CREDIT RATING

AN ANALYSIS OF THE CREDIT RATING AGENCIES

ANSHUMAN DUTTA,

1YR DoMS, NITT

ROLL NO-215111070

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CONTENTS

INTRODUCTION--------------------------------------------------------------------------2

ROLE OF CREDIT RATING ON COUNTRIES------------------------------------3

ECONOMIC RESILIENCY--------------------------------------------------------------3

FINANCIAL ROBUSTNESS-------------------------------------------------------------3

STANDARD & POOR---------------------------------------------------------------------5

MOODY’S CORPORATION------------------------------------------------------------7

FITCH-----------------------------------------------------------------------------------------8

USES OF RATING-------------------------------------------------------------------------8

METHODS OF RATING-----------------------------------------------------------------9

RATING USED IN STRUCTURED FINANCE------------------------------------10

CRITICISM------------------------------------------------------------------------------- 10

KEY FACTS ON RATING-------------------------------------------------------------15

CONCLUSION----------------------------------------------------------------------------16

REFERENCE------------------------------------------------------------------------------18

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INTRODUCTION

Credit rating agencies (CRA) are companies that assign credit ratings for issuers of certain types

of debt obligations as well as the debt and in certain cases the services of the underlying debt are

also provided ratings.

The impact of credit rating agencies on financial markets has become one of the most important

policy concerns facing the international financial architecture. Ratings indicate a relative credit

risk and serve as an important metric by which many investors and regulations measure credit

risk.

A major problems faced by developing countries is the difficulty in mobilizing funds to increase

investment. The level of income is often too low to generate sufficient savings, and the domestic

financial system often does a poor job of directing those funds back into domestic capital

formation. This makes access to international capital markets an important resource for obtaining

funds to raise the level and accelerate the pace of investment and growth. In order to gain access,

developing countries must first obtain a favorable rating of their creditworthiness by one or more

credit rating agencies.

The credit rating represents the credit rating agency's evaluation of qualitative and quantitative

information for a company or government; including non-public information obtained by the

credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead,

credit rating agencies use their judgment and experience in determining what public and private

information should be considered in giving a rating to a particular company or government.

A poor credit rating indicates a credit rating agency's opinion that the company or government

has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of

long term economic prospects.

The credit score does not take into account future prospects or changed circumstances.

HISTORY

The use of credit ratings arose in the U.S. out of the desire by the growing investing class to have

more information about the many new securities – especially railroad bonds – that were being

issued and traded. In the middle of the 19th century, the U.S. railroad industry began expanding

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across the continent and into undeveloped territories. The industry’s demand for capital exceeded

the ability or willingness of banks and direct investors to provide it. In order to reach a broader

and deeper capital market, railroads and other corporations began raising new capital through the

market for private corporate bonds.

Role of credit ratings on countries

Countries can issue government bonds denoted in the country’s currency in order to raise capital.

Bonds can also be issued in foreign currency, referred to as sovereign bonds. Bonds are often

referred to as risk free due to the fact that they are government owned and hence, governments

can at any time raise taxes or create extra currency in order to redeem their bonds upon maturity.

However, as we have seen recently, the issue of Greece counters this statement.

Bonds are rated on various parameters such as:

Economic Resiliency

The country’s economic strength, captured in particular by the GDP per capita – the

single best indicator of economic robustness and, in turn, shock-absorption capacity.

Institutional strength of the country, the key question being whether or not the quality of

a country’s institutional framework and governance – such as the respect of property

right, transparency, the efficiency and predictability of government action, the degree of

consensus on the key goals of political action – is conducive to the respect of contracts.

Financial Robustness

The financial strength of the government. The question is to determine what must be

repaid and the ability of the government to mobilize resources: raise taxes, cut spending,

sell assets, and obtain foreign currency.

The susceptibility to event risk – that is the risk of a direct and immediate threat to debt

repayment, and, for countries higher in the rating scale, the risk of a sudden multi-notch

downgrade. The issue is to determine whether the debt situation may be (further)

endangered by the occurrence of adverse economic, financial or political events.

Combining these indicators rating agencies determine degrees of financial robustness and

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refine the positioning of the country on the rating scale- very high, high, moderate, low or

very low.

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Standard & Poor's

Henry Varnum Poor first published the "History of Railroads and Canals in the United States

in1860, the forerunner of securities analysis and reporting to be developed over the next century.

Standard & Poor’s (S&P) was created in 1941 through the merger with Standard Statistics and

Poor’s Publishing. The company provides a wide range of information on financial products and

markets. Standard & Poor’s sells investment data, valuations, analysis and opinions. The flagship

product is their S&P 500, an index that tracks the high capitalization equity markets in the

United States. McGraw-Hill Companies acquired Standard & Poor’s in 1966. In 2001, McGraw

Hill Companies had sales of $4.6 billion and income of $377 million. Standard & Poor’s

contributed to the total with sales of almost $1.5 billion and operating profit of $435 million.

Table 2: Standard and Poor's sovereign ratings methodology profile Poor's sovereign

ratings methodology profile

Political risk

• Stability and legitimacy of political institutions;

• Popular participation in political processes;

• Orderliness of leadership successions;

• Transparency in economic policy decisions and objectives;

• Public security; and

• Geopolitical risk.

Income and economic structure

• Prosperity, diversity and degree to which economy is market-oriented;

• Income disparities;

• Effectiveness of financial sector in intermediating funs availability of credit;

• Competitiveness and profitability of non-financial private sector;

• Efficiency of public sector;

• Protectionism and other non-market influences; and

• Labour flexibility.

Economic growth prospects

• Size and composition of savings and investment; and

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• Rate and pattern of economic growth.

Fiscal flexibility

• General government revenue, expenditure, and surplus/deficit trends;

• Revenue-raising flexibility and efficiency;

• Expenditure effectiveness and pressures;

• Timeliness, coverage and transparency in reporting; and

• Pension obligations.

General government burden

• General government gross and net (of assets) debt as a per cent of GDP;

• Share of revenue devoted to interest;

• Currency composition and maturity profile; and

• Depth and breadth of local capital markets.

Offshore and contingent liabilities

• Size and health of NFPEs; and

• Robustness of financial sector.

Monetary flexibility

• Price behaviour in economic cycles;

• Money and credit expansion;

• Compatibility of exchange rate regime and monetary goals;

• Institutional factors such as central bank independence; and

• Range and efficiency of monetary goals.

External liquidity

• Impact of fiscal and monetary policies on external accounts;

• Structure of the current account;

• Composition of capital flows; and

• Reserve adequacy.

External debt burden

• Gross and net external debt, including deposits and structured debt;

• Maturity profile, currency composition, and sensitivity to interest rate changes;

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• Access to concessional lending; and

• Debt service burden.

Source: Standard and Poor's (October 2006). ―Sovereign Credit Ratings: A Primer.

Notes: NFPEs: Non-Financial Public Sector Enterprises

Moody's Corporation

John Moody and Company first published "Moody's Manual" in 1900. The manual published

basic statistics and general information about stocks and bonds of various industries. In 1909

Moody began publishing "Moody's Analyses of Railroad Investments", which added analytical

information about the value of securities. Expanding this idea led to the 1914 creation of

Moody's Investors Service. By the 1970s Moody's began rating commercial paper and bank

deposits, becoming the full-scale rating agency that it is today.

Table 3: Moody’s Sovereign Categories

1. Economic Structure and Performance

- GDP, inflation, population, GNP per capita, unemployment, imports and exports

2. Fiscal Indicators

- Government revenues, expenditures, balance, debt all as percentage of GDP

3. External Payments and Debt

- Exchange rate, labor costs, current account, foreign currency debt and debt service ratio

4. Monetary and Liquidity Factors

- Short-term interest rates, domestic credit, M2/foreign exchange reserves, maturing

debt/foreign exchange reserves, liabilities of banks/assets of banks

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Fitch Rating

John Knowles Fitch founded the Fitch Publishing Company in 1913. Fitch published financial

statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The

Fitch Bond Book."

In 1924, Fitch introduced the AAA through the rating system that has become the basis for

ratings throughout the industry. With plans to become a full-service global rating agency, in the

late 1990s Fitch merged with IBCA of London.

Fitch Ratings provides ratings and research to over 75 countries

Uses of ratings

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.

A poor credit rating indicates a credit rating agency's opinion that the company or government

has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of

long term economic prospects. A poor credit score indicates that in the past, other individuals

with similar credit reports defaulted on loans at a high rate. The credit score does not take into

account future prospects or changed circumstances.

Methods of Credit Ratings:

The key measure in credit risk models is the measure of the Probability of Default (PD) but

exposure is also determined by the expected timing of default and by the Recovery Rate (RE)

after default has occurred:

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Standard and Poor's ratings seek to capture only the forward-looking probability of the

occurrence of default. They provide no assessment of the expected time of default or

mode of default resolution and recovery values.

By contrast, Moody's ratings focus on the Expected Loss (EL) which is a function of

both Probability of Default (PD) and the expected Recovery Rate (RE). Thus EL =PD

(1- RE).

Fitch's ratings also focus on both PD and RE (Bhatia, 2002). They have a more

explicitly hybrid character in that analysts are also reminded to be forward looking and

to be alert to possible discontinuities between past track records and future trends.

The credit ratings of Moody's and Standard and Poor's are assigned by rating

committees and not by individual analysts.

There is a large dose of judgement in the committees’ final ratings.

Rating’s use in structured finance

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,

CRAs provide little guidance as to how they assign relative weights to each factor, though

they do provide information on what variables they consider in determining sovereign

ratings.

Identifying the relationship between the CRAs' criteria and actual ratings is difficult, in part

because some of the criteria used are neither quantitative nor quantifiable but qualitative.

The analytical variables are interrelated and the weights are not fixed either across

sovereigns or over time.

Even for quantifiable factors, determining relative weights is difficult because the agencies

rely on a large number of criteria and there is no formula for combining the scores to

determine ratings.

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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.

Criticism

Credit rating agencies have been subject to the following criticisms:

Credit rating agencies do not downgrade companies promptly enough. For example,

Enron's rating remained at investment grade four days before the company went

bankrupt, despite fact that credit rating agencies had been aware of the company's

problems for months. Or, for example, Moody's gave Freddie Mac preferred stock the top

rating until Warren Buffett talked about Freddie on CNBC and on the next day Moody's

downgraded Freddie to one tick above junk bonds.

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Large corporate rating agencies have been criticized for having too familiar a relationship

with company management, possibly opening themselves to undue influence or the

vulnerability of being misled. These agencies meet frequently in person with the

management of many companies, and advise on actions the company should take to

maintain a certain rating. Furthermore, because information about ratings changes from

the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs

charge debt issuers, rather than investors, for their ratings. This has led to accusations that

these CRAs are plagued by conflicts of interest that might inhibit them from providing

accurate and honest ratings. At the same time, more generally, the largest agencies

(Moody's and Standard & Poor's) are often seen as promoting a narrow-minded focus on

credit ratings, possibly at the expense of employees, the environment, or long-term

research and development.

While often accused of being too close to company management of their existing clients,

CRAs have also been accused of engaging in heavy-handed "blackmail" tactics in order

to solicit business from new clients, and lowering ratings for those firms. For instance,

Moody's published an "unsolicited" rating of Hannover Re, with a subsequent letter to the

insurance firm indicating that "it looked forward to the day Hannover would be willing to

pay". When Hannover management refused, Moody's continued to give Hannover

ratings, which were downgraded over successive years, all while making payment

requests that the insurer rebuffed. In 2004, Moody's cut Hannover's debt to junk status,

and even though the insurer's other rating agencies gave it strong marks, shareholders

were shocked by the downgrade and Hannover lost $175 million USD in market

capitalization.

The lowering of a credit score by a CRA can create a vicious cycle, 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'

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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.

Agencies are sometimes accused of being oligopolists, 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). 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.

Credit Rating Agencies have made errors of judgment in rating structured products,

particularly in assigning AAA ratings to structured debt, which in a large number of cases

has subsequently been downgraded or defaulted. The actual method by which Moody's

rates CDOs has also come under scrutiny. If default models are biased to include

arbitrary default data and "Ratings Factors are biased low compared to the true level of

expected defaults, the Moody’s [method] will not generate an appropriate level of

average defaults in its default distribution process. As a result, the perceived default

probability of rated tranches from a high yield CDO will be incorrectly biased downward,

providing a false sense of confidence to rating agencies and investors.

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Little has been done by rating agencies to address these shortcomings indicating a lack

of incentive for quality ratings of credit in the modern CRA industry. This has led to

problems for several banks whose capital requirements depend on the rating of the

structured assets they hold, as well as large losses in the banking industry. AAA rated

mortgage securities trading at only 80 cents on the dollar, implying a greater than 20%

chance of default, and 8.9% of AAA rated structured CDOs are being considered for

downgrade by Fitch, which expects most to downgrade to an average of BBB to BB-.

These levels of reassessment are surprising for AAA rated bonds, which have the same

rating class as US government bonds.[20][21] Most rating agencies do not draw a

distinction between AAA on structured finance and AAA on corporate or government

bonds (though their ratings releases typically describe the type of security being rated).

Many banks, such as AIG, made the mistake of not holding enough capital in reserve in

the event of downgrades to their CDO portfolio. The structure of the Basel II agreements

meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios

vulnerable to multiple downgrades, essentially precipitating a large margin call. For

example under Basel II, a AAA rated securitization requires capital allocation of only

0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a

52% allocation. For a number of reasons (frequently having to do with inadequate staff

expertise and the costs that risk management programs entail), many institutional

investors relied solely on the ratings agencies rather than conducting their own analysis

of the risks these instruments posed. (As an example of the complexity involved in

analyzing some CDOs, the Aquarius CDO structure has 51 issues behind the cash CDO

component of the structure and another 129 issues that serve as reference entities for $1.4

billion in CDS contracts for a total of 180. In a sample of just 40 of these, they had on

average 6500 loans at origination. Projecting that number to all 180 issues implies that

the Aquarius CDO has exposure to about 1.2 million loans.) Pimco founder William

Gross urged investors to ignore rating agency judgments, describing the agencies as "an

idiot savant with a full command of the mathematics, but no idea of how to apply them.

Ratings agencies, in particular Fitch, Moody's and Standard and Poors have been

implicitly allowed by governments to fill a quasi-regulatory role, but because they are

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for-profit entities their incentives may be misaligned. Conflicts of interest often arise

because the rating agencies, are paid by the companies issuing the securities — an

arrangement that has come under fire as a disincentive for the agencies to be vigilant on

behalf of investors. Many market participants no longer rely on the credit agencies ratings

systems, even before the economic crisis of 2007-8, preferring instead to use credit

spreads to benchmarks like Treasuries or an index. However, since the Federal Reserve

requires that structured financial entities be rated by at least two of the three credit

agencies, they have a continued obligation.

Many of the structured financial products that they were responsible for rating, consisted

of lower quality 'BBB' rated loans, but were, when pooled together into CDOs, assigned

an AAA rating. The strength of the CDO was not wholly dependent on the strength of the

underlying loans, but in fact the structure assigned to the CDO in question. CDOs are

usually paid out in a 'waterfall' style fashion, where income received gets paid out first to

the highest tranches, with the remaining income flowing down to the lower quality

tranches i.e. <AAA. CDOs were typically structured such that AAA tranches which were

to receive first lien (claim) on the BBB rated loans cash flows, and losses would trickle

up from the lowest quality tranches first. Cash flow was well insulated even against

heavy levels of home owner defaults. Credit rating agencies only accounted for a ~5%

decline in national housing prices at worst, allowing for a confidence in rating the many

of these CDOs that had poor underlying loan qualities as AAA. It did not help that 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.

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.

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Rating agencies have come under criticism for a narrow-minded view of government

default from investors' perspective. A government that does not run a sustainable budget

might be forced to print money to meet credit payments, this will then inflate the

economy and devalue the currency. USA is for example thought to be unlikely to default

on their payments since they have the printing power of the dollar, which a country like

Greece does not have for its currency, the Euro. However the Euro, which was introduced

in year 1999 on an even exchange rate with the dollar, was trading almost 50% higher

than the dollar only 10 years after its launch. At that time, because of investor fear for a

default in the peripheral states of EU, Greece's government bond credit rating was in the

junk bond category, while the USA credit rating was still in the top category. The

criticism escalated in summer, 2011, when the European Commission and EC President

and former Portuguese premier José Manuel Barroso, respectively, criticized Moody's

downgrade of Portuguese bonds.

After Moody's reported a surge in "toxic" municipal debt (money owed to banks by

municipalities) in China in summer, 2011, Bank of America Merrill Lynch economist

Ting Lu deemed the assessment ―too pessimistic," saying he disagreed with the

assumptions and the math and the translation-of-terms used by the rating agency.

Moody's had also estimated that "between 8% to 12% of loans extended by Chinese

banks could eventually be classed as non-performing," according to a news report.

Key facts about credit ratings

Credit ratings are only opinions about the relative credit risk of the subject

Credit ratings are not investment advice, or buy, hold, or sell recommendations. They are just one factor investors ‘might consider’ in making investment decisions

Credit ratings are not indications of the market liquidity of a debt security or its price

in the secondary market.

Credit ratings are not guarantees of credit quality or of future credit risk

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VI. Conclusions

CRAs play a key role in financial markets by helping to reduce the informative

asymmetry between lenders and investors, on one side, and issuers on the other side,

about the creditworthiness of companies (corporate risk) or countries (sovereign risk).

CRAs' role has expanded with financial globalization and has received an additional

boost from Basel II which incorporates the ratings of CRAs into the rules for setting

weights for credit risk.

In making their ratings, CRAs analyse public and non-public financial and accounting

data as well as information about economic and political factors that may affect the

ability and willingness of a government or firms to meet their obligations in a timely

manner. However, CRAs lack transparency and do not provide clear information about

their methodologies.

Ratings tend to be sticky, lagging markets, and then to overreact when they do change.

This overreaction may have aggravated financial crises in the recent past, contributing to

financial instability and cross-country contagion(downgrade of US credit rating).

Moreover, the action of countries which strive to maintain their rating grades through

tight macroeconomic policies may be counterproductive for long-term investment and

growth.

The recent bankruptcies of Enron, WorldCom, and Parmalat have prompted legislative

scrutiny of the agencies. Criticism has been especially directed towards the high degree

of concentration of the industry, which in the United States has reflected a registration

and certification process in the form of NRSRO designation biased against new entrants.

The effect of such concentration has been the absence of the discipline enforced by

competition and a low level of innovation.

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In the United States, policy action has included the 2006 Credit Rating Agency Reform

Act which has overhauled the regulatory framework by prescribing procedural

requirements for NRSRO registration and certification and by strengthening the powers

of the SEC.

At international level, the main initiative has been the publication by IOSCO of its Code

of Conduct. This Code aims at developing governance rules for CRAs to ensure the

quality and integrity of the rating process, the independence of the process and the

avoidance of conflict of interest and greater transparency. In its 2005 Technical Advice to

the European Commission on possible Measures Concerning Credit Rating Agencies, the

CESR recommended the implementation of the IOSCO Code and adoption of a "wait and

see" attitude.

Definitive assessment of these initiatives would still be premature. The industry will

receive a fillip from implementation of Basel II. The major CRAs will undoubtedly seek

a substantial share of the new business which will result. Promotion of competition may

require policy action at national level to encourage the establishment of new agencies and

to channel business generated by new regulatory requirements in their direction.

Regulatory action at the national level may also be necessary to ensure that the agencies

operate in accord with levels of accountability and transparency matching the

recommendations of the IOSCO Code.

Ratings agencies do serve a purpose in financial markets. Their value in assessing default risk

and thereby affecting credit spreads plays a critical role in financial markets and especially the

flow of capital to developing countries. Improvements can be made by encouraging more

accurate ratings and requiring more timely ratings. Additional improvement can come through

investor education about the method and meaning of credit ratings, and greater transparency by

the agencies to level the playing field for all investors. Increasing competition may be one

strategy to increase investment and more accurate ratings, but its potential negative

consequences will need to be monitored and supervised to prevent "rate shopping."

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References:-

http://www.investopedia.com/

http://www.forexpromos.com/what-are-credit-rating-companies-and-their-impact-on-the-

economy

CREDIT RATING AGENCIES AND THEIR POTENTIAL IMPACT ON

DEVELOPING COUNTRIES,Marwan Elkhoury,No. 186,January 2008