A credit rating agency (CRA. also called a ratings service ) is a company that assigns credit ratings. which rate a debtor’s ability to pay back debt by making timely interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, [ 1 ] and in some cases, of the servicers of the underlying debt, [ 2 ] but not of individual consumers.

The issuers of the obligations or securities may be companies, special purpose entities. state or local governments, non-profit organizations. or sovereign nations. [ 3 ] A credit rating facilitates the trading of securities on a secondary market. It affects the interest rate that a security pays out, with higher ratings leading to lower interest rates. Individual consumers are rated for creditworthiness not by credit rating agencies but by credit bureaus (also called consumer reporting agencies or credit reference agencies), which issue credit scores .

The value of credit ratings for securities has been widely questioned. Hundreds of billions of securities that were given the agencies’ highest ratings were downgraded to junk during the financial crisis of 2007–08. [ 4 ] [ 5 ] [ 6 ] Rating downgrades during the European sovereign debt crisis of 2010–12 were blamed by EU officials for accelerating the crisis. [ 3 ]

Credit rating is a highly concentrated industry, with the two largest CRAs—Moody’s Investors Service and Standard & Poor’s (S&P)—controlling 80% of the global market share, and the Big Three credit rating agencies —Moody’s, S&P, and Fitch Ratings —controlling approximately 95% of the ratings business. [ 3 ]

Contents

§ History [ edit ]

§ Early history [ edit ]

When the United States began to expand to the west and other parts of the country, so did the distance of businesses to their customers. When businesses were close to those who purchased goods or services from them, it was easy for the merchants to extend credit to them, due to their proximity and the fact that merchants knew their customers personally and knew whether or not they would be able to pay them back. As trading distances increased, merchants no longer personally knew their customers and became leery of extending credit to people who they did not know in fear of them not being able to pay them back. Business owners’ hesitation to extend credit to new customers led to the birth of the credit reporting industry. [ 7 ]

Mercantile credit agencies—the precursors of today’s rating agencies—were established in the wake of the financial crisis of 1837. These agencies rated the ability of merchants to pay their debts and consolidated these ratings in published guides. [ 8 ] The first such agency was established in 1841 by Lewis Tappan in New York City. [ 8 ] [ 9 ] It was subsequently acquired by Robert Dun, who published its first ratings guide in 1859. Another early agency, John Bradstreet. formed in 1849 and published a ratings guide in 1857. [ 8 ]

Credit rating agencies originated in the United States in the early 1900s, when ratings began to be applied to securities, specifically those related to the railroad bond market. [ 8 ] In the United States, the construction of extensive railroad systems had led to the development of corporate bond issues to finance them, and therefore a bond market several times larger than in other countries. The bond markets in the Netherlands and Britain had been established longer but tended to be small, and revolved around sovereign governments that were trusted to honor their debts. [ 10 ] Companies were founded to provide investors with financial information on the growing railroad industry, including Henry Varnum Poor ‘s publishing company, which produced a publication compiling financial data about the railroad and canal industries. [ 11 ] Following the 1907 financial crisis. demand rose for such independent market information, in particular for independent analyses of bond creditworthiness. [ 12 ] In 1909, financial analyst John Moody issued a publication focused solely on railroad bonds. [ 12 ] [ 13 ] [ 14 ] His ratings became the first to be published widely in an accessible format, [ 10 ] [ 12 ] [ 15 ] and his company was the first to charge subscription fees to investors. [ 14 ]

In 1913, the ratings publication by Moody’s underwent two significant changes: it expanded its focus to include industrial firms and utilities, and it began to use a letter-rating system. For the first time, public securities were rated using a system borrowed from the mercantile credit rating agencies, using letters to indicate their creditworthiness. [ 16 ] In the next few years, antecedents of the Big Three credit rating agencies were established. Poor’s Publishing Company began issuing ratings in 1916, Standard Statistics Company in 1922, [ 12 ] and the Fitch Publishing Company in 1924. [ 13 ]

§ Post-Depression era [ edit ]

In the United States, the rating industry grew and consolidated rapidly following the passage of the Glass-Steagall act of 1933 and the separation of the securities business from banking. [ 17 ] As the market grew beyond that of traditional investment banking institutions, new investors again called for increased transparency, leading to the passage of new, mandatory disclosure laws for issuers, and the creation of the Securities and Exchange Commission (SEC). [ 10 ] In 1936, regulation was introduced to prohibit banks from investing in bonds determined by recognized rating manuals (the forerunners of credit rating agencies) to be speculative investment securities (junk bonds, in modern terminology). US banks were permitted to hold only investment grade bonds, and it was the ratings of Fitch, Moody’s, Poor’s, and Standard that legally determined which bonds were which. State insurance regulators approved similar requirements in the following decades. [ 13 ]

From 1930 to 1980, the bonds and ratings of them were primarily relegated to American municipalities and American blue chip industrial firms. [ 18 ] International sovereign bond rating shrivelled during the Great Depression to a handful of the most creditworthy countries, [ 19 ] after a number of defaults of bonds issued by governments such as Germany’s. [ 18 ]

In the late 1960s and 1970s, ratings were extended to commercial paper and bank deposits. Also during that time, major agencies changed their business model by beginning to charge bond issuers as well as investors. [ 12 ] The reasons for this change included a growing free rider problem related to the increasing availability of inexpensive photocopy machines [ 20 ] and the increased complexity of the financial markets. [ 21 ]

The rating agencies added levels of gradation to their rating systems. In 1973, Fitch added plus and minus symbols to its existing letter-rating system. The following year, Standard and Poor’s did the same, and Moody’s began using numbers for the same purpose in 1982. [ 8 ]

§ Growth of bond market [ edit ]

The end of the Bretton Woods system in 1971 led to the liberalization of financial regulations and the global expansion of capital markets in the 1970s and 1980s. [ 12 ] In 1975, SEC rules began explicitly referencing credit ratings. [ 22 ] For example, the commission changed its minimum capital requirements for broker-dealers. allowing smaller reserves for higher-rated bonds; the rating would be done by nationally recognized statistical ratings organizations (NRSROs). This referred to the Big Three, [ 23 ] but in time ten agencies (later six, due to consolidation) were identified by the SEC as NRSROs. [ 13 ] [ 24 ]

Rating agencies also grew in size and profitability as the number of issuers accessing the debt markets grew exponentially, both in the United States and abroad. [ 25 ] By 2009 the worldwide bond market (total debt outstanding) reached an estimated $82.2 trillion, in 2009 dollars. [ 26 ]

§ 1980s–present [ edit ]

Two economic trends of the 1980s and 90s that brought significant expansion for the global capital market were [ 12 ]

• the move away from intermediated financing (bank loans) toward cheaper and longer-term disintermediated financing (tradable bonds and other fixed income securities), [ 27 ] and
• the global move away from state intervention and state-led industrial adjustment toward economic liberalism based on (among other things) global capital markets and arms-length relations between government and industry. [ 28 ]

More debt securities meant more business for the Big Three agencies, which many investors depended on to judge the securities of the capital market. [ 14 ] US government regulators also depended on the rating agencies; they allowed pension funds and money market funds to purchase only securities rated above certain levels. [ 29 ]

A market for low-rated, high-yield junk bonds blossomed in the late 1970s, expanding securities financing to firms other than a few large, established blue chip corporations. [ 30 ] Rating agencies also began to apply their ratings beyond bonds to counterparty risks, the performance risk of mortgage servicers, and the price volatility of mutual funds and mortgage-backed securities. [ 8 ] Ratings were increasingly used in most developed countries’ financial markets and in the emerging markets of the developing world. Moody’s and S&P opened offices Europe, Japan, and particularly emerging markets. [ 12 ] Non-American agencies also developed outside of the United States. Along with the largest US raters, one British, two Canadian, and three Japanese firms were listed among the world’s most influential rating agencies in the early 1990s by the Financial Times publication Credit Ratings International. [ 31 ]

Structured finance was another growth area of growth. The financial engineering of the new private-label asset-backed securities —such as subprime mortgage-backed securities (MBS), collateralized debt obligations (CDO), CDOs squared, and synthetic CDOs —made them harder to understand and to price and became a profit center for rating agencies. [ 32 ] By 2006, Moody’s earned $881 million in revenue from structured finance. [ 33 ] By December 2008, there were over $11 trillion structured finance debt securities outstanding in the US bond market. [ 34 ]

The Big Three issued 97%–98% of all credit ratings in the United States [ 35 ] and roughly 95% worldwide, [ 36 ] giving them considerable pricing power. [ 37 ] This and credit market expansion brought them profit margins of around 50% from 2004 through 2009. [ 38 ] [ 39 ]

As the influence and profitability of CRAs expanded, so did scrutiny and concern about their performance and alleged illegal practices. [ 40 ] In 1996 the US Department of Justice launched an investigation into possible improper pressuring of issuers by Moody’s in order to win business. [ 41 ] [ 42 ] Agencies were subjected to dozens of lawsuits by investors complaining of inaccurate ratings [ 43 ] [ 44 ] following the collapse of Enron. [ 12 ] and especially after the US subprime mortgage crisis and subsequent late-2000s financial crisis. [ 45 ] [ 46 ] During that debacle, 73%—over $800 billion worth [ 47 ] —of all mortgage-backed securities that one credit rating agency (Moody’s) had rated triple-A in 2006 were downgraded to junk status two years later. [ 47 ] [ 48 ]

Downgrades of European and US sovereign debt were also criticized. In August 2011, S&P downgraded the long-held triple-A rating of US securities. [ 3 ] Since the spring of 2010,

one or more of the Big Three relegated Greece, Portugal, and Ireland to junk status—a move that many EU officials say has accelerated a burgeoning European sovereign-debt crisis. In January 2012, amid continued eurozone instability, S&P downgraded nine eurozone countries, stripping France and Austria of their triple-A ratings. [ 3 ]

§ Role in capital markets [ edit ]

Credit rating agencies assess the relative credit risk of specific debt securities or structured finance instruments and borrowing entities (issuers of debt), [ 49 ] and in some cases the creditworthiness of governments and their securities. [ 50 ] [ 51 ] By serving as information intermediaries. CRAs theoretically reduce information costs, increase the pool of potential borrowers, and promote liquid markets. [ 52 ] [ 53 ] [ 54 ] These functions may increase the supply of available risk capital in the market and promote economic growth. [ 49 ] [ 54 ]

§ Ratings use in bond market [ edit ]

Credit rating agencies provide assessments about the creditworthiness of bonds issued by corporations. governments. and packagers of asset-backed securities. [ 55 ] [ 56 ] In market practice, a significant bond issuance generally has a rating from one or two of the Big Three agencies. [ 57 ]

CRAs theoretically provide investors with an independent evaluation and assessment of debt securities ‘ creditworthiness. [ 52 ] However, in recent decades the paying customers of CRAs have primarily been not issuers of securities but buyers, raising the issue of conflict of interest (see below). [ 58 ]

In addition, rating agencies have been liable—at least in US courts—for any losses incurred by the inaccuracy of their ratings only if it is proven that they knew the ratings were false or exhibited reckless disregard for the truth. [ 12 ] [ 59 ] [ 60 ] Otherwise, ratings are simply an expression of the agencies’ informed opinions, [ 61 ] protected as free speech under the First Amendment. [ 62 ] [ 63 ] As one rating agency disclaimer read:

The ratings. are and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities. [ 64 ]

Under an amendment to the 2010 Dodd-Frank Act. this protection has been removed, but how the law will be implemented remains to be determined by rules made by the SEC and decisions by courts. [ 65 ] [ 66 ] [ 67 ] [ 68 ]

To determine a bond’s rating. a credit rating agency analyzes the accounts of the issuer and the legal agreements attached to the bond [ 69 ] [ 70 ] to produce what is effectively a forecast of the bond’s chance of default. expected loss, or a similar metric. [ 69 ] The metrics vary somewhat between the agencies. S&P’s ratings reflect default probability, while ratings by Moody’s reflect expected investor losses in the case of default. [ 71 ] [ 72 ] For corporate obligations, Fitch’s ratings 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. [ 73 ] The process and criteria for rating a convertible bond are similar, although different enough that bonds and convertible bonds issued by the same entity may still receive different ratings. [ 74 ] Some bank loans may receive ratings to assist in wider syndication and attract institutional investors. [ 70 ]

The relative risks—the rating grades—are usually expressed through some variation of an alphabetical combination of lower- and uppercase letters, with either plus or minus signs or numbers added to further fine-tune the rating. [ 75 ] [ 76 ]

Fitch and S&P use (from the most creditworthy to the least) AAA, AA, A, and BBB for investment-grade long-term credit risk and BB, CCC, CC, C, and D for speculative long-term credit risk. Moody’s long-term designators are Aaa, Aa, A, and Baa for investment grade and Ba, B, Caa, Ca, and C for speculative grade. [ 75 ] [ 76 ] Fitch and S&P use pluses and minuses (e.g. AA+ and AA-), and Moody’s uses numbers (e.g. Aa1 and Aa3) to add further gradations. [ 75 ] [ 76 ]