Economics
Credit Rating Agencies
Credit rating agencies are firms that assess the creditworthiness of individuals, companies, and governments. They assign credit ratings based on the borrower's ability to repay debt. These ratings help investors and lenders evaluate the risk associated with providing funds, and they also influence interest rates and investment decisions.
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eBook - ePubCredit Rating Governance
Global Credit Gatekeepers
- Ahmed Naciri(Author)
- 2015(Publication Date)
- Routledge(Publisher)
1 Introduction to the world of credit rating DOI: 10.4324/9781315757834-1A credit rating (CR) is meant to be an opinion on the creditworthiness of an issuing entity (e.g. an issuer of bonds or a contractor of debt), on a debt instrument (e.g. bonds, loans or asset-backed securities)1 or, for some agencies, on the financial strength of an insurer (for life and property-casualty insurers). Credit ratings may allow uninformed investors to quickly assess the broad risk properties of tens of thousands of individual securities using a single and well-known scale (Becker and Milbourn, 2009 ). Credit ratings also can play much more fundamental roles in enhancing market efficiency: (i) they can, for instance, reduce information asymmetries by providing information on the rated security. (ii) They can contribute to solve certain principal–agent problems, such as fixing the level of risk that an agent can take on behalf of his principal. (iii) ‘They can solve collective action problems of dispersed debt investors by helping them to monitor performance, with downgrades serving as a signal to take action’ (World Bank, 2009 ). Credit ratings are supposed to be based on formal, as well as rational, activity and presented according to an agreed ranking system or scale in the form of ‘AAA’, ‘AA’, ‘A’ to ‘CCC’. Till the 1980s, the demand for credit ratings was not substantial, economic entities were still filling most of their financial needs by resourcing to banks and credit unions, and endeavouring to concentrate on things in which they were feeling to have advanced knowledge and intimate confidence. From the 1980s onwards, however, as the financial system became more and more deregulated and an enforcement mechanism reduced, companies started increasingly borrowing from the globalized debt markets, and consequently credit ratings agencies became more and more relevant and valuable (Kingsley, 2012
- David P. Stowell(Author)
- 2012(Publication Date)
- Academic Press(Publisher)
7
Credit Rating Agencies, Exchanges, and Clearing and Settlement
Credit Rating Agencies
Credit Rating Agencies play a very important role in the business of investment banking by assigning credit ratings to debt issuers and their debt instruments. Debt instruments include bonds, convertible bonds, and loans. In addition, Credit Rating Agencies assign ratings to structured finance securities, which are backed by various types of collateral. Structured finance includes asset-backed securities, residential and commercial mortgage-backed securities, and collateralized debt obligations. Investment banks work closely with Credit Rating Agencies when developing structured finance products in order to secure targeted ratings for these securities. This business practice has been one of the major sources of criticism for rating agencies, as will be described later. See Table 7.1 for a summary of the role of Credit Rating Agencies.Table 7.1 Rating Agency RoleTo communicate unbiased opinions on the credit worthiness of companies and their debt instruments to the investment community.Corporate and Government Finance Structured Finance • Bonds/notes/commercial paper • Collateralized debt obligations (CDO) • Convertibles • Residential mortgage-backed securities (RMBS) • Bank notes • Commercial mortgage-backed securities (CMBS) • Asset-backed securities (ABS) Source: Standard & Poor’s.Issuers can be corporations, local, state, or national governments and agencies, special purpose entities, and nonprofit organizations. The ratings process involves an analysis of business risk, including competitive position within the industry, diversity of product lines, and profitability compared to peers; and financial risk, including accounting, cash flow financial flexibility, and capital structure considerations (see Figure 7.1
eBook - ePub- Craig E. Carroll(Author)
- 2016(Publication Date)
- SAGE Publications, Inc(Publisher)
Pierre Pénet Pierre Pénet Pénet, PierreCredit Rating Credit rating235 239Credit Rating
A credit rating is an assessment published by a credit rating agency of the creditworthiness of a financial entity (issuer rating) or a particular financial instrument (issue rating). Users of credit ratings typically include institutional and individual investors, lenders, and public regulators. Credit ratings are not to be confused with credit scores assigned by consumer reporting agencies to represent the creditworthiness of individual consumers. Credit Rating Agencies assign credit ratings to private entities (corporations and financial institutions) and public entities (municipalities, states, sovereign governments, and supranational entities) operating domestically or internationally. Rated instruments include, among other things, bonds, commercial paper, bank deposits, loans, and structured debt instruments.The value added of Credit Rating Agencies is to produce independent credit analysis. Credit ratings are calculated as the likelihood of a default occurring over a short-term or long-term period, and they are expressed as alphanumerical grades on an ordinal scale. The rating scales used by major Credit Rating Agencies display rating grades in inverse order of default likelihood, from lowest (“AAA”) to highest (“C” or “D” according to the rating nomenclature) (see Table 1 ).Table 1Since their emergence in the early 20th century in the United States, credit ratings have spread internationally to every corner of the financial world to become pivotal reputational intermediaries for private and public (including sovereign) financial entities. This entry first gives a brief history of credit ratings since they originated in the United States in the early 20th century. It then discusses rating methodologies and Credit Rating Agencies’ business models. Finally, it examines the significance of ratings in regulatory frameworks.
eBook - ePub- Moorad Choudhry(Author)
- 2010(Publication Date)
- Wiley(Publisher)
Fitch) also has a high profile.The specific factors that are considered by a ratings agency, and the methodology used in conducting the analysis, differ slightly amongst the individual ratings agencies. Although in many cases the ratings assigned to a particular issue by different agencies are the same, they occasionally differ, and in these instances investors usually seek to determine what aspect of an issuer is given more weight in an analysis by which individual agency. Note that a credit rating is not a recommendation to buy (or, equally, sell) a particular bond, nor is it a comment on market expectations. Credit analysis does take into account general market and economic conditions; the overall purpose of credit analysis is to consider the financial health of the issuer and its ability to meet the obligations of the specific issue being rated. Credit ratings play a large part in the decision-making of investors, and also have a significant impact on the interest rates payable by borrowers.CREDIT RATINGS
A credit rating is a formal opinion given by a rating agency, of the credit risk for investors in a particular issue of debt securities. Ratings are given to public issues of debt securities by any type of entity, including governments, banks and corporates. They are also given to short-term debt such as commercial paper as well as bonds and medium-term notes.Purpose of credit ratings
Investors in securities accept the risk that the issuer will default on coupon payments or fail to repay the principal in full on the maturity date. Generally, credit risk is greater for securities with a long maturity, as there is a longer period for the issuer potentially to default. For example, if a company issues 10-year bonds, investors cannot be certain that the company will still exist in 10 years’ time. It may have failed and gone into liquidation some time before that. That said, there is also risk attached to short-dated debt securities; indeed, there have been instances of default by issuers of commercial paper, which is a very short-term instrument.
eBook - ePub- Giulia Mennillo(Author)
- 2022(Publication Date)
- Agenda Publishing(Publisher)
2 What do Credit Rating Agencies do? The authors of the common language of credit riskA credit rating agency rates the creditworthiness of a bond issuer. But what does this actually mean? Common knowledge in the context of financial markets suggests that rating involves an assessment of creditworthiness, which relies on figures and data conventionally deemed relevant for this purpose. Generally speaking, the verb “to rate” signifies the assignment of “a standard or value to (something) according to a particular scale”.1 In the case of credit rating, the object of the assessment refers to any entity seeking access to capital markets by issuing bonds to satisfy its funding needs, ranging from companies, banks, municipalities and sovereigns to supranationals.2 In the case of public entities, the refinancing through capital markets is not as apolitical as it sounds. When a state or municipality resorts to capital markets, it exposes itself to the CRAs’ judgement, becoming subject to the logics and interpretive frameworks of the financial market community. Unlike politically unpopular taxation, a public entity implicitly consents to the rules of the game of the financial market’s sphere. Apart from creating a financial dependence, the borrower tacitly accepts that norms, worldviews and ideas preponderant in financial markets transcend and diffuse into the political sphere.Considering the definition of the verb “to rate” – assigning a standard or value to a particular scale – the specificity of the credit rating scale is that it is created by the CRAs themselves. The same applies to the assigned value – that is, the rating content; scale and value do not exist independently from each other. The scale constitutes the rating content, mirroring how creditworthiness has come to mean “credit rating”. Instead of amounting to a quasi-metric that is fungible and transferable to other units of measurement, credit ratings have gained power of definition over creditworthiness: A bond issuer is deemed creditworthy because
- Daniel Cash(Author)
- 2018(Publication Date)
- Palgrave Pivot(Publisher)
Therefore, what the lender needs in this situation is either (a) a massively high rate of interest, which would deter the borrower from reaching an agreement in reality or (b) an external, and more crucially independent assessor of the borrower’s creditworthiness—that, in a nutshell, is the fundamental purpose of a credit rating agency. There are, of course, a number of nuances to consider. This situation works for the investor because it reduces both the need to conduct the necessary analysis themselves (to a certain extent) and also reduces the need to produce the same level of analysis on a number of borrowers. At the root of the investors’ connection with the CRAs is this notion of cost effectiveness. To aid in that objective, the actual rating mechanisms (the sliding scale of a credit rating from, say ‘AAA’ to ‘C’ [or even ‘D’ for “in default”]) further increase this cost efficiency and are the basis for the symbiotic aura of the rating agencies within the financial marketplace. This is witnessed in regulatory mechanisms whereby certain companies or groups of investors (like Pension Funds) can only invest in debt that is rated in a certain category, usually the top category ‘AAA’ (though that practice has been officially removed after the Financial Crisis, the sentiment still remains). Within the investors themselves, the investment managers can be constrained by the actual investors, so that they may only consider investing in products that carry a particular rating also. Perhaps the genius of the credit rating agency is its simplicity which strikes a chord in the human brain—the sliding scale is, of course, overly basic, but it is something which a dispersed, or even uninterested investor can easily point to in order to constrain a manager acting upon their behalf
eBook - ePub- D. Tennant, M. Tracey(Authors)
- 2017(Publication Date)
- Palgrave Pivot(Publisher)
These questions are of concern not only to the borrowers, but naturally to the creditors as well. Investors face the complex task of assessing the creditworthiness of sovereign debt issues in an environment characterized by increased uncertainty in the post-global crisis era. Even without the heightened uncertainty, the complexity of assessing the creditworthiness of sovereign debt should not be underestimated. This is because a country’s ability and willingness to repay debt is affected not only by its economic, social and political dynamics, but also by increasingly commonplace internal and external shocks.How do creditors make their decisions as to a country’s creditworthiness? Increasingly they have come to rely on the assessments provided by Credit Rating Agencies (CRAs). CRAs garner information on borrowers from a variety of sources and assess the default risk of the financial products being offered. The default risk is computed and condensed into a single relative measure—a credit rating in the form of a letter grade (Kruck 2011). This rating is a judgment on the “future ability and willingness of an issuer to make timely payments of principal and interest on a security over the life of the instrument.”2 This judgment forms the basis of the important but often uneasy relationship between countries which rely on funds from international capital markets, and the CRAs which influence the countries’ ability to access such funds.Gatekeepers to the international capital marketsThe CRAs’ outputs are used to guide the investment choices of government agencies and key institutional investors in the capital markets (pension funds, investment banks and other financial institutions). At the start of the millennium, the two major CRAs (Moody’s and S&P) passed judgment on approximately US$30 trillion worth of securities each year. According to their own estimates, at that time Moody’s had 4,000 clients for its publications and approximately 30,000 regular readers of its print output, and both Moody’s and S&P regularly issued press statements about credit conditions (Sinclair 2005). Output produced for dissemination through the Internet was just then gaining popularity. By the end of the 2007–2009 global crisis, however, CRAs have become known to even the casual newspaper reader. This is not only because of the plethora of articles that have blamed the CRAs for several failures leading up to and exacerbating the crisis, but also because of the demonstration of the critical role that the CRAs play in global investment decisions (Kruck 2011).
eBook - ePubRunning an Effective Investor Relations Department
A Comprehensive Guide
- Steven M. Bragg(Author)
- 2010(Publication Date)
- Wiley(Publisher)
CHAPTER 14Dealing with Credit Rating AgenciesTHE CREDIT RATING ASSIGNED to a company’s debt by a credit rating agency is taken more seriously than the range of buy, sell, or hold ratings assigned by an analyst. The reason is that Regulation FD (Fair Disclosure) exempts Credit Rating Agencies from its requirements, because these agencies must have ongoing access to nonpublic information. Because of their deeper knowledge of a company’s finances and operations, ratings issued by Credit Rating Agencies are accorded considerable weight by the investment community. Thus, it is extremely useful to build a relationship with a credit rating agency.CREDIT RATING AGENCY RELATIONSHIP
If a publicly held company issues debt, it can elect to have that debt rated by either Moody’s, Standard & Poor’s, Fitch, or Dominion Bond Rating Service. These are the four Credit Rating Agencies that the SEC allows to issue debt ratings. A debt rating results in a credit score that indicates the perceived risk of default on the underlying debt, which, in turn, impacts the price of the debt on the open market. Having a credit score is essentially mandatory, since most funds are prohibited by their internal investment rules from buying debt that does not have a specific level of credit rating assigned to it.A company should expect to deal with a credit rating agency through a primary analyst who has considerable credit rating experience and is usually ranked at the director level. The primary analyst is supported by a senior analyst having direct experience in the company’s industry. The primary analyst is responsible for formulating a rating, and for the ongoing monitoring of that rating.The investor relations officer (IRO) is not the key individual representing the company to a credit rating agency. Instead, either the CFO or treasurer usually handles that chore. If there is a chief risk officer or similar position, then this person will also have discussions with the analyst team. It is also entirely likely that the managers of the company’s operating divisions will be asked to participate in some meetings with the analyst team, or to assist them with tours of key company facilities. The IRO is generally limited to ensuring that the primary analyst is included in any mailing lists of new information that the company provides to investors on a regular basis.
