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v t e

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^[1] and in some cases, the servicers of the underlying debt.^[2] 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).^[3]

The issuers of the obligations/securities may be companies, special purpose entities, state and local governments, non-profit organizations, or sovereign nations.^[3] 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"^[4] — but later write-downs at financial institutions of CDOs (triple A and lower rated) totaled over $500 billion.^[5][6] Ratings downgrades during the European sovereign debt crisis of 2010–12 have been 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, 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.^[3]

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).,^[7] Muros Ratings^[8] (Russia alternative rating agency), Rapid Ratings International (U.S.), Credit Rating Information and Services Limited^[9][10](Bangladesh) and Public Sector Credit Solutions (U.S.).

Contents 1 Ratings 2 Uses of ratings 2.1 By bond issuers 2.2 In structured finance 2.3 Ratings use by government regulators 2.3.1 United States 3 Criticism 3.1 Failure to downgrade securities promptly and laxness 3.2 Cosy relationships with securities issuers 3.3 Inaccurate ratings of structured products 3.3.1 Unwillingness to spend on human resources 3.4 Soliciting business by threatening to downgrade 3.5 Downgrading that leads to a vicious cycle 3.6 Conflict of interest in assigning sovereign ratings 3.7 Oligopoly produced by regulation 3.8 Regulatory reliance on credit ratings 4 The Big Three 5 Business models 6 See also 7 References 8 Further reading 9 External links

Ratings

Below are the credit worthiness grades used by the four largest agencies for long and short term debt issues. Higher grades are intended to represent a lower probability of default. For example one study^[11][12] 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."^[13]

Moody's		S&P		Fitch		DBRS
Long-term	Short-term	Long-term	Short-term	Long-term	Short-term	Long-term	Short-term
Aaa	P-1	AAA	A-1+	AAA	F1+	AAA	R-1H	Prime
Aa1		AA+		AA+		AA(high)		High grade
Aa2		AA		AA		AA	R-1M
Aa3		AA-		AA-		AA(low)
A1		A+	A-1	A+	F1	A(high)	R-1L	Upper medium grade
A2		A		A		A
A3	P-2	A-	A-2	A-	F2	A(low)
Baa1		BBB+		BBB+		BBB(high)	R-2H	Lower medium grade
Baa2	P-3	BBB	A-3	BBB	F3	BBB	R-2M
Baa3		BBB-		BBB-		BBB(low)	R-2L, R-3
Ba1	Not prime	BB+	B	BB+	B	BB(high)	R-4	Non-investment grade speculative
Ba2		BB		BB		BB
Ba3		BB-		BB-		BB(low)
B1		B+		B+		B(high)		Highly speculative
B2		B		B		B	R-5
B3		B-		B-		B(low)
Caa1		CCC+	C	CCC	C	CCC(high)		Substantial risks
Caa2		CCC				CCC
Caa3		CCC-				CCC(low)
Ca		CC				CC(high)		Extremely speculative
						CC
						CC(low)
		C				C(high)
						C
						C(low)
C		D	/	DDD	/	D	D	In default
				DD
				D

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."^[14] 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^[14]

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^[15] a significant bond issuance almost always has at least one rating from a respected CRA — generally two^[16] — 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^[17] — 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.^[18]

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".^[19] 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."^[20][21]

Ratings are vital to "private-label" asset-backed securities (ABS), such as subprime mortgage-backed securities (MBS), whose "financial engineering" make them "harder to understand and to price than individual loans".^[22]

These securities pool debt -- consumer credit assets, such as mortgages, credit card or auto loans -- and then "slice" them into "tranches" each given a different priority in the debt repayment stream of income. Tranches are 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.^[23] The higher up the bucket in the income stream the higher the credit ratings and lower its interest payment.

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.^[24] 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.^[25]

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"^[22]

"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."^[26]

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,”^[26]

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.^[27]

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^[28]

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".^[29]

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."^[30]

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."^[31]

Rating agencies bestowed with regulatory power must be vetted under both Basel II and SEC regulations. The Basel II guidelines,^[32] 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.^[33][34]

United States

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.^[35]

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.)^[35]

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".^[36]
• The US Department of Labor restricts pension fund investments to securities rated A or higher.^[35]
• 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.”^[37][35] According to former Moody’s managing director Eric Kolchinsky, the law meant “the rating agencies were given a blank check.”^[38][35]
• The 2001 "Recourse Rule" of the Federal Reserve directly linked the rating agencies’ assessment of asset-backed security tranches to banks' capital reserve requirements — those requirements being a major cost to banks. For example, securities rated AAA or AA required one tenth the capital that anything rated BB required.^[39]
• insurance regulators used credit ratings to ascertain the strength of the reserves held by insurance companies.^{[citation needed]}

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.^[35]

(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.^[40])

The Credit Rating Agency Reform Act went into effect in the Summer of 2007 — after withstanding a court challenge from Standard & Poor's^[41] — 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".^[42]

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."^[43]

Criticism

In the wake of the financial crisis of 2007–2010, the Financial Crisis Inquiry Report^[44] called the "failures" of the Big Three rating agencies "essential cogs in the wheel of financial destruction."^[45] 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.^[46]

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.^[4] 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."^[47]

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. ^[48]

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.^{[49] [50]} 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.`^[51]

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.^[52] 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.^[53] 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",^[15] possibly opening themselves to undue influence or the vulnerability of being misled.^[54]

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.^[55] 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.^[56] Subpoena emails later revealed issuers openly threatened to take their business to another rating agency if the agency's ratings were not high enough.^[57] 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."^[58]

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.^[59][60][61]

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.^[62][63] 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.

Unwillingness to spend on human resources

While Moody's and other credit rating agencies were quite profitable — Moody's operating margins were consistently over 50%, higher than famously successful Exxon Mobil or Microsoft, and its stock rose 340% between the time it was spun off into a public company and February 2007^[64] — its pay was low by Wall Street standards and its employees complained of overwork.

Journalist Michael Lewis argues that the low pay of credit rating agency employees allowed security issuers to game the ratings of their securities. Lewis quotes one Goldman Sachs "trader-turned hedge fund manager" telling him, "guys who can't get a job on Wall Street get a job at Moody's," as Moody's paid much less. This seemed surprising to at least one other Wall Street personality because the ratings produced by analysts at Moody's and other credit raters had considerably more effect on the markets than those of the higher paid analysts at investment banks. "Nobody gives a f**k if Goldman Sachs likes General Electric paper, if Moody's downgrades GE paper, it is a big deal. So why does the guy at Moody's [want to work at Goldman Sachs]"? However, this difference in pay meant that the "smartest" analysts at the credit rating agencies "leave for Wall Street firms where they could use their knowledge (of criteria used to rate securities) to manipulate the companies they used to work for." Consequently, it was widely known on Wall Street that the "inner workings" of the rating models used by the credit rating agencies, while "officially, a secret", "were ripe for exploitation."^[65]

Lack of analysts also affected ratings quality according to journalists Bethany MacLean and Joe Nocera.

"The analysts in structured finance were working 12 to 15 hours a day. They made a fraction of the pay of even a junior investment banker. There were far more deals in the pipeline than they could possibly handle. They were overwhelmed. Moody's top brass ... wouldn't add staff because they didn't want to be stuck with the cost of employees if the revenues slowed down."^[66]

Soliciting business by threatening to downgrade

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.^[67]

Downgrading that leads to a vicious cycle

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 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.^[68]

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"^[69] 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"^[70] 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^[71] 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,^[72] 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.^[73]

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.^[74]

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.^[46]

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."^[46]

To solve this problem, Ms. Casey (and other such as NYU professor Lawrence White^[75]) have proposed removing the NRSRO rules completely.^[46] Professor Frank Partnoy suggests that the regulators use the results of the credit risk swap markets rather than the ratings of NRSROs.^[46]

The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.^[75]

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.^[76]

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.^[77] According to the most recent U.S. Securities and Exchange Commission (SEC) report, the agencies together account for approximately 96% of all credit ratings.^[78] As of December 2012, S&P is the largest of the three, with 1.2 million outstanding ratings and 1,416 analysts and supervisors.^[78][79] Moody's is the second largest agency, with 1 million outstanding ratings and 1,252 analysts and supervisors.^[78][79] 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.^[78][80] 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.^[77]

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.^[81] 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.^[81] 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).^[82][83] While these other agencies remain niche players,^[84] some have gained market share following the 2008 financial crisis,^[85] and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group.^[86]

Business models

Credit rating agencies generate revenue from a variety of activities related to the production and distribution of credit ratings.^[87] 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.^[88] However, agencies may offer additional services using a combination of business models.^[87][89]

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.^[88][90] This revenue provides the main source of agency income, although agencies may also provide other types of services.^[88][91] Under the issuer-pays model, agencies charge issuers a fee for providing credit rating assessments.^[88] This revenue stream allows issuer-pays credit rating agencies to make their ratings freely available to the broader market, especially via the Internet.^[92][93]

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.^[88][90] 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.^[94] Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer-pays model, only Egan-Jones maintains an investor subscription service.^[92] 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.^[95][96]

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.^[97] However, the subscription model is also seen to have disadvantages, as it restricts the ratings' availability to paying investors.^[92][93] 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.^[98] 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.^[99]

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.^[100] 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.^[98][101] 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.^{[102][102][103]}

See also

• Lehman Brothers
• List of countries by credit rating

References

Further reading

• 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

External links

• "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