The following are known as the big three credit rating agencies
A credit rating agency CRA , also called a ratings service is a company that assigns credit ratings , which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, [1] and in some cases, of the servicers of the underlying debt, [2] but not of individual consumers. The debt instruments rated by CRAs include government bonds , corporate bonds , CDs , municipal bonds , preferred stock , and collateralized securities, such as mortgage-backed securities and collateralized debt obligations. The issuers of the obligations or securities may be companies, special purpose entities , state or local governments, non-profit organizations , or sovereign nations. It affects the interest rate that a security pays out, with higher ratings leading to lower interest rates.
Credit rating agency sector needs more competition, experts say
A credit rating agency CRA , also called a ratings service is a company that assigns credit ratings , which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, [1] and in some cases, of the servicers of the underlying debt, [2] but not of individual consumers.
The debt instruments rated by CRAs include government bonds , corporate bonds , CDs , municipal bonds , preferred stock , and collateralized securities, such as mortgage-backed securities and collateralized debt obligations.
The issuers of the obligations or securities may be companies, special purpose entities , state or local governments, non-profit organizations , or sovereign nations. It affects the interest rate that a security pays out, with higher ratings leading to lower interest rates.
Individual consumers are rated for creditworthiness not by credit rating agencies but by credit bureaus also called consumer reporting agencies or credit reference agencies , which issue credit scores.
The value of credit ratings for securities has been widely questioned. Hundreds of billions of securities that were given the agencies' highest ratings were downgraded to junk during the financial crisis of — When the United States began to expand to the west and other parts of the country, so did the distance of businesses to their customers.
When businesses were close to those who purchased goods or services from them, it was easy for the merchants to extend credit to them, due to their proximity and the fact that merchants knew their customers personally and knew whether or not they would be able to pay them back.
As trading distances increased, merchants no longer personally knew their customers and became leery of extending credit to people who they did not know in fear of them not being able to pay them back. Business owners' hesitation to extend credit to new customers led to the birth of the credit reporting industry.
Mercantile credit agencies—the precursors of today's rating agencies—were established in the wake of the financial crisis of These agencies rated the ability of merchants to pay their debts and consolidated these ratings in published guides. Another early agency, John Bradstreet, formed in and published a ratings guide in Credit rating agencies originated in the United States in the early s, when ratings began to be applied to securities, specifically those related to the railroad bond market.
The bond markets in the Netherlands and Britain had been established longer but tended to be small, and revolved around sovereign governments that were trusted to honor their debts. In , the ratings publication by Moody's underwent two significant changes: it expanded its focus to include industrial firms and utilities, and it began to use a letter-rating system. For the first time, public securities were rated using a system borrowed from the mercantile credit rating agencies, using letters to indicate their creditworthiness.
In the United States, the rating industry grew and consolidated rapidly following the passage of the Glass-Steagall act of and the separation of the securities business from banking. US banks were permitted to hold only "investment grade" bonds, and it was the ratings of Fitch, Moody's, Poor's, and Standard that legally determined which bonds were which. State insurance regulators approved similar requirements in the following decades.
From to , the bonds and ratings of them were primarily relegated to American municipalities and American blue chip industrial firms. In the late s and s, ratings were extended to commercial paper and bank deposits. Also during that time, major agencies changed their business model by beginning to charge bond issuers as well as investors.
The rating agencies added levels of gradation to their rating systems. In , Fitch added plus and minus symbols to its existing letter-rating system. The following year, Standard and Poor's did the same, and Moody's began using numbers for the same purpose in The end of the Bretton Woods system in led to the liberalization of financial regulations and the global expansion of capital markets in the s and s. Rating agencies also grew in size and profitability as the number of issuers accessing the debt markets grew exponentially, both in the United States and abroad.
Two economic trends of the s and 90s that brought significant expansion for the global capital market were [12]. More debt securities meant more business for the Big Three agencies, which many investors depended on to judge the securities of the capital market. A market for low-rated, high-yield "junk" bonds blossomed in the late s, expanding securities financing to firms other than a few large, established blue chip corporations.
Along with the largest US raters, one British, two Canadian and three Japanese firms were listed among the world's "most influential" rating agencies in the early s by the Financial Times publication Credit Ratings International. Structured finance was another growth area of growth. The "financial engineering" of the new "private-label" asset-backed securities —such as subprime mortgage-backed securities MBS , collateralized debt obligations CDO , " CDO-Squared ", and " synthetic CDOs "—made them "harder to understand and to price" and became a profit center for rating agencies.
As the influence and profitability of CRAs expanded, so did scrutiny and concern about their performance and alleged illegal practices. It published the "Recommendations of the Securities Industry and Financial Markets Association Credit Rating Agency Task Force," which included a dozen recommendations to change the credit rating agency process. Downgrades of European and US sovereign debt were also criticized.
Credit rating agencies assess the relative credit risk of specific debt securities or structured finance instruments and borrowing entities issuers of debt , [51] and in some cases the creditworthiness of governments and their securities. Credit rating agencies provide assessments about the creditworthiness of bonds issued by corporations , governments , and packagers of asset-backed securities. CRAs theoretically provide investors with an independent evaluation and assessment of debt securities ' creditworthiness.
In addition, rating agencies have been liable—at least in US courts—for any losses incurred by the inaccuracy of their ratings only if it is proven that they knew the ratings were false or exhibited "reckless disregard for the truth". The ratings Under an amendment to the Dodd-Frank Act , this protection has been removed, but how the law will be implemented remains to be determined by rules made by the SEC and decisions by courts. To determine a bond's rating , a credit rating agency analyzes the accounts of the issuer and the legal agreements attached to the bond [72] [73] to produce what is effectively a forecast of the bond's chance of default , expected loss, or a similar metric.
The relative risks—the rating grades—are usually expressed through some variation of an alphabetical combination of lower- and uppercase letters, with either plus or minus signs or numbers added to further fine-tune the rating.
Agencies do not attach a hard number of probability of default to each grade, preferring descriptive definitions, such as "the obligor's capacity to meet its financial commitment on the obligation is extremely strong," from a Standard and Poor's definition of a AAA-rated bond or "less vulnerable to non-payment than other speculative issues" for a BB-rated bond.
One study by Moody's [83] [84] claimed that over a "5-year time horizon", bonds that were given its highest rating Aaa had a "cumulative default rate" of just 0.
See "Default rate" in "Estimated spreads and default rates by rating grade" table to right. Over a longer time horizon, it stated, "the order is by and large, but not exactly, preserved". Another study in the Journal of Finance calculated the additional interest rate or "spread" that corporate bonds pay over that of "riskless" US Treasury bonds, according to the bonds rating. See "Basis point spread" in the table to right. The market also follows the benefits from ratings that result from government regulations see below , which often prohibit financial institutions from purchasing securities rated below a certain level.
For example, in the United States, in accordance with two regulations, pension funds are prohibited from investing in asset-backed securities rated below A, [87] and savings and loan associations from investing in securities rated below BBB.
CRAs provide "surveillance" ongoing review of securities after their initial rating and may change a security's rating if they feel its creditworthiness has changed. CRAs typically signal in advance their intention to consider rating changes. Negative "watch" notifications are used to indicate that a downgrade is likely within the next 90 days. Critics maintain that this rating, outlooking, and watching of securities has not worked nearly as smoothly as agencies suggest.
They point to near-defaults, defaults, and financial disasters not detected by the rating agencies' post-issuance surveillance, or ratings of troubled debt securities not downgraded until just before or even after bankruptcy. In the Enron accounting scandal , the company's ratings remained at investment grade until four days before bankruptcy—though Enron's stock had been in sharp decline for several months [95] [96] —when "the outlines of its fraudulent practices" were first revealed.
Despite over a year of rising mortgage deliquencies, [] Moody's continued to rate Freddie Mac 's preferred stock triple-A until mid, when it was downgraded to one tick above the junk bond level. Expanding yield spreads i. In February , an investigation by the Australian Securities and Investments Commission found a serious lack of detail and rigour in many of the ratings issued by agencies.
It said agencies had often paid lip service to compliance. In one case, an agency had issued an annual compliance report only a single page in length, with scant discussion of methodology. In another case, a chief executive officer of a company had signed off on a report as though a board member.
Also, overseas staff of ratings agencies had assigned credit ratings despite lacking the necessary accreditation. Defenders of credit rating agencies complain of the market's lack of appreciation. Argues Robert Clow, "When a company or sovereign nation pays its debt on time, the market barely takes momentary notice A number of explanations of the rating agencies' inaccurate ratings and forecasts have been offered, especially in the wake of the subprime crisis: [92] [94]. Conversely, the complaint has been made that agencies have too much power over issuers and that downgrades can even force troubled companies into bankruptcy.
The lowering of a credit score by a CRA can create a vicious cycle and a self-fulfilling prophecy : not only do interest rates on securities rise, but other contracts with financial institutions may also be affected adversely, causing an increase in financing costs and an ensuing decrease in creditworthiness.
Large loans to companies often contain a clause that makes the loan due in full if the company's credit rating is lowered beyond a certain point usually from investment grade to "speculative". The purpose of these "ratings triggers" is to ensure that the loan-making 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; if the company is incapable of paying all of these loans in full at once, it is forced into bankruptcy a so-called death spiral. These ratings triggers were instrumental in the collapse of Enron.
Since that time, major agencies have put extra effort into detecting them and discouraging their use, and the US SEC requires that public companies in the United States disclose their existence. The Dodd—Frank Wall Street Reform and Consumer Protection Act [] mandated improvements to the regulation of credit rating agencies and addressed several issues relating to the accuracy of credit ratings specifically. In the European Union , there is no specific legislation governing contracts between issuers and credit rating agencies.
Credit ratings for structured finance instruments may be distinguished from ratings for other debt securities in several important ways. Aside from investors mentioned above—who are subject to ratings-based constraints in buying securities—some investors simply prefer that a structured finance product be rated by a credit rating agency.
The Financial Crisis Inquiry Commission [] has described the Big Three rating agencies as "key players in the process" of mortgage securitization , [31] providing reassurance of the soundness of the securities to money manager investors with "no history in the mortgage business". Credit rating agencies began issuing ratings for mortgage-backed securities MBS in the mids. In subsequent years, the ratings were applied to securities backed by other types of assets.
From to , Moody's rated nearly 45, mortgage-related securities as triple-A. In contrast only six private sector companies in the United States were given that top rating. Rating agencies were even more important in rating collateralized debt obligations CDOs.
Still another innovative structured product most of whose tranches were also given high ratings was the " synthetic CDO ". Cheaper and easier to create than ordinary "cash" CDOs, they paid insurance premium-like payments from credit default swap "insurance", instead of interest and principal payments from house mortgages. If the insured or "referenced" CDOs defaulted, investors lost their investment, which was paid out much like an insurance claim. However when it was discovered that the mortgages had been sold to buyers who could not pay them, massive numbers of securities were downgraded, the securitization "seized up" and the Great Recession ensued.
Critics blamed this underestimation of the risk of the securities on the conflict between two interests the CRAs have—rating securities accurately, and serving their customers, the security issuers [] who need high ratings to sell to investors subject to ratings-based constraints, such as pension funds and life insurance companies. A small number of arrangers of structured finance products—primarily investment banks —drive a large amount of business to the ratings agencies, and thus have a much greater potential to exert undue influence on a rating agency than a single corporate debt issuer.
In the wake of the global financial crisis , various legal requirements were introduced to increase the transparency of structured finance ratings.
The European Union now requires credit rating agencies to use an additional symbol with ratings for structured finance instruments in order to distinguish them from other rating categories.
Credit rating agencies also issue credit ratings for sovereign borrowers, including national governments, states, municipalities , and sovereign-supported international entities. Sovereign credit ratings represent an assessment by a rating agency of a sovereign's ability and willingness to repay its debt. National governments may solicit credit ratings to generate investor interest and improve access to the international capital markets.
The Big Three Agencies Fitch is one of the world's top three credit rating agencies. Expanding this idea led to the creation of Moody's Investors Service, which, in the following 10 years, would provide ratings for nearly all of Standard and Poor's has become best known by indexes such as the. The Big Three credit rating agencies are Standard & Poor's (S&P), Moody's, and Fitch Group. S&P and Moody's are based in the US, while Fitch is has.
Advertiser Disclosure: The credit card and banking offers that appear on this site are from credit card companies and banks from which MoneyCrashers. This compensation may impact how and where products appear on this site, including, for example, the order in which they appear on category pages. Advertiser partners include American Express, Chase, U. Bank, and Barclaycard, among others. Credit rating agencies have been around for the better part of the 20th century, and have played a key role in the financial world by providing ratings on the creditworthiness of bonds and other debt instruments.
NEW YORK, May 4 IFR - US regulators have largely failed to loosen the grip that the big three credit rating agencies have on the bond rating business, even after reforms put in place in the wake of the last financial crisis. Even before the crash, the Securities and Exchange Commission started expanding the list of officially approved rating agencies from the big three in to 10 at present.
Please click to read our informative text prepared pursuant to the Law on the Protection of Personal Data No. An oligopoly of three U.
History of Credit Rating Agencies and How They Work
According to an analysis by Deutsche Welle , "their special status has been cemented by law — at first only in the United States, but then in Europe as well. The European Union has considered setting up a state-supported EU-based agency. For full article, see Credit rating agencies and the subprime crisis. The Big Three have been "under intense scrutiny" since the — global financial crisis following their favorable pre-crisis ratings of insolvent financial institutions like Lehman Brothers , and risky mortgage-related securities that contributed to the collapse of the U. In the wake of the financial crisis, the Financial Crisis Inquiry Report [6] called the "failures" of the Big Three rating agencies "essential cogs in the wheel of financial destruction". The three credit rating agencies were key enablers of the financial meltdown.
Credit rating agencies: everything you need to know
Credit ratings provide retail and institutional investors with information that assists them in determining whether issuers of bonds and other debt instruments and fixed-income securities will be able to meet their obligations. When they issue letter grades, credit rating agencies CRAs provide objective analyses and independent assessments of companies and countries that issue such securities. Here is a basic history of how the ratings and the agencies developed in the U. Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take the overall economic conditions of a country into account, including the volume of foreign, public and private investment, capital market transparency , and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country. The sovereign rating is often the prerequisite information institutional investors use to determine if they will further consider specific companies, industries and classes of securities issued in a specific country. Credit ratings, debt ratings, or bond ratings are issued to individual companies and to specific classes of individual securities such as preferred stock , corporate bonds, and various classes of government bonds.
View more search results. Credit rating agencies have one of the most important roles in the financial markets.
In the last few years Credit Rating Agencies have come under a lot of criticism, especially because the credit risk of structured credit products has been underestimated or has been communicated too late by CRAs which led to issues at the macro-economic level like the case of Greece in as well as at the micro- economic level like the case of Enron from or the case of Lehman Brothers from has shown. CRAs are private, profit-oriented companies which evaluate credit risks of organizations like governments, financial or non financial institutions that issue debt in public markets.
