Credit Rating Agencies. What Impact Do They Have and Do We Really Need Them?

Table of Contents

Executive Summary

Table of Contents

List of Abbreviations & Symbols

List of Tables

1 Introduction
1.1 Problem Definition and Objective
1.2 Scope of Work

2 Background on Credit Rating Agencies
2.1 Definition, Purpose and Function
2.2 Structure of Credit Rating Process
2.3 Market Structure of Credit Rating Agencies

3 Impact of Credit Rating Agencies in the financial world
3.1 The Collapse of Enron and other examples
3.2 Critical Analysis of CRAs
3.3 Learnings and regulatory solutions

4 Conclusion and Outlook

Bibliography

List of Abbreviations & Symbols

Abbildung in dieser Leseprobe nicht enthalten

List of Tables

Table 1: Overview Long-term Credit rating grades in decreasing order of quality

Table 2: Number credit ratings per NRSRO and rating category

Executive Summary

In the last few years Credit Rating Agencies have come under a lot of criticism, especially because the credit risk of structured credit products has been underestimated or has been communicated too late by CRAs which led to issues at the macro-economic level like the case of Greece in 2010 as well as at the micro- economic level like the case of Enron from 2001 or the case of Lehman Brothers from 2008 has shown.

CRAs are private, profit-oriented companies which evaluate credit risks of organizations like governments, financial or non financial institutions that issue debt in public markets. While assigning a letter grade to a bond, which represents an opinion, CRAs indirectly inform if the organization is able to pay back capital and interest in time. In an oligopoly market with a total revenue of €4,1 billion and a growth rate of 22.4% since 2010, there are three main competitors, whereas over 150 different CRAs are known. The so called "Big Three" have a share of around 95% of the market. This assignment analyses the impact of Credit Rating Agencies on the financial market focusing on corporate institutions. In the case of Enron, a former American energy, commodities and services company, it received good credit ratings up until four days before bankruptcy. Other examples like Lehman Brothers or WorldCom show, that Moody's, S&P and Fitch still rated these companies as safe investments days before their bankruptcy. Credit Rating Agencies influence about 80% of the world market capital. The industry is dominated by S&P and Moody's which lead to a lack of competition.

Ratings have an impact on the overall economic performance, recently proofed by the financial crisis caused in the US subprime mortgage market. The conflict of interest occurs from the issuer-pay model where almost all credit ratings are paid by the issuer of the instrument. CRAs are governed by the International Organization of Securities Commissions (IOSCO) which established a "Code for Conduct Fundamentals" for CRAs, a voluntary code without enforcement mechanisms.

Authorities have responded with a range of regulatory reforms. There is currently no consensus on a common set of reform. The overall rating agencies do not take any responsibility for damage caused to governments or investors.

1 Introduction

1.1 Problem Definition and Objective

John Moody has founded the first rating agency in the US in 1909, the start for a multi-trillion dollar market.¹ Nowadays Credit Rating Agencies (CRAs) play an important role in the globalized financial markets.

Taking into consideration the Oil crisis in 1973/76, the Asian crisis in 1997 or the more recent world financial crisis in 2008, CRAs have come under a lot of criticism in the last few years. According to the opinion of many observers, the credit risk of structured credit products has been underestimated or has been communicated too late by CRAs which led to issues at the macro-economic level like the case of Greece in 2010 as well as at the micro-economic level like the case of Enron from 2001 or the case of Lehman Brothers from 2008 has shown.²

This work will critically review the impact and importance of CRAs on global financial systems and global economy. The impact on issuing sovereign ratings will only party be touched as the main focus is on corporations and financial institutions on capital markets. Based on the impact shown in this assignment a critical analysis will identify why CRAs are criticized and how the related issues can be solved.

1.2 Scope of Work

A brief description of the topic and objective of this assignment has been presented in this chapter. Within chapter two, basic information on the purpose and function of CRAs and the market structure of credit rating will be provided. Chapter three focus on the impact of CRAs, providing the key-facts of criticism along the case example of Enron and others. Finally the last chapter will offer a conclusion and will give an outlook on the ideas how the situation needs to be changed to solve the main issues with CRAs.

2 Background on Credit Rating Agencies

2.1 Definition, Purpose and Function

Credit rating can be defined as "an opinion regarding the creditworthiness of an entity, a debt or financial obligation, debt security, preferred share or other financial instrument, or of an issuer of such a debt […] issued using an established and defined ranking system of rating categories".³

CRAs are private, profit-oriented companies which evaluate credit risks of organizations like governments, financial or non-financial institutions that issue debt in public markets. While assigning a letter grade to a bond, which represents an opinion, CRAs indirectly inform if the organization is able to pay back capital and interest in time.⁴ Generally CRAs reduce the asymmetries in available information between issuer and investors while providing rating to "make it easy for investors to compare different potential investments".⁵ The provided ratings do not cover all important aspects, like price volatility or market liquidity, being able to make investment decisions. This means e.g. that bonds with the same rating can have different market prices.⁶

For each rating the CRAs use own and different methodologies, tools and scales. For different sectors, asset classes⁷ or geographical regions a calculation is based on different criteria (qualitative and quantitative).⁸ Compared to corporate debt ratings, which are based on public available data, the data used by the CRAs for financial ratings comes from the issuer and is nonpublic and nonstandard.

In literature three main purposes of credit ratings can be found. Beside the mentioned "information service", where information asymmetries between debt issuer and investor are solved through evaluation of the ability meeting debt obligations through the issuer with the result of increasing the number of potential borrowers and promoting liquid markets, CRAs are also providing "monitoring services" where they implicitly influence issuer to take corrective actions to minimize risk of downgrades. Downgrades can destabilize financial markets through "statistically significant spillover effects across countries and financial markets"⁹. Especially through the "certification services" (e.g. rating of securities as investment or non-investment grade) CRAs are strongly embedded into regulatory within capital requirements (e.g. calculation of Basel II capital risk-requirements). In these ways CRAs have an impact on the demand and the market liquidity.¹⁰

Historically the business model of CRA's was different before the 1970s, where subscription fees for rating have been charged to investors. During this time the CRAs were less successful not playing an important role in the financial system, especially because ratings were created on publicly available data and therefore not very interesting for investors. Due to less importance the US Securities and Exchange Commission (SEC) decided not to regulate the credit rating industry but to rely on the ratings of mayor agencies and creating the concept of NRSROs (Nationally Recognized Statistical Rating Organizations)¹¹ in 1975. By nominating mayor CRAs for NRSRO and by establishing legal rules where companies depend on NRSRO ratings the business of rating grew significantly during 1990s.¹²

2.2 Structure of Credit Rating Process

The methodologies and processes used for ratings are different from agency to agency. Despite the various approaches, the international CRAs follow similar procedures depending on the different rating targets¹³. In general the overall rating process takes between one and two month but can differ if e.g. the complexity of the rating is high.¹⁴

The common rating process can be divided into five steps: Within the first step the rating is initiated on request by the issuer. In this phase a contract is signed regulating the key points of collaboration (e.g. confidentiality) between CRA and issuer. Step two includes the collection of necessary data and is either based on publicly available information or requested from the issuer. Within step three the analytical team of the CRA evaluates the collected data quantitatively and qualitatively based on their specific methods taking factors like characteristics of a country or global environment into consideration.¹⁵ Beside the fact of having different methodologies, the main objective of the CRA is to analyze all factors affecting the creditworthiness of an issuer (cp. 2.1), which are e.g. characteristics of industry, business and finance, efficiency of operation or quality of management, competitive situation of the issuer or legal issues. As the credit rating is more related to specific financial instruments it includes further factors like earnings capacity of the company and their volatility, level of liquidity, financial flexibility of the company to raise funds to overcome temporal financial needs or available support from strong external sites. Having the information analyzed the committee of the CRA responsible for specific rating votes on the grade. Findings are presented to the issuer who is given the chance to comment on the rating or to provide further information which may be relevant to adjust the rating. The rating is published after the issuer has finally accepted it. The final step includes the continuous monitoring of the financial instrument during its life- time. CRAs are obliged to review the information regularly, to change the rating when necessary and to publish the new results.¹⁶ The rating grade gives an opinion about the quality of a rated product. Ratings for securities with a runtime of less than one year are called short-term ratings and long-term ratings exceeding runtime of one year.¹⁷ Table 1 shows the grades of the three main CRAs for long-term ratings.

Abbildung in dieser Leseprobe nicht enthalten

Table 1: Overview Long-term Credit rating grades in decreasing order of quality ¹⁸

All grades below BB+ / Ba1 are speculative with a high risk to default, grades above are counted as investment potential with a lower risk. A high credit grade indicates a stronger credit profile and will generally result in lower interest rates charged by lenders.

2.3 Market Structure of Credit Rating Agencies

In an oligopoly market with a total revenue of €4,1 billion and a growth rate of 22.4% since 2010, there are three main competitors, whereas over 150 different CRAs are known. The so called "Big Three" have a share of around 95% of the market. Standard & Poor's Rating Services with 40%, Moody's Investors Service with 40% and Fitch Ratings with 15%.¹⁹ Table 2 shows the dominant market position of the "Big Three" based on the number of credit ratings per rating category. The small CRAs like DBRS²⁰ play de facto no role.

Abbildung in dieser Leseprobe nicht enthalten

Table 2: Number credit ratings per NRSRO and rating category ²¹

The market barrier entries are very high for new competitors. Beside the strong regulations by SEC (Cp. 2.1) or the high dependency on available information as a business model especially the "pressure of reputation"²² is the limiting factor for new CRAs. Most financial institutions (Demand side of market) would simply ignore new agencies thus issuer of financial instruments (Supply side of market) would do so.

[...]

¹ Cp. Sylla R. (2002), p.19.

² Cp. de Haan J., Amtenbrink, F. (2011), p.1.

³ European Parliament (2009), L 302/1.

⁴ Cp. Financial Times Online (2014), w/o p.

⁵ Langohr H., Langohr P. (2010), p.1.

⁶ Cp. Katz J., Salinas E., Stephanou C. (2009), p.1.

⁷ Such as corporates, financial institutions, public/structured finance, insurance companies.

⁸ Cp. Alcubilla R., Ruiz del Pozo J. (2012), p.184.

⁹ International Monetary Fund (2010), p.86.

¹⁰ Cp. Kiff H., Nowak S., Schumacher L. (2012), p.12.

¹¹ See also External Credit Assessment Institution (ECAI) in the European Union.

¹² Cp. Partnoy F. (2006), p. 62-64.

¹³ E.g.: companies, financial institutions, insurance.

¹⁴ Cp. Alcubilla R., Ruiz del Pozo J. (2012), p.18.

¹⁵ Cp. Kruck A. (2011), p. 26.

¹⁶ Cp. Host A. (2012), p. 645.

¹⁷ Cp. Standard & Poor's (2012b), p. 3-6.

¹⁸ Modified by the author according to International Monetary Fund (2010), p. 90.

¹⁹ U.S. Securities and Exchange Commission (2013), p. 8.

²⁰ Biggest Canadian rating agency.

²¹ Data Source: U.S. Securities and Exchange Commission (2013), p. 8.

²² Utzig S. (2010), p. 10.