Credit agency

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 by making timely interest payments and of the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, the debt instruments,[1] and/or in some cases, the servicers of the underlying debt,[2] but not individual consumers.

Debt instruments the agencies rate may include government bonds, corporate bonds, CDs, municipal bonds, preferred stock, and collateralized securities, such as mortgage-backed securities and 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 a security pays out, with higher ratings leading to lower interest rates. Individual consumers are not rated for credit-worthiness by credit rating agencies, but by credit bureaus, or consumer credit reporting agencies, which issue credit scores.

The value of such security ratings has been widely questioned. Hundreds of billions of securities given the agencies highest rating were downgraded to junk during the 2007–09 financial crisis.[4][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]

History

Origins

In the 19th century, creditworthiness was evaluated by the financial press, investment bankers and credit reporting agencies (CRA). CRAs evaluated a merchant's ability to repay its debt and are considered a precursor to credit rating agencies that evaluate bonds.[7][8][9] The first credit reporting agency was established in 1841 by Louis Tappan in New York, just after the financial crisis of 1837.[7][8] It was acquired by Robert Dunn, who published its first ratings guide in 1859. Another early CRA, John Bradstreet, also formed a CRA in 1849 and published a ratings guide in 1857.[8]

Early history

In the early 1840s, following the financial crisis of 1837, agencies were established in the United States to rate the ability of merchants to pay their debts, which they published in ratings guides.[8] These mercantile rating agencies are now seen as the precursors of the credit rating agencies.[7]

Credit rating agencies originated in the U.S. in the early 1900s, when ratings began to be applied to securities, specifically those related to the railroad bond market.[8] In the U.S., 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 trusted to honor their debts.[9] 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.[10] Following the 1907 financial crisis demand rose for such independent market information, in particular for independent analyses of bond creditworthiness.[11] In 1909, financial analyst John Moody issued a publication focused solely on railroad bonds.[12][13][11] His ratings became the first to be published widely, in an accessible format[14][11][9] and his company was the first to charge subscription fees to investors.[13]

Establishment of "The Big Three"

In 1913, the ratings publication by Moody's underwent two significant changes: it expanded its focus to include industrial firms and utilities, and 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.[15] 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,[11] and the Fitch Publishing Company in 1924.[12]

Growth of bond market

The relationship between the U.S. bond market and rating agencies developed further in the 1930s. 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).[9] In 1936, regulation was introduced to prohibit banks from investing in bonds determined by "recognized rating manuals" to be "speculative investment securities" ("junk bonds", in modern terminology). Banks were permitted only to hold "investment grade" bonds, following the judgment of Fitch, Moody's, Poor's and Standard. State insurance regulators approved similar requirements in the following decades.[12]

In the late 1960s and 1970s, ratings were extended to commercial paper and bank deposits, and the major agencies began to charge bond issuers as well as investors.[11] Reasons for this change included a growing free rider problem related to the increasing availability of inexpensive photocopy machines,[16] and the increased complexity of the financial markets.[17] As bond issuers replaced bond buyers as the agencies' source of revenue, rating agencies became "potentially beholden to the same people whose bonds they were rating",[18] possibly opening themselves to undue influence or the vulnerability of being misled.[19]

Rating agencies also grew in size as the number of issuers accessing the debt markets grew exponentially, both in the United States and abroad, making the credit rating business significantly more profitable.[20]

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.[11] In 1975, the SEC changed its minimum capital requirements for broker-dealers, using bond ratings as a measurement. Ten credit rating agencies (later six, due to consolidation) were identified by the SEC as "nationally recognized statistical ratings organizations" (NRSROs) for broker-dealers to use in meeting these requirements.[12][21] It was at this point that SEC rules began explicitly referencing credit ratings.[22]

During this period, the growth of the capital markets led more useful credit ratings globally; ratings were increasingly used in most developed countries' financial markets. In addition, there was an increase in the number of ratings agencies outside of the U.S. Along with the four largest U.S. raters, one other U.S., one British, two Canadian, and three Japanese firms are listed among the world's "most influential" rating agencies by the Financial Times in its publication Credit Ratings International.[8]

The ratings systems used by the agencies also underwent change during the period from the early 1970s to early 1980s. In 1973, Fitch began to use plus and minus symbols added to its existing letter-rating system, creating more levels of gradation to allow greater detail in distinguishing between issuers. The following year, Standard and Poor's added plus and minus symbols to their ratings, and Moody's began using them in 1982.[8]

Pre-Financial crisis

The 1980s and beyond were a time of significant expansion for the global capital market[11] and the number of bonds rated by the Big Three agencies grew substantially as well.[13] Ratings agencies also began to apply their ratings to counterparty risks, performance risk of mortgage servicers and price volatility of mutual funds and mortgage-back securities.[8] Following this expansion, in the 2000s, the credit agencies experienced increased profits.[23]

After 2000

Some journalists noted that rating agencies often did not downgrade ratings until just before or after bankruptcy.[24] For example, in the 2001 Enron accounting scandal, the company's ratings remained at investment grade until four days before bankruptcy, though it had been distressed for several months.[25] [26] Despite troubles in the mortgage industry, Freddie Mac's preferred stock was awarded the top rating by Moody's until mid-2008 when Warren Buffett told CNBC he had "passed on an opportunity to help the troubled mortgage giant". The next day Moody's downgraded Freddie to one tick above junk bonds.[27]

In the structured finance boom of the mid-2000, high ratings of securities became more important, because larger group of investors — money market funds and pension funds — were forbidden by their bylaws to buy securities not rated as triple-A.[28] 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.[29] Subpoena emails later revealed issuers openly threatened to take their business to another rating agency if the agency's ratings were not high enough.[30]

Financial crisis of 2007-2010

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There is broad consensus among experts that rating agencies played a substantial role in the financial crisis of 2007-2010.[31] After the financial crisis of 2007–2010, the Financial Crisis Inquiry Report[32] called the "failures" of the Big Three rating agencies "essential cogs in the wheel of financial destruction."[33] 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.[31]

Rating agencies enabled the financial crisis by providing triple-A ratings on risky mortgage-related securities that allowed them to be easily marketed and sold. The report notes that Moody's rated 45,000 mortgage-related securities as triple-A and 83 percent of them were downgraded within one year. It concludes that the crisis would have been avoided without the actions of rating agencies.[34][35]

Recent history

As of 2011, more than half of the CDOs originally rated triple-A were "impaired"—either having lost principal or been downgraded to "junk" status.[36][37][38][39][40] One study of "6,500 structured debt ratings" produced by Standard & Poor’s, Moody's and Fitch, found ratings by agencies "biased in favour of issuer clients that provide the agencies with more rating business."[41]

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.[42]

In August 2011, S&P's 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]

Ratings

See also: Credit ratings and Bond credit rating

Ratings — in the case of Moody's (the oldest rating agency) — are based on models and the judgement of the rating committee. For example, in the case of ratings of mortgage-backed securities, Moody's models "incorporated firm- and security-specific factors, market factors, regulatory and legal factors, and macroeconomic trends."[43]

Higher grades are intended to represent a lower probability of default. One study by a rating service (Moody's)[44][45] claimed that over a "5-year time horizon" bonds it gave its highest rating (Aaa) to had a "cumulative default rate" of just 0.18%, the next highest (Aa2) 0.28%, the next (Baa2) 2.11%, 8.82% for the next (Ba2), and 31.24% for the lowest it studied (B2). Over a longer time horizon it stated "the order is by and large, but not exactly, preserved".[46]

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 solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities[43]

Impact of ratings

Some empirical studies have documented that rather than a downgrade by a CRA lowering the value and raising the interest rates of corporate bonds, cause and effect is reversed. Yield spreads of corporate bonds start to expand as credit quality deteriorates, preceding a rating downgrade and casting doubt on the informational value of credit ratings.[47] This has led to suggestions that financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spreads, not CRA ratings, when calculating the risk in their portfolio.

Integrity and accuracy of ratings

According to The Washington Post, "many people inside and outside the industry" accuse Credit Rating Agencies of blackmailing companies into buying their services. For example, in one case Hannover Re was getting positive ratings from the rating agencies it was paying fees to, while Moody's, who was soliciting them for business unsuccessfully, was continually downgraded, resulting in a loss of $175 million in market capitalization.[48]

Journalist Michael Lewis argues that the low pay of credit rating agency employees allowed security issuers to game the ratings of their securities. 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."[49] At least one other investment firm that bet against the agencies' credit ratings believed “there was a massive amount of gaming going on.”[50]

When asked by the Financial Crisis Inquiry Commission about "the high turnover" at rating agencies the "revolving door that often left raters dealing with their old colleagues, this time as clients", Moody's president Brian Clarkson noted that investment banks paid more than his agency so retaining employees was always a challenge. Moody’s employees were prohibited from rating deals by a bank or issuer while they were interviewing for a job with that particular institution, but notifying management of any such interview was the responsibility of the employee. After getting a job at an investment bank former employees were barred from interacting with Moody’s on "the same series of deals they had rated while in its employ", but not on any other deals with Moody’s.[51]

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."[52]

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.

US courts have ruled that ratings are opinions protected by the First Amendment and rating agencies are not liable for misstatements.

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.[53]

As part of the 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[56] 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.

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.[57] According to the most recent U.S. Securities and Exchange Commission (SEC) report, the agencies together account for approximately 96% of all credit ratings.[58] As of December 2012, S&P is the largest of the three, with 1.2 million outstanding ratings and 1,416 analysts and supervisors.[58][59] Moody's is the second largest agency, with 1 million outstanding ratings and 1,252 analysts and supervisors.[58][59] 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.[58][60] 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.[57]

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.[61] 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.[61] 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).[62][63] While these other agencies remain niche players,[64] some have gained market share following the 2008 financial crisis,[65] and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group.[66]

The European Union has considered setting up a state-supported EU-based agency.[67]

Role in capital markets

Credit rating agencies assess the relative credit risk of borrowing entities (issuers of debt), specific debt securities or structured finance instruments.[68] By serving as information intermediaries, credit rating agencies theoretically reduce information costs, increase the pool of potential borrowers and promote liquid markets.[69][70][71] These functions may increase the supply of available risk capital in the market and promote economic growth.[68][71] Some rating agencies rate the creditworthiness of governments and their securities.[72][73]

By bond issuers

Because many investors won't buy an unrated bonds[18] a significant bond issuance almost always has at least one rating from a respected CRA — generally two[74] — 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[75] — and structured finance became a key part of rating agencies business leading up to the 2006-2008 "subprime crisis" and "Great Recession". In the words of 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.[76]

Between 2002 and 2007, the agencies gave top ratings on debt pools that "included $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes", many of which defaulted.[77] In the case of one of the Big Three — Moody's — structured finance went from 28% of that company's revenue in 1998 to almost 50% in 2007, and "accounted for pretty much all of Moody's growth."[78][79]

Securities

Ratings are vital to "private-label" asset-backed securities (ABS) — such as subprime mortgage-backed securities (MBS), and collateralized debt obligations (CDO), "CDOs squared", and "synthetic CDOs" — whose "financial engineering" make them "harder to understand and to price than individual loans".[80]

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.[81] 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.[82] 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.[83]

This complexity, and the position of the Big Three credit rating agencies "between the issuers and the investors of securities", is what "transformed" the agencies into "key" players in the process, according to the Financial Crisis Inquiry Report.[80] "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." [84]

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,”[84]

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.[85]

CDOs

Rating agencies were even more important in disposing of the MBS tranches that could not be rated triple-A. Although these were a minority of MBS tranches, unless buyers were found for these lower-rated slices the rest of the pool could not be sold. And because traditional mortgage investors were risk adverse (often because of SEC regulations or restrictions in their charters), these tranches were the most difficult to sell.[86][87]

To sell these "mezzanine" tranches, investment bankers pooled them to form another security—the collateralized debt obligation (CDO). Despite the fact that its raw material was made up of BBB, A-, etc. tranches, 70%[88] to 80%[89] of the new CDO tranches were rated triple A by the rating agencies. The 20-30% remaining BBB, A, A-, etc. tranches were sometimes bought up by other CDOs, to make "CDO squared" which also produced tranches rated mostly triple A by rating agencies.[90] This was characterized as a way of transforming "dross into gold." [91] or "ratings laundering"[92] by at least some business journalists.

Rating agencies not only evaluated CDOs, they helped issuers design the tranches to "squeeze the most profit out of the CDO by maximizing the size of the tranches with the highest ratings" according to Charles Calomiris[93]

[94]

Trust in rating agencies was particularly important for CDOs, as the contents of the CDO were subject to change, so CDO managers "didn't always have to disclose what the securities contained". This lack of transparency did not affect demand for the securities. Investors "weren't so much buying a security. They were buying a triple-A rating," according to business journalists Bethany McLean and Joe Nocera.[95]

Still another structured product was the "synthetic CDO". These CDOs were cheaper and easier to create than original "cash" CDOs. Rather than providing funding for housing, synthetic CDO-buying investors were in effect providing insurance (in the form of "credit default swaps") against mortgage default. Synthetics "referenced" cash CDOs, and instead of providing investors with interest and principal payments from MBS tranches, they paid insurance premium-like payments from credit default swap "insurance". If the referenced CDOs defaulted, investors lost their investment, which was paid out as insurance.[96] Because synthetics "referenced" another (cash) CDO, more than one — in fact numerous — synthetics could be made to reference the same original, multiplying the effect if a referenced security defaulted.[97][98]

Here again CRA ratings of triple A to "large chunks"[99] of synthetics were crucial to the securities success, because the buyer of synthetics (who often went on to lose their investment) was seldom an analyst "who had investigated the mortgage-backed security", was aware of deteriorating mortgage underwriting standards, or the fact that the payments they would receive were often coming from investors betting against mortgage-backed security solvency. Rather, "it was someone who was buying a rating and thought he couldn't lose money."[100]

Financial crisis

In the wake of securities defaults, many lawsuits have been filed against rating agencies. Plaintiffs have included by CDO investors (the state of Ohio for losses of $457 million),[101][102] the bankrupt investment bank Bear Stearns (for losses of $1.12 billion from alleged "fraudulently issuing inflated ratings for securities"[103]), bond insurers,[104] and the US government (S&P for $5 billion for "misrepresenting the credit risk of complex financial products").[105][41][106] On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ratings practices," including conflicts of interest.[107][108]

Rating agencies have argued that they were not alone in failing to predict massive mortgage defaults -- "none of the primary market participants predicted the collapse"[106] and that they are not liable for investor losses. 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".[109]

Use by government regulators

Further information: Basel III

Regulatory authorities and legislative bodies in the United States and other jurisdictions rely on credit rating agencies' assessments of a broad range of debt issuers, and thereby attach a regulatory function to their ratings.[110][111] This regulatory role is a derivative function in that the agencies do not publish ratings for that purpose.[110] Governing bodies at both the national and international level have woven credit ratings into minimum capital requirements for banks, allowable investment alternatives for many institutional investors, and similar restrictive regulations for insurance companies and other financial market participants.[112][113]

The use of credit ratings by regulatory agencies is not a new phenomenon.[110] In the 1930s, regulators in the United States used credit rating agency ratings to prohibit banks from investing in bonds that were deemed to be below investment grade.[114] In the following decades, state regulators outlined a similar role for agency ratings in restricting insurance company investments.[110][114] From 1975 to 2006, the U.S. Securities and Exchange Commission (SEC) recognized the largest and most credible agencies as Nationally Recognized Statistical Rating Organizations, and relied on such agencies exclusively for distinguishing between grades of creditworthiness in various regulations under federal securities laws.[110][115] The Credit Rating Agency Reform Act of 2006 created a voluntary registration system for CRAs that met a certain minimum criteria, and provided the SEC with broader oversight authority.[116]

The practice of using credit rating agency ratings for regulatory purposes has since expanded globally.[110] Today, financial market regulations in many countries contain extensive references to ratings.[110][117] The Basel III accord, a global bank capital standardization effort, relies on credit ratings to calculate minimum capital standards and minimum liquidity ratios.[110]

The extensive use of credit ratings for regulatory purposes can have a number of unintended effects.[110] Because regulated market participants must follow minimum investment grade provisions, ratings changes across the investment/non-investment grade boundary may lead to strong market price fluctuations and potentially cause systemic reactions.[110] The regulatory function granted to credit rating agencies may also adversely affect their original market information function of providing credit opinions.[110][118]

Against this background and in the wake of criticism of credit rating agencies following the subprime mortgage crisis, legislators in the United States and other jurisdictions have commenced to reduce rating reliance in laws and regulations.[114][119] The 2010 Dodd–Frank Act removes statutory references to credit rating agencies, and calls for federal regulators to review and modify existing regulations to avoid relying on credit ratings as the sole assessment of creditworthiness.[120][121][122]


Business models

Credit rating agencies generate revenue from a variety of activities related to the production and distribution of credit ratings.[123] 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.[72] However, agencies may offer additional services using a combination of business models.[123][124]

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.[72][125] This revenue provides the main source of agency income, although agencies may also provide other types of services.[72][126] Under the issuer-pays model, agencies charge issuers a fee for providing credit rating assessments.[72] This revenue stream allows issuer-pays credit rating agencies to make their ratings freely available to the broader market, especially via the Internet.[127][128]

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.[72][125] 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.[129] Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer-pays model, only Egan-Jones maintains an investor subscription service.[127] 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.[130][131]

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.[132] However, the subscription model is also seen to have disadvantages, as it restricts the ratings' availability to paying investors.[127][128] 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.[133] 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.[134]

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.[135] 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.[133][136] 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.[137][138]

Oligopoly produced by regulation

Agencies are sometimes accused of being oligopolists,[139] 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.[140]

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.[141] Celebrated investor Warren Buffet described the company as “a natural duopoly,” with “incredible” pricing power, when asked by the Financial Crisis Inquiry Commission about his ownership of 15% of the company.[142][143]

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.[31]

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."[31]

To solve this problem, Ms. Casey (and other such as NYU professor Lawrence White[144]) have proposed removing the NRSRO rules completely.[31] Professor Frank Partnoy suggests that the regulators use the results of the credit risk swap markets rather than the ratings of NRSROs.[31]

The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.[144]

See also

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 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.
  • 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

  • Securities Exchange Commission Office of Credit Ratings
  • SIFMA
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