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A Credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.
In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.
The value of such security ratings has been widely questioned after the 2007-09 financial crisis. In 2003 the U.S. Securities and Exchange Commission 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.[1] More recently, ratings downgrades during the European sovereign debt crisis of 2010-11 have drawn criticism from the EU and individual countries.
A company that issues credit scores for individual credit-worthiness is generally called a credit bureau (US) or consumer credit reporting agency (UK).
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Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk; this generally increases the efficiency of the 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 opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities.
Issuers rely on credit ratings as an independent verification of their own credit-worthiness and the resultant value of the instruments they issue. In most cases, a significant bond issuance must have at least one rating from a respected CRA for the issuance to be successful (without such a rating, the issuance may be undersubscribed or the price offered by investors too low for the issuer's purposes). Studies by the Bond Market Association note that many institutional investors now prefer that a debt issuance have at least three ratings.
Issuers also use credit ratings in certain structured finance transactions. For example, a company with a very high credit rating wishing to undertake a particularly risky research project could create a legally separate entity with certain assets that would own and conduct the research work. This "special purpose entity" would then assume all of the research risk and issue its own debt securities to finance the research. The SPE's credit rating likely would be very low, and the issuer would have to pay a high rate of return on the bonds issued.
However, this risk would not lower the parent company's overall credit rating because the SPE would be a legally separate entity. Conversely, a company with a low credit rating might be able to borrow on better terms if it were to form an SPE and transfer significant assets to that subsidiary and issue secured debt securities. That way, if the venture were to fail, the lenders would have recourse to the assets owned by the SPE. This would lower the interest rate the SPE would need to pay as part of the debt offering.
The same issuer also may have different credit ratings for different bonds. This difference results from the bond's structure, how it is secured, and the degree to which the bond is subordinated to other debt. Many larger CRAs offer "credit rating advisory services" that essentially advise an issuer on how to structure its bond offerings and SPEs so as to achieve a given credit rating for a certain debt tranche. This creates a potential conflict of interest, of course, as the CRA may feel obligated to provide the issuer with that given rating if the issuer followed its advice on structuring the offering. Some CRAs avoid this conflict by refusing to rate debt offerings for which its advisory services were sought.
Regulators use credit ratings as well, or permit ratings to be used for regulatory purposes. 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. In the United States, the Securities and Exchange Commission (SEC) permits investment banks and broker-dealers to use credit ratings from "Nationally Recognized Statistical Rating Organizations" (NRSRO) for similar purposes. The idea is that banks and other financial institutions should not need keep in reserve the same amount of capital to protect the institution against (for example) a run on the bank, if the financial institution is heavily invested in highly liquid and very "safe" securities (such as U.S. government bonds or short-term commercial paper from very stable companies).
CRA ratings are also used for other regulatory purposes as well. The US SEC, for example, permits certain bond issuers to use a shortened prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimic the safety and liquidity of a bank savings deposit, but without Federal Deposit Insurance Corporation insurance) comprise only securities with a very high NRSRO rating. Likewise, insurance regulators use credit ratings to ascertain the strength of the reserves held by insurance companies.
In 2008, the US SEC voted unanimously to propose amendments to its rules[2] that would remove credit ratings as one of the conditions for companies seeking to use short-form registration when registering securities for public sale.
This marks the first in a series of upcoming SEC proposals in accordance with Dodd-Frank to remove references to credit ratings contained within existing Commission rules and replace them with alternative criteria.
Under both Basel II and SEC regulations, not just any CRA's ratings can be used for regulatory purposes. (If this were the case, it would present a moral hazard). Rather, there is a vetting process of varying sorts. The Basel II guidelines[3] (paragraph 91, et al.), for example, describe certain criteria that bank regulators should look to when permitting the ratings from a particular CRA to be used. These include "objectivity," "independence," "transparency," and others. Banking regulators from a number of jurisdictions have since issued their own discussion papers on this subject, to further define how these terms will be used in practice. (See The Committee of European Banking Supervisors Discussion Paper,[4] or the State Bank of Pakistan ECAI Criteria).[5]
In the United States, since 1975, NRSRO recognition has been granted through a "No Action Letter" sent by the SEC staff. Following this approach, if a CRA (or investment bank or broker-dealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determines that this is the case, it sends a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff will not recommend enforcement action against that entity. These "No Action" letters are made public and can be relied upon by other regulated entities, not just the entity making the original request. The SEC has since sought to further define the criteria it uses when making this assessment, and in March 2005 published a proposed regulation to this effect.
On September 29, 2006, US President George W. Bush signed into law the "Credit Rating Reform Act of 2006".[6] This law requires the US Securities and Exchange Commission to clarify how NRSRO recognition is granted, eliminates the "No Action Letter" approach and makes NRSRO recognition a Commission (rather than SEC staff) decision, and requires NRSROs to register with, and be regulated by, the SEC. S & P protested the Act on the grounds that it is an unconstitutional violation of freedom of speech.[6] In the Summer of 2007 the SEC issued regulations implementing the act, requiring rating agencies to have policies to prevent misuse of nonpublic information, disclosure of conflicts of interest and prohibitions against "unfair practices".[7]
Recognizing CRAs' role in capital formation, some governments have attempted to jump-start their domestic rating-agency businesses with various kinds of regulatory relief or encouragement. This may, however, be counterproductive, if it dulls the market mechanism by which agencies compete, subsidizing less-capable agencies and penalizing agencies that devote resources to higher-quality opinions.
Credit rating agencies may also play a key role in structured financial transactions. Unlike a "typical" loan or bond issuance, where a borrower offers to pay a certain return on a loan, structured financial transactions may be viewed as either a series of loans with different characteristics, or else a number of small loans of a similar type packaged together into a series of "buckets" (with the "buckets" or different loans called "tranches"). Credit ratings often determine the interest rate or price ascribed to a particular tranche, based on the quality of loans or quality of assets contained within that grouping.
Companies involved in structured financing arrangements often consult with credit rating agencies to help them determine how to structure the individual tranches so that each receives a desired credit rating. For example, a firm may wish to borrow a large sum of money by issuing debt securities. However, the amount is so large that the return investors may demand on a single issuance would be prohibitive. Instead, it decides to issue three separate bonds, with three separate credit ratings—A (medium low risk), BBB (medium risk), and BB (speculative) (using Standard & Poor's rating system).
The firm expects that the effective interest rate it pays on the A-rated bonds will be much less than the rate it must pay on the BB-rated bonds, but that, overall, the amount it must pay for the total capital it raises will be less than it would pay if the entire amount were raised from a single bond offering. As this transaction is devised, the firm may consult with a credit rating agency to see how it must structure each tranche—in other words, what types of assets must be used to secure the debt in each tranche—in order for that tranche to receive the desired rating when it is issued.
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.[8]
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.
Complicating matters, particularly where structured finance transactions are concerned, the rating agencies state that their ratings are opinions (and as such, are protected free speech, granted to them by the "personhood" of corporations) regarding the likelihood that a given debt security will fail to be serviced over a given period of time, and not an opinion on the volatility of that security and certainly not the wisdom of investing in that security. In the past, most highly rated (AAA or Aaa) debt securities were characterized by low volatility and high liquidity—in other words, the price of a highly rated bond did not fluctuate greatly day-to-day, and sellers of such securities could easily find buyers.
However, 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 or 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.
Credit rating agencies have been subject to the following criticisms:
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"[25] 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"[26] 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[27] 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.
According to professor Frank Partnoy, the regulation of CRAs by the Securities and Exchange Commission (SEC) and the FED 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.[29]
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."[29]
To solve this problem, Ms. Casey proposed to remove the NRSRO rules completely.[29] Also professor Lawrence White (NYU) has made the same proposition.[30] Professor Frank Partnoy suggests that the regulators should trust in credit risk swap markets instead of NRSROs.[29]
The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.[30]
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 S&P, thus using public policy and ultimately taxpayers’ money to strengthen an anti-competitive duopolistic industry. Ironically, European governments have abdicated most of their regulatory authority in favor of a non-European, highly deregulated, private cartel… [31]
For more information, see Bond credit rating.
Agencies that assign credit ratings for corporations include:
The Big Three credit rating agencies are Standard & Poor's, Moody's Investor Service, and Fitch Ratings.[36] Moody's and S&P each control about 40 percent of the market. Third-ranked Fitch Ratings, which has about a 14 percent market share, sometimes is used as an alternative to one of the other majors.[37]
Most credit rating agencies follow one of two business models. Originally, all CRAs relied on a "subscriber-based" business model where the CRA would not distribute the ratings for free but would instead only provide the ratings to subscribers to the CRA's publications. Subscription fees would provide the bulk of the CRA's income. Today, most smaller CRAs still rely on this business model, which proponents believe allows the CRA to publish ratings that are less likely to be tinged by certain types of conflicts of interest. By contrast, most large and medium-sized CRAs (including Moody's, S&P, Fitch, Japan Credit Ratings, R&I, A.M. Best and others) today rely on an "issuer-pays" business model in which most of the CRA's revenue comes from fees paid by the issuers themselves. Under this business model, while subscribers to the CRA's services are still provided with more detailed reports analyzing an issuer, these services are a minor source of income and most ratings are provided to the public for free. Proponents of this model argue that if the CRA relied only on subscriptions for income, the vast majority of bonds would go unrated since subscriber interest is low for all but the largest issuances. These proponents also argue that while they face a clear conflict of interest vis-a-vis the issuers they rate (as described above), the subscriber-based model also presents conflicts of interest, since a single subscriber may provide a large portion of a CRA's revenue and the CRA may feel obligated to publish ratings that support that subscriber's investment decisions.
In October 2011, a new collaboration based business model called wikirating was developed by Austrian mathematician Dorian Credé. The online community credit rating platform aims to provide a transparent source of credit rating information, reviewed by a worldwide commnunity.[38]