Understanding Credit Rating Agencies: A Comprehensive Guide

A rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts. The rating assigned to a given debt shows an agency’s level of confidence that the borrower will honor its debt obligations as agreed.

Each agency uses unique letter-based scores to indicate if a debt has a low or high default riskSystemic RiskSystemic risk can be defined as the risk associated with the collapse or failure of a company, industry, financial institution or an entire economy. It is the risk of a major failure of a financial system, whereby a crisis occurs when providers of capital lose trust in the users of capital and the financial stability of its issuer. The debt issuers may be sovereign nations, local and state governments, special purpose institutions, companies, or non-profit organizations.

Following the Global Financial Crisis of 2008, credit agencies drew criticisms for giving a high credit rating to debts that later turned out to be high-risk investments. They failed to identify risks that would have warned investors against investing in certain types of debts such as mortgage-backed securitiesMortgage-Backed Security (MBS)A Mortgage-backed Security (MBS) is a debt security that is collateralized by a mortgage or a collection of mortgages. An MBS is an asset-backed security that is traded on the secondary market, and that enables investors to profit from the mortgage business.

Rating agencies were also criticized for possible conflict of interest between them and issuers of securities. Issuers of securities pay the rating agencies for providing rating services, and therefore, the agencies may be reluctant to give very low ratings to securities issued by the people who pay their salaries.

The Big 3 Credit Rating Agencies

The credit rating industry is dominated by three big agencies, which control 95% of the rating business. The top firms include Moody’s Investor Services, Standard and Poor’s S&P – Standard and Poor'sStandard & Poor’s is an American financial intelligence company that operates as a division of S&P Global. S&P is a market leader in the(S&P), and Fitch Group. Moody’s and S&P are located in the United States, and they dominate 80% of the international market. Fitch is located in the United States and London and controls approximately 15% of the global market.

Morningstar Inc. has been expanding its market share in recent times and is expected to feature in the “top four rating agencies.” The U.S. Securities and Exchange Commission (SEC) identified the big three agencies as the Nationally Recognized Statistical Rating Organizations (NRSRO) in 1975.

The big three agencies came under heavy criticism after the global financial crisis for giving favorable ratings to insolvent institutions like Lehman Brothers. They were also blamed for failing to identify risky mortgage-backed securities that led to the collapse of the real estate market in the United States.

In a report titled “Financial Crisis Inquiry Report,” the big three rating agencies were accused of being the enablers of the 2008 financial meltdown. In a bid to tame the market dominance of the big three, Eurozone countries have encouraged financial firms and other companies to do their own credit assessments, instead of relying on the big three rating agencies.

Role of Rating Agencies in Capital Markets

Rating agencies assess the credit risk of specific debt securities and the borrowing entities. In the bond market, a rating agency provides an independent evaluation of the creditworthiness of debt securities issued by governments and corporations. Large bond issuers receive ratings from one or two of the big three rating agencies. In the United States, the agencies are held responsible for losses resulting from inaccurate and false ratings.

The ratings are used in structured finance transactions such as asset-backed securities, mortgage-backed securities, and collateralized debt obligationsCollateralized Debt Obligation (CDO)A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period.. Rating agencies focus on the type of pool underlying the security and the proposed capital structure to rate structured financial products. The issuers of the structured products pay rating agencies to not only rate them, but also to advise them on how to structure the tranches.

Rating agencies also give ratings to sovereign borrowers, who are the largest borrowers in most financial markets. Sovereign borrowers include national governments, state governments, municipalities, and other sovereign-supported institutions. The sovereign ratings given by a rating agency shows a sovereign’s ability to repay its debt.

The ratings help governments from emerging and developing countries to issue bonds to domestic and international investors. Governments sell bonds to obtain financing from other governments and Bretton Woods institutions such as the World Bank and the International Monetary Fund.

Benefits

At the consumer level, the agency’s ratings are used by banks to determine the risk premium to be charged on loans and bonds. A poor credit rating shows that the loan has a higher risk premium, and this prompts an increase in the interest charged to individuals and entities with a low credit rating. A good credit rating allows borrowers to easily borrow money from the public debt market or financial institutions at a lower interest rate.

At the corporate level, companies planning to issue a security must find a rating agency to rate their debt. Rating agencies such as Moody’s, Standards and Poor’s, and Fitch perform the rating service for a fee. Investors rely on the ratings to decide on whether to buy or not to buy a company’s securities.

Although investors can also rely on the ratings given by financial intermediariesFinancial IntermediaryA financial intermediary refers to an institution that acts as a middleman between two parties in order to facilitate a financial transaction. The institutions that are commonly referred to as financial intermediaries include commercial banks, investment banks, mutual funds, and pension funds. and underwriters, ratings provided by international agencies are considered more reliable and accurate since they can access lots of information that is not publicly available.

At the country level, investors rely on the ratings given by the credit rating agencies to make investment decisions. Many countries sell their securities in the international market, and a good credit rating can help them access high-value investors. A favorable rating may also attract other forms of investments like foreign direct investments to a country.

In addition, a low credit rating or relegation of a country from a high rating to a low rating can discourage investors from purchasing the country’s bonds or making direct investments in the country. For example, the downgrading of Greece, Portugal, and Ireland by S&P in 2010 worsened the European sovereign debt crisis.

Credit ratings also help in the development of financial markets. Rating agencies provide risk measures for various entities, and this allows investors to understand the credit risk of various borrowers. Institutions and government entities can access credit facilities without having to go through lengthy evaluations by each lender.

The ratings provided by rating agencies also serve as a benchmark for financial market regulations. Some laws now require certain public institutions to hold investment-grade bonds, which have a rating of BBB or higher.

Related Readings

CFI offers the Commercial Banking & Credit Analyst (CBCA)®Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Market Value of DebtMarket Value of DebtThe Market Value of Debt refers to the market price investors would be willing to buy a company's debt at, which differs from the book value on the balance sheet.
• Cost of DebtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis.
• Credit RiskCredit RiskCredit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally,
• Debt ScheduleDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows