Credit Ratings

A CRISIL rating reflects CRISIL's current opinion on the relative likelihood of timely payment of interest and

principal on the rated obligation. It is an unbiased, objective, and independent opinion as to the issuer's

capacity to meet its financial obligations.

So far, CRISIL has rated 30,000 debt instruments, covering the entire debt market.

The debt obligations rated by CRISIL include:

Non-convertible debentures/bonds/preference shares

Commercial papers/certificates of deposits/short-term debt

Fixed deposits

Loans

Structured debt

CRISIL Ratings' clientele includes all the industry majors - 23 of the BSE Sensex constituent companies and

39 of the NSE Nifty constituent companies, accounting for 80 per cent of the equity market capitalisation, are

CRISIL's clients.

CRISIL's credit ratings are

An opinion on probability of default on the rated obligation

Forward looking

Specific to the obligation being rated

But they are not

A comment on the issuer's general performance

An indication of the potential price of the issuers' bonds or equity shares

Indicative of the suitability of the issue to the investor

A recommendation to buy/sell/hold a particular security

A statutory or non-statutory audit of the issuer

An opinion on the associates, affiliates, or group companies, or the promoters, directors, or officers of

the issuer

CRISIL ratings are based on a robust and clearly articulated analytical framework, which ensures

comprehensiveness, standardisation, comparability, and effective communication of the ratings assigned and

of every timely rating action. The assessment is based on the highest standards of independence and

analytical rigour.

CRISIL rates a wide range of entities, including:

Industrial companies

Banks

Non-banking financial companies (NBFCs)

Infrastructure entities

Microfinance institutions

Insurance companies

Mutual funds

State governments

Urban local bodies

List of Credit Rating Agencies in function at present : 

1.       Credit Rating Information Services of India Ltd. (CRISIL)2.       Investment Information and Credit Rating Agency of India Ltd. (ICRA)3.       Credit Analysis and Research Ltd. (CARE)4.       Duff and Phelp Credit Rating India Pvt. Ltd. (DCR India)/ Fitch Ratings

India Pvt. Ltd.( DCR has now become Fitch) There are two other Rating Agencies(for SME scale industries) also but it’s not listed in the SEBI website :1.       ONICRA Credit Rating Agency of India Ltd.2.       SME Rating Agency of India Ltd.

   

Explanation :             Definition :

"Associate" in relation to a promoter, includes a body corporate in which the promoter holds ten percent or more, of the share capital;   "Associate", in relation to a credit rating agency, includes a person – (i) who, directly or indirectly, by himself, or in combination with relatives, owns or controls shares carrying not less than ten percent of the voting rights of the credit rating agency, or (ii) in respect of whom the credit rating agency, directly or indirectly, by itself, or in combination with other persons, owns or controls shares carrying not less than ten percent of the voting rights, or (iii) majority of the directors of which, own or control shares carrying not less than ten percent of the voting rights of the credit rating agency, or (iv) whose director, officer or employee is also a director, officer or employee of the creditrating agency;"Promoter" means a person who holds ten percent or more, of the shares of the

credit rating agency.  

1. Procedure of formation  :Credit Rating Agencies can work and start functioning only after due approval from the SEBI (The Board) under the Securities Exchange Board of India (Credit Rating Agencies) Regulations, 1999. Application should be made in Form A with the fees as stipulated forth; (1)Application fee (Rs) 50, 000/-, (2) Registration fee for grant of certificate (Rs) 5, 00, 000/-, (3)Renewal fee (Rs.) 10, 00, 000/-.The validity period of the certificate granted by the Board is 3 years and then it needs to be renewed.

  Application for registration should satisfy the following conditions namely (a) the company should have “rating activity” as one of its main objective in the MoA,(b) It has a minimum net worth of rupees five crore, (c)it has adequate infrastructure, to enable it to provide rating services in accordance with the provisions of the Act and these regulations;  the applicant and the promoters of the applicant, referred have professional competence, financial soundness and general reputation of fairness and integrity in business transactions, to the satisfaction of the Board; (d)  neither the applicant, nor its promoter, nor any director of the applicant or its promoter, is involved in any legal proceeding connected with the securities market, which may have an adverse impact on the interests of the investors; or has been convicted of any offence involving moral turpitude or any economic offence; (e) it has persons having adequate professional and other relevant experience to the satisfaction of the Board; (f) neither the applicant, nor

any person directly or indirectly connected with the applicant has in the past been – (i) refused by the Board a certificate under these regulations or (ii) subjected to any proceedings for a contravention of the Act or of any rules or regulations made under the Act. 

2. Promoter of credit rating agency : The Board shall not consider an application unless the applicant is promoted by a person belonging to any of the following categories, namely: (a) a public financial institution, as defined in section 4 A of the Companies Act, 1956 (1 of 1956); (b) a scheduled commercial bank included for the time being in the second schedule to the Reserve Bank of India Act, 1934 (2 of 1934); (c) a foreign bank operating in India with the approval of the Reserve Bank of India; (d) a foreign credit rating agency recognised by or under any law for the time being in force in the country of its incorporation, having at least five years experience in rating securities; (e) any company or a body corporate, having continuous net worth of minimum rupees one hundred crore as per its audited annual accounts for the previous five years prior to filing of the application with the Board for the grant of certificate under these regulations. 

3. liabilities Every credit rating agency has the liability to continuously monitor such securities rated by it during the lifetime of those securities and to disseminate information regarding newly assigned ratings, and changes in earlier rating promptly through press releases and websites, and, in the case of securities issued by listed companies, such information shall also be provided simultaneously to the concerned regional stock exchange and to all the stock exchanges where the said securities are listed.

 Every credit rating agency has to keep and maintain, for a minimum period of five years, the following books of accounts, records and documents, namely: (a) copy of its balance sheet, as on the end of each accounting period; (b) a copy of its profit and loss account for each accounting period; (c) a copy of the auditor’s report on its accounts for each accounting period; (d) a copy of the agreement entered into, with each client; (e) information supplied by each of the clients; (f) correspondence with each client; (g) ratings assigned to various securities including upgradation and down gradation (if any) of the ratings so assigned; (h) rating notes considered by the rating committee; (i) record of decisions of the rating committee; (i) letter assigning rating; (k) particulars of fees charged for rating and such other records as the Board may specify from time to time.

 

4. Rating process A CRA needs to get into a written agreement with the Issuer before rating its securities and this is a mandatory process. Every CRA is bound to specify and file with the Board the rating process and a copy of the same or modification or addition therein and it shall follow a proper rating process. It needs to have a professional rating committee, comprising members who are adequately qualified and knowledgeable to assign a rating. All rating decisions, including the decisions regarding changes in rating is taken by such rating committee. It must be staffed by analysts qualified to carry out a rating assignment. Apart from that CRA is bound to inform the Board about new rating instruments or symbols introduced by it. Rating definition, as well as the structure for a particular rating product can not be changed by a CRA without prior information to the Board. A credit rating agency is bound to disclose to the concerned stock exchange, through press release and websites for general investors, the rating assigned to the securities of a client, after periodic review, including changes in rating, if any.

 

 

5. Restrictions A credit rating agency can not rate securities issued by it nor their promoters. In case promoter is a lending institution, its Chairman, director or employee shall not be a Chairman, director or employee of credit rating agency or its rating committee. Apart from that, it can not  rate a security issued by an entity, which is a borrower of its promoter; or  a subsidiary of its promoter; or an associate of its promoter, if (i) there are common Chairman, Directors between credit rating agency and these entities; (ii) there are common employees; (iii) there are common Chairman, Directors, Employees on the rating committee.Also it can not rate a security issued by its associate or subsidiary, if the credit rating agency or its rating committee has a Chairman, director or employee who is also a Chairman, director or employee of any such entity. But in such a case it can rate a security issued by its associate having a common independent director with it or rating committee if  such an independent director does not participate in the discussion on rating decisions, and the Credit Rating Agency makes a disclosure in the rating announcement of such associate (about the existence of common independent director) on its Board or of its rating committee, and that the common independent director did not participate in the rating process or in the meeting of its Board of Directors or in the meeting of the rating committee, when the securities rating of such associate was discussed.

 

6. Code of Conduct : Credit Rating Agencies are bound to follow some code of conducts and ethics under Regulation 13 of the said Regulation, 1999. Chiefly, A CRA can not indulge in unfair competition nor shall they wean away client of any other rating agency on assurance of higher rating and they can not make any exaggerated statement, whether oral or written, to the client either about its qualification or its capability to render certain services or its achievements in regard to services rendered to other clients. It can not generally and particularly in respect of issue of securities rated by it be party to (a) creation of false market; (b) passing of price sensitive information to brokers, members of the stock exchanges, other players in the capital market or to any other person or take any other action which is unethical or unfair to the investors. It needs to maintain an arm’s length relationship between its credit rating activity and any other activity. Either a CRA or any of his employees can not render, directly or indirectly any investment advice about any security in the publicly accessible media, whether real – time or non- real time, unless a disclosure of his interest including long or short position in the said security has been made, while rendering such advice. It has to ensure that the Board is promptly informed about any action, legal proceedings etc., initiated against it alleging any material breach or non-compliance by it, of any law, rules, regulations and directions of the Board or of any other regulatory body and in case an employee of the credit rating agency is rendering such advice, he shall also disclose the interest of is dependent family members and the employer including their long or short position in the said security, while rendering such advice.It is bound  to comply with award of the Ombudsman passed under the Securities and Exchange Board of India (Ombudsman) Regulations, 2003. It can not render, directly or indirectly any investment advice about any security in the publicly accessible media. It can not offer fee-based services to the rated entities, beyond credit ratings and research. Every CRA has to develop its own internal code of conduct for governing its internal operations and laying down its standards of appropriate conduct for its employees and officers in the carrying out of their duties within the credit rating agency.

 

7. Enquiry and Action

If there is any need for inspection or investigation/ inquiry then the Board or the Chairman shall after consideration of inspection or investigation report take such action as the Board or Chairman may deem fit and appropriate including action under the Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty) Regulations, 2002It includes :(1) A penalty of cancellation of certificate of registration of a credit rating agency may be imposed by the Board, if:

(a) the credit rating agency is guilty of fraud, or has been convicted of an offence involving moral     turpitude or an economic offence; or(b) in case of repeated defaults of the nature mentioned in sub-regulation (1)

of regulation 34.(c) the credit rating agency is declared insolvent or wound up;

(2) The Board shall furnish to the credit rating agency reasons in writing for cancellation of registration 

8. Appeals Any person aggrieved by an order of the Board made, on and after the commencement of the Securities Laws (Second Amendment) Act, 1999, (i.e., after 16th December 1999), under these regulations may prefer an appeal to a Securities Appellate Tribunal having jurisdiction in the matter.

 Appeal to the Central GovernmentAny person aggrieved by an order of the Board under these Regulations;(a) Suspending a certificate of registration;(b) Cancelling certificate of registration,may prefer an appeal to the Central Government against such order, in accordance with the Securities and Exchange Board of India (Appeal to Central Government) Rules, 1993]

Credit Rating Agencies rate the credit-worthiness of securities instruments.The reason for doing so is for investors to gain confidence that what they are buying is what they think it is.The big players in the industry (pension/insurance funds) have mandates which prevents them from investing in securities below a certain rating.You could say that they act as a means of protecting society from excessive speculation using 'social' funds (pension/insurance) by fund managers who are out to speculate short term by taking excessive risk.

A credit rating agency assigns credit ratings to certain types of debt obligations and debt instruments.

ONICRA CREDIT AGENCY

Onicra Credit Rating Agency of India Ltd. is one of the leading Credit and Performance Rating agencies in India. It provides ratings, risk assessment and analytical solutions to Individuals, MSMEs and Corporates. Third party credit rating and assessment helps to create “trust” between players in financial markets that underpins transactions and trading. ONICRA plays a central and critical role in analyzing, assessing and rating various entities to enable transactions. 

We provide comprehensive ratings, risk assessment and analytical solutions to individuals and businesses across all areas enabling clients to make independent, informed & value based decisions on various stakeholders. Our commitment is to build credible, independent and leadership positions to help our customers’ business grow profitably and securely. 

Micro, Small and Medium Enterprises (MSME) RatingSmall & medium firms play a key role in transition and developing countries. These firms typically account for more than 90% of all firms outside the agricultural sector, constitute a major source of employment and generate significant domestic and export earnings. As such, SME development emerges as a key instrument in poverty reduction efforts. 

India is no exception and a large part of business in the country is done through SMEs. Today, it accounts for nearly 35% of the gross value of output in the manufacturing sector and over 40% of the total exports from the country. The sector's contribution to employment is next only to agriculture in India. It is therefore an excellent sector of economy for investment. 

However, despite its strategic importance in any industrialization strategy, the opportunities that the Indian landscape presents and its immense potential for employment generation, the MSME sector confronts several challenges. Absence of adequate and timely banking finance, limited capital and knowledge, non-availability of suitable technology, low production capacity, ineffective marketing strategy are just a few to name. Onicras endeavor to provide an objective assessment of MSME with regard to their performance capability and financial strength is helping MSME establish their credibility and thus access adequate and timely financing at affordable rate. 

BENEFITS:

For Lenders 

The rating will be an additional input to objectively and scientifically make lending decisions, and determine terms

like interest rates and margins for SSI borrowers

Comfort level for prudent decision-making

Reduction in information asymmetry in the MSME sector

Warning signals through periodic rating review

For the Rated MSME

Adds credibility to the status of the MSME

Improves the comfort level with prospective/existing lenders

Negotiate better terms on the basis of the credit quality reflected by the Rating

Increases credit acceptability with banks and financial institutions

Reduces the time involved in obtaining loan approvals

Project a better image to prospective/existing trade partners

Motivation to adopt good governance practices

Tool for self correction & self improvement

Concession in interest rate on NSIC’s Raw Material Assistance / BG Scheme

Creates confidence among buyers and suppliers by establishing credibility & goodwill.

Education Grading

With rapid expansion and commercialization of the education sector, it is imperative that continuous

monitoring and controlled mechanism be built to ensure a systematic enhancement in the quality of

education. 

There is a wide variation in the quality of training being imparted by various education institutes making

it necessary for a system to be evolved; where a common platform of benchmarking across the country

is in place. 

A publicly available and highly credible bench-marking exercise acts as a powerful tool for non-intrusive

regulation and quality enhancement. This will lead to healthy functioning of the institutes, providing their

stakeholders a standing in the environmental struggle and increasing their level of productivity to

perform effectively in the Indian and Global environment. 

Onicra Education Grading provides assessment of academic quality of educational institutions,

Programmes conducted therein and their infrastructure to aid them identify, validate and improve quality

of education and standard of curriculum, thus achieving excellence in specific facets of education. 

The service addresses the perceived need among students and other stakeholders for an informed,

reliable and independent opinion on the quality of education imparted by the various Education

Institutes.

Healthcare GradingWhile ever-increasing demand for healthcare products and services bring enormous opportunities; some

common threats exist like soaring costs, inequitable and mismanaged access and inconsistent quality. 

Gradings foster transparency, accountability and best practices in the industry. 

ONICRA Grading for Healthcare Institutions is an opinion on the relative quality of healthcare delivered

by the institution to its patients. 

A healthcare institution with a higher Grading would have relatively better facilities and processes than those

Graded lower. 

While evaluating a healthcare institution ONICRA looks into a host of factors such as availability of infrastructure,

equipment, manpower, systems and clinical algorithms, all from the user’s point of view. 

The evaluation of these core factors involves a review of the institution’s resources, processes and outcome to

determine its capability to deliver quality healthcare. 

After a grading has been assigned, Onicra monitors the on-going performance of the institutions. 

A transparent system of evaluation and grading serves to benefit not only the healthcare organization but all

stakeholders associated with it. 

* The grade assigned to a Healthcare Institution is, however, not a comment on the probability of outcome of any

particular treatment, procedure or surgery .

Here is the list of Top 10 Credit Rating Agencies of the world. These agencies are Nationally Recognized

Statistical Rating Organizations by the U.S. Securities and Exchange Commission

1. MODDY’S

Moody’s is the oldest credit rating agency. It is also the first

rating agency to be recognized by NRSRO in 1975.  The company became public in 2000. It has been earning

huge profits. Average profit margin was 53% from 2000 to 2007. Structured finance products was its top source

of revenue by 2000.

2. Standard & Poor’s

The agency is owned by Mc Graw-Hill Inc. It has been

published any stock indices of the world, most famous being S&P 500 index which is the most watched index in

the world. McGraw-Hill reported a net profit margin of 12.6 percent for 2008.

3. Fitch

Fitch is smallest among the top three agencies. It is a

part of Fitch Group, a subsidiary of Fimalac S.A FIM.PA. Was the third agency to become an NRSRO in 1975.

From 1975 to 1992, four other agencies were recognized as NRSROs and all subsequently merged with Fitch.

4. DBRS

DBRS is privately owned Canadian ratings agency. Has been the top ratings

agency in Canada for 30 years. It became the fourth NRSRO in 2003. DBRS believes that it can compete with

the big three but is not favored by authorities.

5. Egan-Jones

Egan-Jones is a Philadelphia-based agency

founded in 1995. It was granted NRSRO status in December 2007 after a nine-year process. Although they are

paid by investor-subscribers, Egan-Jones will give out their ratings to anyone who asks.

6. A.M Best

A.M Best was founded in 1899 in

New York City and became an NRSRO in 2005. It specializes exclusively on the insurance marketplace and so

not a competitor with the others per se. But has recently begun issuing debt and financial-strange ratings for

small and mid-sized commercial banks.

7. Japan Credit Rating Agency Limited

Japan Credit rating Agency

was established in 1985 and based in Tokyo and it became an NRSRO in 2007. It is a small agency when

compared to competitors. it has a staff of just 90.

8. Rating and Investment Information Inc

The second Japanese credit ratings agency to become an NRSRO in 2007.

It was set up in 1975, now based in Nihonbashi. New York office was set up in 2005.

9. LACE Financial

It was founded in 1984, and became a NRSRO in 2008. The second

NRSRO after Egan-Jones to operate on investor-paid business model.

10. Realpoint LLC

Realpoint LLC became a NRSRO in 2008. It is one of the smallest

NRSROs and is paid by issuers. Obtained an exemption in 2008 from the SEC regulation that an NRSRO is

prohibited from rating an issuer that contributes 10 percent or more of its revenue.

CREDIT RATING AGENCIES PROVIDE INVESTORS AND DEBTORS WITH IMPORTANT INFORMATION REGARDING THE CREDITWORTHINESS OF AN INDIVIDUAL, CORPORATION, AGENCY OR EVEN A SOVEREIGN GOVERNMENT. THE CREDIT RATING AGENCIES HELP MEASURE THE QUANTITATIVE AND QUALITATIVE RISKS OF THESE ENTITIES AND ALLOW INVESTORS TO MAKE WISER DECISIONS BY BENEFITING FROM THE SKILLS OF PROFESSIONAL RISK ASSESSMENT CARRIED OUT BY THESE AGENCIES. THE QUANTITATIVE RISK ANALYSIS CARRIED OUT BY CREDIT RATING AGENCIES INCLUDE COMPARISON OF CERTAIN FINANCIAL RATIOS WITH CHOSEN BENCHMARKS AND THE QUALITATIVE ANALYSIS FOCUSES ON THE MANAGEMENT CHARACTER, LEGAL, POLITICAL AND ECONOMIC ENVIRONMENT IN A JURISDICTION.

Development of Financial Markets

Credit rating agencies help provide risk measures for various entities and make it easier for financial market participants to assess and understand the credit risk of the parties involved in the investing process. Individuals can get a credit score in order to be eligible for easy access to credit cards and other loans. Institutions can borrow money easily from banks without having

to go through lengthy evaluations from each individual lender separately. Also corporations and governments can issue debt in the form of corporate bonds and treasuries to attract investors based on the credit ratings.

Credit Rating Agencies Help Regulate Financial Markets

The credit ratings provided by popular rating agencies including Moody’s, Standard & Poor’s and Fitch, have become a benchmark for regulation of financial markets. Legal policies require certain institutions to hold investment graded bonds. Bonds are classified to be investment graded based on their ratings by these agencies, any corporate bond with a rating higher than BBB is considered to be investment graded bond.

Estimation of Risk Premiums

The credit ratings provided by these agencies are used by various banks and financial institutions in determining the risk premium they will charge on loans and corporate bonds. A poor credit rating implies a higher risk premium with an increase in the interest rate charged to corporations and individuals with a poor credit rating. Issuers with a good credit rating are able to raise funds at a lower interest rate.

Enhanced Transparency in the Credit Markets

The credit rating agencies provide improved efficiency in the credit markets and allow for more transparency in dealings. The ratings help monitor the credit soundness of various borrowers through a set of well-defined rules.

Standardization of the Evaluation Process

Most credit agencies use their own methodology for determining credit ratings, but since only a handful of popular credit rating providers exist, this adds a great deal of standardization in the rating process. The credit ratings of different borrowers can be easily compared using ratings provided by a credit rating company and the applications can be easily sorted.

What is the role of Credit Rating Agencies in the financial crisis on Wall Street?

Credit rating agencies compile consumer information that they receive from lenders and other related companies and assign borrowers a score based on their short and long term uses of credit. They exact methods used to assign one score or another are not nearly as important, though, as how much weight lenders place on credit reports when determining whether someone deserves a home or not. 

During the housing boom, virtually the entire loan application process depended on the borrowers' credit scores. If a home buyer had displayed responsible use of credit, a prime loan was almost guaranteed, while debtors with lower credit scores were often given subprime mortgages to purchase or refinance a house. In any event, other qualifications like down payment and stable income history became far less important than having a high credit score. 

One of the maxims of stock market investing has always been that "past performance is no indication of future results." However, this is exactly what mortgage lenders were counting on by giving huge sums of money to people who had good credit histories but little money or other resources to meet a financial hardship. Wall Street was willing to give mortgages to people and then hoped that they would pay reasonably on time, since they may have done so somewhat consistently in the past. 

With the right subprime lender, even previous foreclosure victims and those who had filed bankruptcy numerous times in the past could obtain a loan to purchase a new house. Some banks specialized in such difficult to place mortgages, knowing it would be easy to increase fees and the interest rate of the loan because of the poor credit history. This meant more income for banks, investment firms, and investors, until the homeowners inevitable defaulted on their mortgage again. 

The ratings agencies did not substantially alter their methods of scoring loan applicants or borrowers in general during the run-up in housing prices from the late 1990s to the middle of this decade. It was mortgage lenders that ignored other previously important loan qualification criteria and placed too much faith in simply having a good credit score. And having a somewhat poor credit history just meant more fee and interest income for the banks, so even that was no barrier against obtaining a mortgage. 

While home prices were rising every year, this strategy made some sense for the banks, who could just loan money to everyone, collect the payments, and then foreclose on the house later on if necessary, selling it for a profit on the open market. But when home values began falling, investors realized they had been stuck with toxic loans going delinquent by the hour, and no one was buying the foreclosed properties at all anymore, let alone at a profit. Many lenders went out of business, while others began to tighten up lending guidelines. 

It was at this point that the credit rating agencies began to take a more traditional role in the lending process. A good credit score more important than having any credit score at all, and mortgage companies began to focus on other factors like down payments and having a job that produced enough income to pay the mortgage. This is a more reasonable role for credit agencies, as a guide to assist mortgage companies in viewing a complete picture of a borrower's ability to pay a loan, instead of as the sole determinant of fee and interest income for every loan applicant.

IBA (INTERNATIONAL BAR ASSOCIATION)- RATES CREDIT RATING AGENCIES

THE US AND COUNTRIES ACROSS EUROPE HAVE BEEN HUMBLED BY DOWNGRADES FROM THE

HUGELY POWERFUL CREDIT RATING AGENCIES. AS MARKETS REACT RUTHLESSLY TO THEIR

PROCLAMATIONS, AND GOVERNMENTS TOPPLE THROUGHOUT THE EUROZONE, IBA GLOBAL

INSIGHT ASSESSES THEIR INFLUENCE.

In August 2011, credit rating agency Standard & Poor’s (S&P) downgraded the United States’ top-notch AAA

credit rating for the first time ever. The company cut the long-term US rating by one notch to AA+ with a

negative outlook, arguing that the deficit reduction plan passed by the US Congress did not go far enough.

The decision sent shockwaves through the world of finance and provoked an angry reaction from the US

Government. John Bellows, Acting Assistant Secretary for economic policy at the US Treasury, claimed the

firm’s analysis contained a major mistake that led it to ‘dramatically overstate projected deficits – by $2 trillion

over ten years’.

Regardless of S&P’s ‘mistake’, Bellows said there was ‘no justifiable rationale’ for the downgrade. ‘There are

millions of investors around the globe that trade Treasury securities,’ he said. ‘They assess our

creditworthiness every minute of every day, and their collective judgment is that the US has the means and

political will to make good on its obligations

Edward Greene, senior counsel at Cleary Gottlieb in New York and a member of the IBA’s Task Force on the Financial Crisis, says the stinging rebuke reflects the frustrations felt by sovereign states at not getting a chance to review and dispute their rating and provide alternative evidence to be taken into account. ‘This is a pretty opaque process, especially with respect to sovereign debt,’ he says, primarily because it is not clear how much information rating agencies can access. ‘How can they be sure about the overall economic condition of Greece, for example, given that no one else seems to know what it is?’

This is not an issue when the agencies are rating companies, as it is clear they have access to reported

information and can hold meetings with representatives of the organisations seeking the rating. ‘With

sovereigns it’s basically what’s out in the market and then it’s down to their judgment,’ says Greene. ‘In their

rating of the US, S&P said they were taking into account the likely political paralysis that would prevent any

kind of systemic addressing of the deficit. So they’re making judgments on political stability and political

willingness to deal with certain economic problems as much as on economic conditions. It’s pretty subjective.’

The credit rating agencies: Power, responsibility and accountability

By Robert D. Piliero, Esq., Butzel Long 

(Robert D. Piliero is a shareholder in the New York office of Butzel Long with extensive experience in complex commercial and securities litigation, with specific emphasis in recent years in litigation arising from the global credit crisis.  The opinions expressed are those of the author and do not necessarily reflect the views of the firm or its clients.  This article is for general information purposes and is not intended to be and should not be taken as legal advice.) 

The credit rating agencies are balanced at the fulcrum of bond issuers’ financial success or failure.  Standard & Poor’s, Moody’s, Fitch and a few other credit rating agencies determine the cost of capital and in many cases whether capital can effectively be raised at all.  They evaluate the creditworthiness of bonds issued not only by manufacturers, tech companies and financial institutions, but even by sovereign states.

The most notorious example of the extent of this unelected, inadequately regulated, quasi-governmental power was the decision of S&P to reduce the credit rating of debt issued by the United States itself.  Not even the most casual observer could legitimately dispute that these arbiters of “good” and “bad” credit risks wield enormous economic power.  It was not always so.

Before 1975, credit rating agencies used publicly available information about corporations to generate unsolicited opinions about the creditworthiness of the corporations they

reviewed, and their compensation was paid by potential investors wishing to view those opinions before making an investment decision.  There was thus no question of bias or impaired judgment based on the self-interest of the credit rater.  The credit rating agencies nonetheless prospered because they performed a valuable service and they were perceived to be quite proficient at it.

Over time, the independence and reliability of their opinions came to be regarded as so unimpeachable that the Securities and Exchange Commission decided to confer the special status of “nationally recognized statistical rating organization,” or NRSRO, on the most credible and reliable of those organizations.  That occurred in 1975 and unexpectedly became one of the many elements that ultimately enabled the current global credit crisis.

Although the credit rating agencies are supposed to be regulated by the SEC (the Credit Rating Agency Reform Act of 2006 prohibits states and municipalities from regulating the substance of credit ratings), that oversight has been sporadic and anemic at best.  That may be an obsolete vestige of the credit rating agencies’ early history of independence and reliability, or it may simply be the result of generally inadequate governmental oversight.

Despite this regulatory torpor, however, numerous federal regulations continue to exalt the role of credit rating agencies by making investment-grade credit ratings a central touchstone in the selection of investment alternatives available to certain fiduciary investors.  But even if that were not the case, credit ratings have historically been so firmly ensconced as presumptively reliable indicators of quality and creditworthiness that no issuer of a debt instrument would even consider going to market without purchasing a credit rating from an “independent” NRSRO.

Credit ratings have thus become the nearly universal and indispensable tickets to the marketplace for debt instruments, as issuers, investors and the credit rating agencies themselves are well aware.  The position of great power that has thereby been conferred on the credit rating agencies has regrettably not been accompanied by a commensurate level of public responsibility or, until recently, any meaningful threat of accountability.

THE GLOBAL CREDIT CRISIS

The global credit crisis that began in 2007 and peaked in 2008 and 2009, with the economic aftershocks still being felt globally with no sign of abatement, is largely traceable to the residential real estate mortgage market.  The furnace that created the financial meltdown was fed by blind and unreasonable market optimism, a characteristic that was indelibly labeled as “irrational exuberance” less than a decade earlier regarding another type of investment: dot-com companies with stunning and ever-escalating market capitalizations despite their lack of revenues, or indeed in many cases even a viable revenue model.

In the current debacle, the irrational belief was that real estate values could and would always continue to appreciate and that they would do so at a significant pace.  This near-universal transformation of otherwise sensible and somewhat conservative homeowners into a nation of Ralph Kramdens, when coupled with sharply reduced credit underwriting standards for mortgages, coalesced to create an unsustainable level of mortgage debt.

That problem was, in turn, compounded many times over by the facts that:

•  Mortgage originators almost universally sold the mortgages they had approved, thereby escaping financial

responsibility for the losses that would flow from their own relaxed (in many cases essentially nonexistent) credit standards.

•  The mortgages were then packaged into so-called residential mortgage-backed securities, or RMBS, which were then resold and repackaged, in some cases several times over, into collateralized debt obligations, or CDOs, and other structured finance products, which were then sold to investors.

The results are by now well-known.

THE PARTICIPATION OF THE CREDIT RATING AGENCIES

This is how the role of the credit rating agencies was described by the Financial Crisis Inquiry Commission in January 2011: 

The 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’

judgment was baked into collateral agreements and other financial contracts.1 

The performance of the credit rating agencies as essential participants in this market has been abysmal.  In September 2011 Moody’s reported that new “impairments,” that is, non-payments, of principal and interest obligations owed to investors through these structured-finance products soared from only 109 in 2006 to 2,153 in 2007 to 12,719 in 2008 and peaked at 14,242 in 2009, but with still more than 8,000 new impairments in 2010.2  Thus, more than 37,000 discrete investment products defaulted in that time period.

Analysts have calculated that although investments holding triple-A ratings have traditionally enjoyed a default probability of less than 1 percent, more than 90 percent of the triple-A ratings given to subprime RMBS securities

originated in 2006 and 2007 were later downgraded to junk status.

According to an April 2011 report of the Senate Permanent Committee on Investigations, in 2006 and 2007, the credit rating agencies placed their investment-grade imprimatur on complex mortgage-backed derivative products “despite signs of a deteriorating mortgage market,” and then precipitously downgraded those same products only six months later.3  

According to the report, “the July [2007] mass downgrades, which were unprecedented in number and scope, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the beginning of the financial crisis.”4 

The financial impact on investors, including municipal pension funds and the retirement plans of their fund beneficiaries, has been devastating.

CREDIT RATING AGENCY FAILURES

Substantial evidence has suggested that this epidemic of ratings “errors” was not the product of mere negligence, but rather was the direct and foreseeable consequence of the credit rating agencies’ business models and their largely undisclosed economic partnerships with the issuers that paid them for their investment-grade ratings.

It is well known that at some point, the historical revenue model in existence at the time that NRSROs were anointed by the SEC as unbiased and objective evaluators of creditworthiness (“investors pay for independent credit opinions”) was converted into an “issuer pays” model, which produced far more predictable streams of revenue and far, far greater profits.

Less widely reported, however, is the fact that the new revenue model also provided that in most cases, the credit

rating agencies’ compensation was conditioned on a successful placement of the bonds to investors.  Put another way, the higher the rating, the more likely there would be a successful debt placement, and the more likely the credit rating agencies would have a lucrative payday.

Evidence shows that this combination of incentives was more than adequate to unleash the bias in the formerly unbiased.  The appearance of credit rating agency independence nonetheless continued to exist until it was too late to avoid the staggering losses in the junk bonds that had been awarded “investment-grade” status.  Unfortunately, securities regulators were among the groups that failed to recognize that the paradigm of independence and reliability that was historically attributed to credit rating agencies had been replaced by “caveat emptor.”

This unannounced off-loading of independence, which was undoubtedly spawned by this change in revenue model, appeared in many forms.  It is by now widely known, for example, that the credit rating agencies:

•  Were chronically understaffed.

•  Failed to perform loan-level review of RMBS and CDO products.

•  Failed to account adequately for the significant correlation risks.

•  Systematically awarded investment-grade ratings that were not warranted by their own rating models.

•  Continued to use their own admittedly outdated rating models long after they ceased to be valid.

•  Failed to monitor the ratings they had issued to detect whether downgrades were required.

It has been reported that credit rating agencies even provided their customers with access to their proprietary rating software and models, and turned a blind eye as their customers made superficial changes to deal parameters so as to appear entitled to better ratings.

Where that exercise was inadequate to achieve the desired result, the deal sponsors issued, and the credit rating agencies approved, “waivers” of noncompliance with deal guidelines.  In some cases, the nature and extent of noncompliance that should have required a lower credit rating was so broad that waivers were given to as much as 50 percent of the loans in a pool.

And these noncompliance points were not merely technical in nature.  By some accounts, in some cases, credit rating agencies issued investment-grade ratings despite the fact that more than 46 percent of the loans in some of the asset pools failed to meet underwriting standards, because the issuing banks were willing to “waive in” nearly 40 percent of defective loans, without disclosure to investors.

One inevitable result (a cynic might suggest it was an intended result) of this pattern of conduct was that, even as market conditions continued to deteriorate in 2007, these unjustifiably enhanced ratings enabled issuers — the credit rating agencies’ customers and paymasters — to unload their own distressed portfolios into new CDOs and CDO-squared products5 and then sell the resulting tranches at significant premiums to actual value because of the inflated ratings, thereby transferring their unrealized losses to pension funds and other institutional investors.

THE LEGAL RESPONSE SO FAR

Because a comprehensive understanding of the credit ratings agencies’ misconduct did not begin to emerge until the

release in January and April 2011 of the two governmental reports mentioned above, credit rating agencies have not been as obvious a target for widespread and significant litigation as the banks that structured the financial products or the financial services organizations that marketed and sold them.  Attempts to hold credit rating agencies strictly liable under Section 11 of the Securities Act of 1933 as underwriters of the debt they rated have been unsuccessful.6  

Several cases asserting claims against the credit rating agencies based on theories of common-law fraud and negligent misrepresentation have met with mixed results at the pleading stage, with some dismissal motions granted and others denied.  Where dismissal motions were unsuccessful, the credit rating agencies have often entered into confidential settlements.  No case alleging credit rating agency liability has yet proceeded to trial.

In virtually all cases, the credit rating agencies have postured themselves as journalists whose credit “opinions” are supposed to merit protection under the First Amendment.  Surprisingly, there is language in some cases, including Ohio Police & Fire Pension Fund v. Standard & Poor’s Financial Services,7 that actually accepts the “we are journalists and these were our opinions” defense, despite the clearly commercial nature of the speech.

But to be fair, that decision and the few others like it dealt with complaints that were prepared without the benefit of the detailed findings contained in the 2011 reports of the Financial  Crisis Inquiry Commission and the Senate Permanent Committee on Investigations referred to above.  All courts that have considered the First Amendment issue in the context of well-pleaded allegations of the kind of fraudulent conduct described in those reports agree that the

“free speech” defense is unavailable.  Some courts have gone further, holding that credit ratings are not predictive opinions at all, but statements assessing current value.8 

The most recent high-visibility opinion addressing the First Amendment defense was the January 2012 decision in California Public Employees’ Retirement System v. Moody’s Corp., which denied the credit rating agencies’ special motion to strike based on California’s anti-SLAPP statute.9 

After concluding that the credit rating agencies had made a threshold showing that the challenged cause of action arose from the presumptively “protected activity” of free speech involving a public issue, the court nonetheless held that CalPERS had pleaded sufficient facts to support its claim of negligent representation. Cross-appeals have been filed and the briefing schedule that was set suggests no appellate decision will be rendered until next year.

It is noteworthy that, as with Ohio Police & Fire Pension Fund, CalPERS filed its complaint in July 2009, before the full extent of the credit rating agencies’ abuses had been documented in the two federal reports noted above. Despite that, however, the California court still found the material allegations sufficiently well-pleaded to survive the credit rating agencies’ First Amendment defense.

Another defense favored by the credit rating agencies is that investors lack standing to assert claims against them for negligent misrepresentations or fraud because the “opinions” they issued were solely for the benefit of the issuer that paid for them and, beyond that — if at all — only for the benefit of any investors that had been specifically identified and that the credit rating agencies knew would be relying on the credit ratings.

This defense likewise found some traction in the earlier cases on the ground that a defendant cannot be found liable for negligent misrepresentation in the absence of a “special relationship” with the plaintiff, a relationship the credit rating agencies claimed did not exist.

That defense was most recently, and quite persuasively, rejected by U.S. District Judge Shira Scheindlin of the Southern District of New York in King County v. IKB Deutsche Industriebank AG.10  In a scholarly and detailed opinion spanning 60 pages and supported by more than 200 footnotes, the judge held, among other things, that the credit rating agencies most assuredly did have a “special relationship” with, and therefore owed a special duty to, the pool of investors to which the investment was targeted.

Judge Scheindlin recognized the existence of that special relationship because the ratings were prepared with the “end and aim” of inducing the targeted investor pool to make those investments.  She thus found that the rating agencies intended that:

•  Their ratings would be used to evaluate the rated investment.

•  The targeted pool of eligible investors would rely on those ratings.

Judge Scheindlin recently denied the defendants’ motions for reconsideration and for permission to take an interlocutory appeal.11 

Just as the escape routes favored by the credit rating agencies are being blockaded with more regularity, the intensity of the attacks on them has escalated as well.  Last January, the state of Illinois sued Standard & Poor’s Financial Services LLC and its parent company.12  The first paragraph

of the complaint, brought under the Illinois Consumer Fraud and Deceptive Business Practices Act, 815 Ill. Comp. Stat. 505/1-1, and the Uniform Deceptive Trade Practices Act, 815 Ill. Comp. Stat. 510/1-1, sets the tone for the state’s case:

This lawsuit seeks redress for S&P’s unfair, deceptive, and illegal business practice of

systematically misrepresenting that its credit analysis of structured finance securities was

objective, independent and not influenced by either S&P’s or its clients’ financial interests.  These

representations were untrue.13 

The detailed factual allegations, spanning 47 pages and 171 paragraphs of the complaint — many with quotations from S&P’s own internal correspondence — provide robust factual support for this blistering attack.

CONCLUSIONThe leading credit rating agencies, including Moody’s and S&P, have adopted the International Organization of Securities Commissions’ “code of conduct fundamentals for credit rating agencies” as part of their own codes of conduct.  A central tenet and representation of all these codes is the assurance of integrity and independence in the issuance of credit ratings.  Assurances such as these are common in the marketing materials and on the websites of financial services organizations.

In Richman v. Goldman Sachs Group, a class-action lawsuit brought by a Goldman Sachs shareholder in the aftermath of the Abacus debacle and Goldman’s payment of the largest penalty in SEC history, the plaintiffs based their fraud claim in part on similar assurances of integrity.14 Goldman’s motion to dismiss argued, in part, that such assurances could not form the basis for a fraud claim because they were mere “statements of opinion” and “puffery.”

In a June 21 opinion rejecting that argument, U.S. District Judge Paul Crotty of the Southern District of New York made

an observation that will be instructive in the event the credit rating agencies seek the same unworthy safe haven from their own assurances of integrity.  Labeling Goldman’s argument “Orwellian,” Judge Crotty observed:

Words such as “honesty,” “integrity,” and “fair dealing” apparently do not mean what they say; they do not set standards; they are mere shibboleths.  If Goldman’s claim[s] of “honesty” and “integrity” are simply puffery, the world of finance may be in more trouble than we recognize.15 

The barricades shielding the credit rating agencies from accountability for their indispensable contribution to the global credit crisis appear to be falling.  An update to this article, or one like it, in six months may well have a great deal more activity to report on this front.

HOW DO RATING AGENCIES MAKE THEIR DECISIONS?

THEY LOOK AT THE PROBABILITY OF DEFAULT OF THE COUNTRY.

THEY LOOK AT VARIOUS INDICATORS LIKE THE SIZE OF ITS DEBT

COMPARED WITH GDP, ITS ABILITY TO COVER INTEREST PAYMENTS

ON TIME AND SO ON. WHAT THEY’RE MEASURING IS ESSENTIALLY

THE PROBABILITY FROM AN INVESTOR’S PERSPECTIVE THAT THERE

MAY BE SOME DELAY IN RECEIVING INTEREST OR PRINCIPAL

REPAYMENTS AND THE POSSIBILITY OF LOSS.

Why do they do this?

In general investors struggle to assess the likelihood of default or the risk of a

particular issuer of debt and also it’s become commonplace for a lot of

investors such as fund managers and institutional investors to have

requirements that they are only allowed to invest in certain types of securities

that meet various standards – which have been created by the ratings

agencies.

For example, ratings of BBB+ have become regarded as investment grade

and institutions like superannuation funds or various university endowments

may have restrictions on investing only in investment-grade bonds.

Do the ratings vary much between agencies?

Not a lot, no. They have different symbols, one of them will use AAA, one

might have Aaa, but you can relate them fairly closely and its not often that

you get what is referred to as split ratings, which is where they have a

difference in the rating. Typically if they have a split rating, the difference is

only fairly minor.

If there was a downgrade of the US AAA rating, what would happen first?

One consequence is that the US government would be very angry! In general

the effects are probably not going to be too dramatic, but it’s very hard to tell.

This may be a case where the ratings agencies’ opinions are not going to be

regarded as highly as they might otherwise be.

People in general would perceive the US as unlikely to actually default on its

debt; it may be that there could be some delay of interest payments, but I

understand they are reaching an agreement on expanding the debt ceiling, so

there is no current issue if that’s the case.

Could a downgrade happen anyway?

Yes, because of what might happen in the future, because we’re talking about

debt securities which in the US case stretch out to 30 years maturity.

What would be the impact on Australia?

If there was a ratings downgrade you would probably expect to see some

decline in the price of US government bonds so to the extent that Australian

superannuation funds are holding those they will probably suffer a decline in

the market value of those assets. Realistically, in terms of the long run stream

of interest and principal repayments, it wouldn’t have that much effect.

However, if investors worldwide decide to divest their holdings of government

securities around the world, then Australian government bonds start to look

attractive. The only problem there is not very many of them to go round.

(Because Australian bonds can only be purchased in Australian dollars, this

increases demand and pushes the Australian dollar higher.)

The influence of ratings agencies has been highly debated, haven’t they?

Yes, the ratings agencies got a lot of stick during the global financial crisis

because they were rating a whole lot of very complex securities and had

conflicts of interests in terms of the ratings, because they were also providing

information to the issuers of the products about what characteristics those

products had to have in order to get a AAA rating.

As hindsight shows very clearly, lots of things that were rated AAA were a

long way from AAA. That reflected the fact that in general people didn’t

understand the risks associated with lots of those securities.

It’s interesting how the ratings agencies have managed to bounce back very

strongly from all of the bad press they get during the global financial crisis and

seem to have moved back into a very strong position in terms of their role in

financial markets.

Is that warranted? Have they addressed these faulty practices?

In general ratings agencies have tried to put in place much better governance

arrangements, but I think there is still potential for international regulators to

demand more of them.

Certainly there were a number of multinational agencies which had various

proposals for ratings agencies, but I think in general the governance has

improved, although it’s early days to make a firm judgement on that.

Those proposals didn’t get very far.

No. The ratings agencies have managed to escape fairly well from all of this.

One of the issues that will have to occur in the next few years is the extent to

which the legal privilege of ratings agencies decline in the US and also the

extent to which there will be the growth of new competitors for them.

Effectively there has only been the three major agencies operating – Standard

& Poors, Moody’s and Fitch.

One of the things they have going for them is that even though they are in a

position of significant influence, because of the way in which they are

legislated in the US they are effectively regarded as giving their opinion and

not subject to legal liability on people acting on their ratings.

This is not the case in Australia, where in the last couple of years, if retail

investors were utilising any ratings information, ASIC has required agencies to

hold an Australian financial services licence and be members of an external

dispute resolution scheme.

THEY DO NOT RATE THE COMPANIES, BUT THEIR

INDIVIDUAL DEBT SECURITIES.

Key areas considered in a rating include the following:i) Business Risk : To ascertain business risk, the ratingagency considers Industry's characteristics, performanceand outlook, operating position (capacity, market share,distribution system, marketing network, etc.), technologicalaspects, business cycles, size and capital intensity.ii) Financial Risk : To assess financial risk, the rating agencytakes into account various aspects of its FinancialManagement (e.g. capital structure, liquidity position,financial flexibility and cash flow adequacy, profitability,leverage, interest coverage), projections with particularemphasis on the components of cash flow and claimsthereon, accounting policies and practices with particularreference to practices of providing depieciation, incomerecognition, inventory valuation, off-balance sheet claimsand liabilities, amortization of intangible assets, foreigncurrency transactions, etc.iii) Management Evaluation : Management evaluation includesconsideration of the background and history of the issuer,corporate strategy and philosophy, organisational structure,quality of management and management capabilities understress, personnel policies etc.iv) Business Environmental Analysis : This includesregulatory environment, operating environment, nationaleconomic outlook, areas of special significance to thecompany, pending litigation, tax status, possibility of defaultrisk under a variety of scenarios.

In India, at present, there are four credit Rating Agencies:i) Credit Rating and Information Services of India Limited(CRISIL).ii) Investment Information and Credit Rating Agency of IndiaLimited (ICRA) .I iii) Credit Analysis and Research Limited (CARE).iv) Duff and Phelps Credit Rating of India (Pvt.) Ltd.

AkM indicates highest safety of timely payment of interestand principal.AA indicates high safety of timely payment of interest andprincipal.A indicates adequate safetv of timely payment of interestand principal.

A credit rating agency gives a forward-looking opinion about the creditworthiness of a borrower with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program. 

A rating takes into consideration the creditworthiness of guarantors, insurers, or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated. Issue of credit ratings can be either long term or short term depending on the nature of the obligations. In the US, for example, that means obligations with an original maturity of no more than 365 days–including commercial paper. 

The United States, which till now enjoyed the highest credit rating of AAA from S&P, has just seen a down grade for the first time in ithe country’s history to AA+, which means ‘very strong capacity to meet financial commitments’. 

India’s current credit rating by S&P is BBB- (BBB minus), which, according to S&P definitions is considered lowest investment grade by market participants. 

Despite the weak rating, S&P in its statement said “We expect India’s fiscal consolidation to continue in the next few years, supported by a strong growth momentum. The stable outlook reflects our view that India’s external flexibility and fiscal performance will temper the effects of inflation and political uncertainty.”

Different agencies use different symbols and definitions for credit ratings and their ratings for the same entity can also vary. 

The definition of ratings

The general meaning of S&P’s credit rating opinions is summarised below:

AAA: Extremely strong capacity to meet financial commitments. This the highest Rating.

AA: Very strong capacity to meet financial commitments.

A: Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.

BBB: Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

BBB-: Considered lowest investment grade by market participants.

BB+: Considered highest speculative grade by market participants.

BB: Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

B: More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

CCC: Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.

CC: Currently highly vulnerable.

C: Currently highly vulnerable obligations and other defined circumstances.

D: Payment default on financial commitments.