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 major impact on the availability and cost of credit for borrowers.

"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. In a market with borrowers and lenders, borrowers know more about their own financial prospects than lenders do. 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. And therefore lenders will not lend as much as they could, especially to lesser known borrowers such as smaller municipalities; or lenders will offer higher rates to offset the uncertainty. Credit rating agencies provide access to more information about the borrower than a lender may be able to access, and on accumulated experience in evaluating credit. 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. In an earlier study he refers to numerous academic studies that show 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 those affecting securities, pensions, banking, real estate, and insurance regulation. 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.

Rating performance

According to expert testimony to a Senate Committee they do not make any significant effort to verify that data .

Regulation of the agencies

the conditions required by that commission for their designation as "Nationally Recognized Statistical Rating Organizations" (NRSROs).