
• the regulatory barriers to entry that are believed to be responsible for the dominance of Standard and Poor and Moodys.

Legislation or codes of practice bearing on some of those issues have also been enacted or are under consideration by several national and international authorities outside the United States.