Credit rating agency

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This editable Main Article is under development and subject to a disclaimer.

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A credit rating agency provides independent assessments, in the form of credit ratings, of the probability of default of companies, governments and the providers of a wide range of financial instruments. Credit ratings have a major impact on the availability and cost of credit for borrowers. Following the discovery of shortcomings in 2008, revisions to the methods of regulating the agencies are under consideration.

"There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful"
(Thomas L. Friedman, in an interview with Jim Lehrer on Newshour, PBS television, Feb. 13, 1996).

## Contents

* 1 Introduction: credit ratings and rating agencies
* 2 The rôle of the agencies
* 3 Rating performance
* 4 Systemic influence
* 5 Legal liability
* 6 Regulation of the agencies
* 7 Notes and references

## Introduction: credit ratings and rating agencies[edit]

The term "credit" is used in this context in its sense of trustworthiness, and refers to the extent to which its subject can be trusted to be willing and able to comply with the terms of a financial contract. Assessments of individual creditworthiness (usually stated as "credit scores") are not undertaken by organisations known as credit rating agencies, and are not further referred to in this article.

Credit rating agencies assess the creditworthiness of the issuers of debt instruments, including bonds issued by corporations and governments and mortgages and their derivatives, and they express their findings as alphabetically-coded "rating" categories such as AAA, AA, and BB. Credit ratings have been presented by the issuing agencies as statements of opinion, implying the absence of any legally-enforceable commitment to their reliability.

The major credit rating agencies are located in the United States and are regulated by the United States Securities and Exchange Commission They undertake "solicited ratings" for a fee at the request of the issuers of debt instruments, basing their assessments upon data supplied to them by the issuers. They also undertake unsolicited assessments at their own expense, using published data. Their credit ratings are freely available to investors.

## The rôle of the agencies[edit]

As the light-hearted opening quotation implies, the credit rating agencies exert a powerful influence upon the financial system. Views differ concerning the source of that power, however. According to a spokesman of the United States Department of the Treasury it arises from the fact that rating agencies solve a basic market failure by providing information about the borrower that a lender would otherwise be unable to obtain. Especially in the capital markets, where a lender is likely purchasing just a small portion of the borrower’s debt in the form of a bond or asset-backed security – it can be inefficient, difficult and costly for a lender to get all the information they need to evaluate the credit worthiness of the borrower. In the absence of credit ratings, lenders would not lend as much as they could, and borrowers would have to offer higher rates to offset uncertainty. [1]. But, according to an eminent Professor of Law, they do not so much provide the market with information, so much as reflect the information that it already has; and they are not widely respected among sophisticated market participants. Several studies have indicated that the market anticipates ratings changes [2][3]. (The fact that ratings are correlated with actual default experience – does not alter that conclusion because ratings can be both correlated with default and have little informational value ) [4]. Professor Partnoy believes that their influence stems almost entirely from their rõle in the regulatory system. Since 1973 credit ratings have been incorporated into hundreds of regulatory decisions, including decisions affecting securities, pensions, banking, real estate, and insurance. Some businesses are not permitted to hold assets rated below stipulated grade, and others are required to maintain reserve ratios that depend upon the ratings of their assets. Large numbers of businesses are consequently dependent upon recognised credit ratings to enable them to raise money on terms that they can afford [5]. There is evidence that all types of rating announcements – outlooks, reviews and rating changes, whether positive or negative – have a significant impact on the risk premiums that are embodied in the interest rates on bonds (as reflected in the prices of credit default swaps) [6].

## Rating performance[edit]

The rating agencies claim that their ratings have performed well on the whole, but a survey of their performance over the period 1979-99 found that they had systematically failed to anticipate currency crises and that nearly half of all defaults were linked with a currency crisis. [7], and a 2001 survey of 100 bond managers found that only 29% of them believed that the agencies updated their ratings in a timely manner, [8] . Since then there have been several dramatic defaults of rated corporations.

A report to a Senate Committee on the 2001 collapse of the Enron Corporation commented that

"The credit rating agencies... failed to warn the public of Enron’s precarious situation until a mere four days before Enron declared bankruptcy. Until that time, the rating agencies gave Enron an "investment grade" rating, which indicated that Enron was creditworthy and its bonds were a safe investment .. because they did not exercise the proper diligence [and]...did not sufficiently consider factors affecting the long-term health of the company" [9].

\- and other failures that have been reported, include the failure to anticipate the 2002 collapse of WorldCom [10].

[11]

During 2007 and 2008 the Standard and Poor agency downgraded more than two-thirds of its investment-grade ratings, and the Moodys agency downgraded over 5,000 mortgage-backed securities, precipitating the subprime mortgage crisis and contributing to the crash of 2008. Those failures were referred to by the chairman of a Congressional Committee as a "story of colossal failure" [12], and the President of Standard and Poor acknowledged that "the historical data we used and the assumptions we made significantly underestimated the severity of what has actually occurred"[13]. A former Director of Moodys has attributed their misconduct to a drive to retain market share in face of attempts by the major banks to play each agency off against the others - a tactic knows as "ratings shopping"[14]. (The originate and distribute policy that had been adopted by the banks would have given them a strong incentive to get good ratings for their CDOs that they were attempting to sell.) And Standard and Poor's technical shortcomings were attributed by a former senior executive to its use of outdated models [15]. Errors have also been attributed to their acknowledged failure to verify the data provided to them by their clients [16].

a further analysis of the rating agencies' credit rating errors is available on the addendum subpage

## Systemic influence[edit]

Some observers consider it likely that the credit rating agencies contribute to the instability of the international financial system by increasing systemic risk. Amadou Sy, the Deputy Division Chief at the International Monetary Fund Institute has commented that

Credit ratings increase systemic risk and may be procyclical, helping fuel investments in 'good times' and accelerating market losses in 'bad times'. CRAs can increase systemic risk through unanticipated and abrupt downgrades. They may also increase procyclicality. Such rating crises can lead to large market losses, fire sales and a dry-up of liquidity, and have knock-on effects on a number of systemically important market participants, either through contractual arrangements or investment practice.[17].

## Legal liability[edit]

Until November 2012, the ratings agencies had escaped legal liability for their errors in actions for negligence on the grounds that their ratings are expressions of opinion that are protected by constitutional safeguards on free speech, and that it would be imprudent for an investor to rely solely upon them. That argument was rejected by the Federal Court of Australia in their ruling of 5th November 2012 against Standard & Poor's [18]. There is to be an appeal.

## Regulation of the agencies[edit]

A 2008 report by the staff of the United States Securities and Exchange Commission identified a number of shortcomings in the procedures used by the three largest agencies[19] and contained a list of recommended remedial measures. The features of the present situation that are under review include:

* the embodiment of credit rating requirements in legislation;
* the rating agencies' immunity from legal action for negligence;
* the absence of a duty to exert "due diligence" in verifying data supplied by applicants for rating;
* the conflict of interest arising from the fact that ratings are paid for by the rated businesses.
* the practice of "ratings shopping";
* limitations upon the powers of the Securities and Exchange Commission (including provisions that bar the Securities and Exchange Commission from concerning itself with the methodology and substance of ratings);
* the conditions required by that Commission for their designation of agencies as "Nationally Recognized Statistical Rating Organizations" (NRSROs)[20], including:-
* the lack of transparency of the data and methods of analysis used by the agencies; and,
* the regulatory barriers to entry that are believed to be responsible for the dominance of Standard and Poor and Moodys.

Amadou Sy has commented that the proposals are of an exclusively microprudential nature, and that they overlook the broader issue of systemic financial stability[17].

## Notes and references[edit]

1. ↑ Michael S. Barr, Assistant Secretary-Designate for Financial Institutions, U.S. Department of the Treasury; Testimony before Hearing of the U.S. Senate Committee on Banking, Housing, and Urban Affairs: Examining Proposals to Enhance the Regulation of Credit Rating Agencies, Wednesday, August 5, 2009
2. ↑ eg; L. Macdonald Wakeman: The Real Function of Bond Rating Agencies, Modern Theory of Corporate Finance, 391 1984]
3. ↑ Jonathan R. Macey, testimony before the House Committee on Financial Services on The Credit Rating Agency Duopoly Relief Act of 2005, November 29, 2005
4. ↑ Frank Partnoy: How and Why Credit Rating Agencies are Not Like Other Gatekeepers, San Diego Legal Studies Paper No. 07-46, University of San Diego School of Law, 2006
5. ↑ Lawrence J. White: Testimony to the U.S. Senate Committee on Banking, Housing, and Urban Affairs hearing: Examining Proposals to Enhance the Regulation of Credit Rating Agencies, Wednesday, August 5, 2009
6. ↑ Fabian Dittrich: The Credit Rating Industry: Competition and Regulation", Inaugural dissertation zur Erlangung des Doktorgrades der Wirtschafts- und Sozialwissenschaftlichen Fakultät der Universität zu Köln 2007
7. ↑ Carmen M. ReinhartDefault, Currency Crises and Sovereign Credit Ratings, NBER Working Paper No. W8738, January 2002
8. ↑ Sattar A. Mansi and Sattar A. Mansi: Assessing Credit Rating Agencies by Bond Issuers and Institutional Investors, Table 9, June 18, 2001
9. ↑ Financial Oversight of Enron: The SEC and Private-Sector Watchdogs, Report of the Staff to the Senate Committee on Governmental Affairs October 8, 2002
10. ↑ Claire A. Hill: Regulating the Rating Agencies, Washington University Law Quarterly, Vol. 82, p. 43, 2004
11. ↑ Ashok Vir Bhatia: Sovereign Credit Ratings Methodology: An Evaluation, Working Paper WP/02/170, International Monetary Fund, October 2002
12. ↑ Opening Statement of Rep. Henry A. Waxman to the Committee On Oversight and Government Reform's Hearing on the Credit Rating Agencies and the Financial Crisis, October 22, 2008
13. ↑ Deven Sharma: testimony before the United States House Of Representatives Committee On Oversight And Government Reform, October 22, 2008
14. ↑ Jerome S. Fons: testimony before the United States House of Representatives Committee on Oversight and Government Reform, October 22, 2008
15. ↑ Frank L. Raiter testimony before the United States House of Representatives Committee on Oversight and Government Reform, October 22, 2008
16. ↑ Testimony of Professor John H Coffee, given before the United States Senate Committee on Banking, Housing and Urban Affairs hearing on Examining Proposals to Enhance the Regulation of Credit Rating Agencies, Wednesday, August 5, 2009]
17. ↑ 17.0 17.1 Amadou N R Sy: The Systemic Regulation of Credit Rating Agencies and Rated Markets, World Economics, October-December 2009
18. ↑ Crisis in ratings land?, The Economist, 10 November 2012
19. ↑ Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, United States Security and Exchange Commission, July 2008[1]
20. ↑ Amendments to the Rules Relating to the Oversight of Nationally Recognized Statistical Rating Organizations, Securities and Exchange Commission, November 2009