Credit rating agencies are responsible for providing institutional, as well as individual investors with important information to assess the quality of debt obligations and securities. In assessing the financial strength of companies and government entities, credit agencies are able to give a rating for an issued debt that reflects the confidence of the issuer to meet obligations and promised interest payments.
Their function in facilitating a better understanding between the borrower and lender is vital in creating a more informed environment for the globalized investment market, in which diversification and risk management still remains a big challenge for both the institutional and individual investor.
A brief history of Credit Rating Agencies
At present, there are 3 largest and most reputable credit rating agencies, mainly known as Moody's, Standard & Poor's and Fitch's. In recent years, another agency A.M. Best has gained popularity in specializing in issuing financial ratings for insurance companies.
Credit ratings gained its popularity in the 1900s due to the creation of a large market in US railroad companies issuing bonds. While the bond markets had already existed for centuries, they were mainly comprised of sovereign debt between countries, mainly the Dutch, English and the American governments. [Evolution of credit ratings, Ruth Rudden, 2005]By the early 1900s, the corporate bond market, given the rapid development of the huge market in railroad companies issued bond debt was several times larger than that of the combined sovereign debt bond markets. Moody's was the first credit rating agency, set up in 1909 by John Moody to provide analytical information about the value of securities. By 1924, Moody's ratings covered nearly 100 percent of the US bond market. [Moody's Corporation, Moody's history: A century of market leadership]
Standard Statistics and Poor's Publishing, both in the business of securities analysis, merged to form Standard and Poor's Corporation in 1941. Today, Standard and Poor's has the world's largest market share on the credit ratings and are perhaps best known to investors for providing stock market indexes, such as the S&P 500, which serves as an important indicator on the US economy. [A Brief History of Credit Rating Agencies, Denise Finney]
Fitch Publishing Company was founded in 1913 by John Knowles Fitch. Fitch Company started off by publishing financial statistics for the investment industry. Later in 1924, they introduced a system of ratings from AAA to D, which has now evolved to become the industry standard for rating corporate and municipal bonds.
In 1970, the National Recognized Statistical Rating Organizations (NRSRO) was established. Before this, investors were the buyers of credit ratings while the corporate issuers of bonds were not required to pay any fees to the credit rating agencies. The NRSRO began to implement important changes to the industry, observing that good ratings handed out by the credit rating agencies were facilitating the securities issuers by increasing their value in the market, and significantly lowering the costs of obtaining capital. This led to the industry wide implementation of imposing fees on the issuers for rating services from the credit rating agencies. This was both a logical and economical decision, as the expansion and complexity of capital markets saw an increasing demand for more statistical and advanced analytical models to derive credit ratings.
Credit Ratings and Securitization Design
Credit ratings on corporate debt are assessed based on the issuers' credit worthiness. Rating agencies claim that ratings assigned are comparable across assets. "The comparability of these opinions hold regardless of the country of the issuer, its industry, asset class or type of fixed income security," released in a presentation on May 2004 by Federic Drevon, Moody's Senior Managing Director.
Given that assigned ratings are based on expected default by the issuer, a security with a higher probability of default (lower rating), would require a higher coupon rate as compensation to the investor. By offering high coupon rates to the investors, the cost of obtaining capital would prove very expensive to the issuer. As such, issuers would use credit enhancements to improve credit worthiness, and in turn raising their credit ratings. Some methods of credit enhancements are as discussed below.
Over-Collateralization: The issuer could back the loan with assets that are in excess to loan, and thereby limiting the risk to the creditor. For example, a company could place an asset such as a building worth $300,000 in exchange for a loan worth $250,000.
Reserve Accounts: By maintaining a reserve account, the issuer would have to set aside cash reserves up to a proportion of the loan. For bonds, this provision would be equivalent to having a sinking fund on the assigned debt. This would provide added insurance to investors that the issuer is able to service interest payments and even to a certain fraction of the principal amount of the loan.
Excess Spread: Usually applied for asset-backed securities. Excess spread is to maintain a difference between payments receivable from underlying collateral and the coupon of the issued debt. This would ensure that coupon payments to creditors could be made even in events when underlying loan payments receivables are late or defaulted.
Credit ratings during the US housing boom
The development of the financial markets and creation of complex securities through financial engineering meant that the role of credit rating agencies were increasingly important in maintaining a fair handshake between the issuer and lender. Rating complex instruments such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO), and given the boom of the housing industry in the US prior to 2005 meant that credit rating agencies such as Moody's, Fitch's and Standard & Poor's were reaping in lucrative profits.
Credit rating agencies were helping issuers of mortgage-backed securities (MBS) on how to develop their financial instruments in a way that would receive the best possible ratings. This was achieved by structuring tranches within an underlying MBS or CDO asset pool.
The main purpose of tranching was to maximize the size of the highest rating class such that the issuer would be able create an asset class with higher credit rating than the average rating of the asset pool. Credit rating agencies would then rate each tranche individually, based on their quality of credit worthiness. As result of this, at the height of housing industry boom, almost all senior tranches had the highest rating of AAA. [What role did CRAs play in the financial crisis, Amanda Bahena]
The Subprime Mortgage Crisis and AAA-rated Securities
In the years before the mortgage crisis took place in 2007, the behavior of issuers of loans changed dramatically. More loans were being offered to high-risk borrowers in a bid to reap in higher profits. In addition, loans were known to include risky options and borrowing incentives in their contracts to attract home buyers. However, investment grade ratings were given to MBS that were created based on these risky subprime mortgage loans. These MBS were then sold to investors, mainly financial institutions, and fueling the housing boom. The demand for MBS grew to be very heavy, with US investors and others from all over the world being attracted to these AAA rating securities that promised an attractive return, believing that these almost riskless investment was as safe as putting their money in a bank.
Up to 2006, the US market for housing was flourishing and more people were rushing to buy houses. Banks started to loosen their criteria for obtaining loans, as every other competitor bank was doing the same. The banks believed that they were in a covered position, having bought these MBS and selling them to Wall Street, which was then distributed to global investors.
Eventually, housing prices began to rise so steeply such that the average household income could not match these high prices. Mortgage lending companies began to face a big problem with people defaulting on their very first mortgage payment. With a huge oversupply of people putting back their housing properties due to defaulting mortgages, and lack of buyers in the market, house prices plunged in late 2006. Unfortunately, all sorts of investors around the world had bought the AAA-rated securities began to realize the true risk of their investments. However, the financial market was already intertwined by these derivatives that were changing hands between individuals and large financial institution, and many were not spared from the crisis when the securities were now worth easily half of its original value.
Criticism of Credit Rating Agencies
Credit rating agencies have come under huge criticisms of late, due to the role that they played leading to the financial crisis. Discussed below are some of the following criticisms:
Credit rating agencies have been irresponsible in their duties by giving AAA credit ratings to structured products that were very risky. AAA ratings meant that these investments were supposed to be as safe as the US Treasury bonds which yielded systematically lower returns in comparison. Many of these products were subsequently defaulted or downgraded, leading many to question the ability of credit rating agencies to provide reliable ratings in the first place.
There were conflicts of interest between credit rating agencies and the issuers of securities, leading to highly inflated ratings. Credit rating agencies were supposed to serve investors by providing a neutral and objective view for making decision on their investments. However, credit rating agencies maintained close working relationship with the issuers of these structured products and in many situations, advised their clients on how to obtain the best possible credit ratings. Understandably, almost all of the ratings published were paid for by the issuers, and not investors themselves. Therefore, an incentive exists for credit rating agencies to produce objective ratings to maintain ongoing business with the issuers.
It is argued that credit rating agencies placed over-reliance on statistical and mathematical methodologies to derive their ratings. These methodologies were mainly based on inadequate data and inaccurate assumptions, which comprised of historical data for calculations. The failure to take into considerations the market and macroeconomic developments as important factors for ratings led to the shortcomings of credit ratings being overestimated. [The financial crisis and the regulation of credit rating agencies: A European banking perspective, Siegfried Utzig, Jan 2010]
Basel II Accord
In June 2004, central bank governors and the head of bank supervisory authorities from the G-10 countries endorsed the Basel II framework. The New Basel Capital Accord consisted of three mutually reinforcing pillars.
Pillar 1: Sets the minimum capital requirements for credit, market and operational risks
Pillar 2: Requires banks to assess their capital requirements in relation to their risk and supervisors to take action if risks are too high
Pillar 3: Establishing core disclosure by banks in order to improve market discipline
The Basel Committee developed the so-called "standardized approach" for calculating regulatory capital for credit risk. The standardized approach uses external ratings such as those provided by "external credit assessment institutions" to determine risk-weights for capital charges.
The increased role given to credit rating agencies in the standardized approach to credit risk has led to many reactions from national supervisors and academic researchers. On the supervisory side, many studies and enquiries into the work and functioning of credit rating agencies have been launched with the aim of better understanding the credit rating industry and making policy recommendations to reform it (e.g. Basel Committee [2000] and Securities and Exchange Commission [2003]). On the academic side, many studies have pointed to some potential dangers of linking regulatory risk-weights to credit ratings, which would lead to greater capital requirements (Amato and Furfine, 2003) and a greater volatility of capital requirements for banks (Ferri et al., 2001).
The minimum capital requirements for credit risk in Basel I and Basel II are set according to the following formulas:
