Credit Rating Agencies. Still credible?

The impact of Credit Rating Agencies on the economic crisis 2008/9

Research Paper (undergraduate), 2011
50 Pages, Grade: 2:0


Table of Contents


2.2-General review on credit rating agencies:
2.2.1-Definition and role of Credit Rating Agencies:
2.2.2-The Rating process of credit rating agencies:
2.2.3-The Credibility concept:
2.2.4-The Content of CRA’s credibility:
2.2.5- CRA’s credibility perception:
2.2.6-The different Criticisms on CRA’s:
2.3. Conclusions:


4.2.1.-Moody’s Investors:
4.2.3- Fitch Ratings:
4.3.1- CRA’s regulations:
4.3.2-CRA’s remuneration and rating assessment:
4.3.3- CRA’s analyst competences:
4.3.4- CRA’s methodologies assessment:
4.4.1-The Financial Crisis:
4.4.2-The role of CRAs in the Financial Crisis:





The worldwide financial crisis has thrust credit rating agencies into the spotlight. The purpose of this study was to investigate the Credit Rating Agencies credibility after the crisis and the role they play in the global investment and financial markets. Another aim was to find out how the Credit Rating agencies were implicated in the crisis. Finally an explanation of the different aspects of rating process was given in the study.

As an explanatory research, a case study analysis method was applied. This method was carried out by opting for a documentary analysis which relies highly on qualitative data. This research initiative currently under consideration can be seen as an effort to summarise the current reputation of Credit Rating Agencies and answer the question whether their credibility was affected or not.

The results of the study discover that the credibility of Credit rating agencies was affected by the financial crisis, and this was due to its implication in this crisis by implying a non accurate methodology process for products assessment.

The principal conclusion was that the credit rating agencies had a slight loss on their credibility after the financial crisis, but due to their previous role in sustaining the world financial markets and the need of market assessment by investors give another chance to restore this credibility.


I would like to convey my deepest gratitude to my supervisor, Dr. Mohamed Nurullah, who has given me his full support and guidance in completing this book. Without his supervision I would not complete this actual project.

I would also like to thank all my friends who have been extremely caring and understanding during the period of my project.

Finally, I would like to thank all members of my family, who have given me their entire support and love.



In order to define the original aspects of the problem to be addressed by this research, it is very important to begin by clarifying the activity and principals of credit rating agencies and their relation to the sub-prime mortgage market.

In 2007, the global world economy was affected by the US sub-prime mortgages crisis which led to a world economic crisis. Referring to Boakes (2009), the prime lending rate is the rate of interest charged to creditworthy companies and individuals in the US; the sub-prime market refers to the lending of money to much higher credit risk individuals at a higher rate of interest.

The development of complex financial products such as asset-backed securities and credit derivatives and the increasing reliance on credit rating in financial regulation led to an expanding role of credit rating agencies in capital markets (Frost, 2006).

The risk assessment in financial markets rely highly on the credit rating agencies, basically the major ones which are the US based Standard& poor’s, moody’s and Fitch.

They provide investors with assessments of investment risk, the issuers of investments (especially for debt securities) pay credit rating agencies to provide them with ratings. A high rating indicates low risk and may therefore encourage investors to buy a security. However, the methods of credit ratings agencies have been subject to criticism. For example, most agencies gave high-risk mortgage backed securities top ratings until they defaulted at the collapse of the housing bubble.

Years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property.

Lenders were free with their funds, especially in the US, where billions of dollars of so-called Ninja mortgages - no income, no job or assets - were sold to people with weak credit ratings (called sub-prime borrowers).

The barmy notion was that if they ran into trouble with their repayments rising house prices would allow them to remortgage their property.

It seemed a good idea when Central Bank interest rates were low; the trouble was it could not last.

Interest rates hit rock bottom in America in 2004 at just 1 per cent, but in June that year they began to rise. As interest rates jumped, US house prices started to fall and borrowers began to default on their mortgage payments sparking trouble for us all. (Budworth. 2010)

The way the debt was sold on to investors gave the crisis global significance.

The US banking sector package sub-prime home loans into mortgage-backed securities known as CDOs (collateralised debt obligations).

These were sold on to hedge funds and investment banks who decided they were a great way to generate high returns.

When borrowers started to default on their loans, the value of these investments plummeted resulting in huge losses for banks globally. (Budworth, 2010)

Credit Rating Agencies have the power to produce an authoritative analysis which means borrowers are more likely to have an easy access to capital markets and raise capital under favourable conditions if they follow CRAs regulations and assessment criteria rather than ignoring them. (Dieter, 2004)

CRAs have sensitive importance in the management of credit risk; Gautam and Randal (2003) highlights that most corporations rely on CRA’s to built their creditworthiness in the market as borrowers or guarantors. CRA’s impact on private debt markets is highly important for developing countries, where investors affiliate sovereign risk with country risk, especially when the country is barely known by investors or slight information’s are published to the outside world.

According to the international Monetary Fund (1999), CRAs can also influence investors’ portfolio holdings. In the case of Institutional borrowers for example, they are pressurized to hold only securities that credit rating agencies have endorsed as investment grade.

The Credit Rating Agencies had previously showed several bad performances in predicting risks and failure to anticipate currency crisis such as the previous South East Asia crisis or to assess the economic health state of companies like WorldCom and Enron and predict their collapse.

As previously mentioned, the evidence of their importance is clearly stated by the current turmoil. Alan Blinder (2000, p. 1421), said:” In a world credibility matters in theory, it is certainly believed to matter in practice”. This fact remains, credibility is crucial for every kind of business in any market; it’s the engine of investment and assurance provider.

Many opinions affirm that investors will ignore the financial crisis. the validity of this statement is questioned by investors, Economist Paul De Grauwe (2009) insist on their wrong risk analysis as they default in anticipating market changes and deliver accurate assessment, or the expert Richard Larkin (2008) who consider that the esteem Credit Rating Agencies had will be very difficult to be held or regained after this financial turmoil.

These different opinions on CRA’s impact on the crisis are clearly stated, but needs a proper clarification in order to give an easy understanding to the reader. That is why this research is an important open window to bring some clarifications.


The aim of this research project is to develop an understanding of the role and credibility of credit rating agencies (CRA’s) in the global investment and financial markets. The research will be focus on key objectives, such as the perception of the CRA’s credibility conducted by a qualitative research and developing an understanding and evaluation framework based upon this research.


The research methodology is based highly on secondary data which allows an easy access to information and data collection. The nature of our project is defined as an explanatory research; a qualitative data will be adopted relying highly on analysing and assessing case studies regarding the role and credibility of credit rating agencies.

Case study research excels at bringing us to an understanding of a complex issue or object and can extend experience or add strength to what is already known through previous research. Case studies emphasize detailed contextual analysis of a limited number of events or conditions and their relationships.

Researchers have used the case study research method for many years across a variety of disciplines. Social scientists, in particular, have made wide use of this qualitative research method to examine contemporary real-life situations and provide the basis for the application of ideas and extension of methods.

Researcher Robert K. Yin defines the case study research method as an empirical inquiry that investigates a contemporary phenomenon within its real-life context; when the boundaries between phenomenon and context are not clearly evident; and in which multiple sources of evidence are used. (Soy, Susan K. 1997)


To answer the question of the topic, a structural organization will be followed in order to take the readers throw the different steps of the research. In addition to the current chapter which content a general introduction of the dissertation topic and the aims and objectives, the second chapter will presents a review of related literature, about the nature of Credit Rating Agencies business, their role, their regulation and credibility in financial markets. Chapter three will explain the methodology and rational of using a case study (documentary) research method, the data collection source and the analytical tool (content analysis) used for assessments.

In chapter four, the analysis of the three case studies (Standard&Poor’s, Moody’s and Fitch) collected will be conducted in order to give an explanation to the phenomena and answer the research questions. Finally, chapter five will concludes the research by giving some recommendations.



This chapter intends to highlight the degree of credibility of credit rating agencies.

Focusing primarily on the role they played before, during and after the sub-prime crisis and the importance of its credibility in sustaining the world economy.

The scope of the review focused largely on information concerning the rating agencies, their role and their credibility, in line with the aim and objectives of the research.

The parameters of this chapter comprise: Definitions, Role and rating process of Rating Agencies which will give an overview of CRA’s and a clear idea of the business.

The credibility concept of rating agencies and the importance of trust and reputation, the methodology and regulation employed and the perception of these CRA’s before, during and after the crisis.

Finally, the criticism shown by different institutions and personalities will be discussed in order to clear any ambiguity on their statements.

2.2-General review on credit rating agencies:

Rating Agencies were an American phenomenon, which began during the 20th century before it spread to take a global dimension in the 70s with the expansion of capital markets (MPRA, 2002). There are between 130 and 150 credit rating agencies worldwide according to the Bank of International Settlement (BIS). Due to their size, most of these agencies are focus on a niche markets limited by sectors or geographical presence. The three major agencies are those mentioned previously: Standard and Poor, Moody’s, and Fitch (which own a significantly smaller market share than its two main rivals).

Not many companies operate in this specialised sector due to some barriers to entry. About 80 percent of the market is controlled by the two major operators Moody's and S&P (US SEC, 2003). Third-ranked Fitch Ratings control about 14 percent market share, it is used as an alternative to one of the other majors in case of similarities or differences on ratings.

These agencies are based on a particular process of evaluation due to the different purposes of users.

2.2.1-Definition and role of Credit Rating Agencies:

Referring to Gautam and Randall (2003), rating agencies role is based on evaluating Debtors or Debt Instrument and assign it a grade referring to its credit worthiness. According to their respective websites, Standard & Poor, Moody’s and Fitch provide ratings for several categories of institution worldwide like; Financial institutions, Banks, Corporate, Municipals and Sovereigns (countries).

Credit ratings are used by investors, issuers, governments, investment banks and broker- dealers due to the value placed on the ratings and their ability to access capital. For investors, credit rating agencies increase the range of investment alternatives and provide independent measurements of relative credit risk; this generally increases the efficiency of the market, lowering costs for both borrowers and lenders. Some users established their own internal research departments for analysis relying highly on CRA’s ratings as relevant inputs. Also they are used for a regulatory purpose worldwide in financial context (US SEC, 2003).

Issuers of securities are companies, state and local governments, non-profit organizations, or national governments issuing debt like securities (bonds), which can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's ability to pay back a loan, and affects the interest rate applied to the particular security being issued (US SEC, 2003)

The sell-side firms which include for example broker-dealers that make recommendations and sell securities to their clients are other users of CRAs. As well as” buy-side firms” which will be explained, they conduct their own credit analysis for risk management and trading purposes. However, many broker-dealers maintain rating advisory group which can for example assist underwriting clients in selecting appropriate rating agencies for offerings (US SEC, 2003).

The buy-side firms such as mutual funds and assurance companies are some of the largest owners of debt securities, commercial paper and preferred stock in the United States. Even though, they conduct their own credit analysis to identify pricing discrepancies for their trading operations or for management purpose. They use rating agencies information’s to ensure compliance with various regulatory requirements. They can for example use them to anticipate the likelihood of future credit rating actions or to comply with internal restrictions by law or investment policies that require certain minimum credit ratings for investments (US SEC, 2003).

To respond to their investors’ expectations, these agencies use a particular rating process. As highlighted by the International Organisation of Securities Commissions (IOSCO) members, the first purpose of rating agencies is their investors’ help for assessing their credit risk.

2.2.2-The Rating process of credit rating agencies:

The appraisal process used by CRA’s is based on qualitative and quantitative factors which affect the payback capacity of the security issuer.

The rating process followed by CRA’s begins with an application originated by the firm aiming to be assessed and obtaining a rating grade for its debts issues (Dari, 2006). After the request, an engagement is made between the rating agency and the issuer company which requires confidentiality and security of information’s between counterparties.

The next step is the analysis. Once CRAs receive the formal request for rating and depends on the nature of the business, they either assign the job to their analytical team or use a model based analysis, which includes analysts who have expertise in the relevant business area. At this stage of the analysis, the analyst’s team has to obtain the adequate information such as financial statements and budgets from the client firm. For a better understanding and accurate assessment of the client’s operations, analysts meet with management team to review and discuss these information’s. Based upon the data collected in this part, a primary analysis is made, followed by a report’s draft which discusses the key analytical aspects. This report is raised to the rating committee which at its turn will assess the report and issue the ratings.

At this stage of the process the rating committee can approve the report and release it to the issuer who can after this notification either agree or appeal to the committee and provide new and significant information; the committee can also decide to review the rating in the light of these additional information; finally the issuer can disagree and bring more evidence for better rating or accept the committee’s rating. If the issuer accepts the committee’s rating, the agency releases the rating to the public through printed report.

The above summary is just an overview of a very complex rating process. Indeed, Rating agencies generally survey ratings over time by reviewing corporate filings, monitoring industry trends, and maintaining a dialogue with corporate management with reference to new economical, political and financial development ; this process will also requires a country visit in case of rated sovereign (Charles, 1999).

The complexity of this process is to assure effectiveness of the assessment and keep investors trust. As stated by Kuhner (2001), legally there are no mechanisms mandating the quality of CRA’s assessment, the assignment value rely highly on the agencies efficiency and incentive to build up and maintain good reputation in the international financial market.

Abbildung in dieser Leseprobe nicht enthalten

Source: Standard&Poors (2010)

2.2.3-The Credibility concept:

The credibility is defined as “The quality of being trusted and believed in” by Oxford dictionary, It can also be defined as a reputation or a status. Indeed credibility and reputation are clearly linked. Reputation at its turn is defined by the Oxford Dictionary as “fame, credit or notoriety for doing something”.

A global question on rating agencies credibility rose when these agencies failed to anticipate financial disruptions and lugged to answer fast changing events. Indeed, as mentioned earlier, the success of credit rating agencies business and function is based on the level of trust and credibility they are able to build with users in the markets. (Mila and John, 2004),

CRA’s likelihood in the market place depends on its reputation for objectivity and accuracy; these agencies will suffer a loss of reputation if there provided ratings are qualified as inaccurate and unreliable (Richard, 2002).

Rating Agencies also deliberate publicly that the existence of their business depends on their reputations. As Standard and Poor’s state in its website:” Many investors know Standard & Poor’s for its respected role as an independent provider of credit rating”; Moody’s also define itself as follow:” Moody’s Investors service is among the world’s most respected. Moody’s commitment and expertise contribute to stable, transparent and integrated financial markets, protecting the integrity of credit”; finally, Fitch qualified itself as” widely recognized by investors, issuers, and brokers for its credible, transparent, and timely coverage.

Indeed, the fact that reputation is an important driver of success for these agencies in this complex business raises our interest on “credibility” potential intrinsic.

2.2.4-The Content of CRA’s credibility:

The Basel Committee in 2004 highlighted that objectivity, transparency, international access, independence, disclosure and the resources CRA’s possess are the main component that CRA’s credibility derived off.

The Basel committee proposed a systematic and accurate methodology with some form of objectivity and validity based on previous experience; an independent analysis without any political or economical pressure that may affect the final rating; transparency on the assessment, availability to internal and external market participants with the use of a published methodologies, a complete dissemination and sufficient resources and data to carry out high quality assessment. Moreover, assessment must be subject to ongoing review and responsive to changes in financial condition. The committee stated that CRA’s credibility also gathered from “the existence of internal approach to prevent the misuse of confidential information”.

The IOSCO’ code in 2004 explained that conflict of interest is a factor that might influence the sovereignty of rating agencies’ decisions and can seriously attenuate their credibility.

The IOSCO’ code added that if a rating agency suffers a lack of autonomy and hide it from investors, therefore, these investors can lose confidence in clearness and integrity of the market. This code then proposed different measures to rating agencies regarding their rating process’ quality and integrity, their updating and their freedom in order to guarantee credibility.

These statements helped us to summarize credibility definition on different basis, which is as follow: Independence, transparency, objectivity, disclosure, resources and regulation.

2.2.5- CRA’s credibility perception: perception before the economic crisis:

Jonathan Macey stated in 1998 that:”Indeed, the only reason that rating agencies are able to charge fees is because the public has enough belief in the integrity of these ratings to find them worth of evaluating the riskiness of investment”. Carmen (2002) affirmed that even if rating agencies consistently fail to anticipate previous currency crisis, they do considerably better in forecasting default. Downgrades in credit ratings usually follow currency crises, possibly suggesting that currency instability increases the risk of default.

In 2003, Edward Emmer, executive managing at S&P exclude the thesis of conflict of interest on CRA’s methodology based on a research done by the Federal Reserve Bank at the period. This study concluded that there was no correlation between the fees perceived by rating agencies and the ratings they establish, and that the independence of decisions is guaranteed by CRA’s. In addition, the study deduces that CRA’s credibility is their most crucial asset in the business (Chesler, 2004).

The senior European Counsel at Fitch Rating Susan Launi, in 2005insist that despite the fact the fallout from Parmalat, Enron or WorldCom’ scandal, the need for government regulation on rating agencies is dispensable and utopian. She support her view by saying that the market can be seen as regulator and if rating Agencies did not produce appropriate and accurate ratings, the market would ignore them(Cushnie, 2005).

In January 2006, The European Commission based on CERS (Committee of European Securities Regulators) advices, published its approach of CRA’s in a communiqué to the public. The European Commission come to an end that no new legislatives proposals were needed to reform or reinforces rating agencies (CERS, 2008).

Different opinions consider that rating business already have its own integrity and reliability, the president of investment Company Institute in 2006 said:” I firmly believe that robust competition for the credit rating industry is the best way to promote the continued integrity and reliability of their rating”. However, different views and questions on CRA’s credibility have been asked after the financial crisis. perception during the economic crisis:

The financial crisis takes the plunge after the bad performances in the U.S housing market and its spread into the global market (Stuart, Michel and Robert, 2008). This was due to the historical low interest rates in the U.S market, the huge boom in lending, and the increase of subprime borrowers was the main drivers of the crisis (Carr, 2008).

The unexpected reduction in loans availability and other kinds of credit facilities from financial organisations and banks led to a “credit crunch”, Burden (2008). The increased attention to the economist’ term” credit crunch”, can be defined by the Oxford English Dictionary (OED) as “a severe shortage of money or credit”.

In the context of mortgage lending, asset-backed securities is an established investment practices by financial institutions to protect and prevent high risk activities.

The high reliance of U.S housing market on lax lending criteria employed by lenders, result on borrowers who fail to afford the pay back of their loans. The quality of the securities held by these subprime borrowers was very poor and once interest rate began to rise; these borrowers started to default on their payments (Carr, 2008). This unexpected situation led to a shortage in liquidity and reducing the lending activities, the uncertainty in the market result in limiting or stopping the access to credit and affecting the whole economic circuit.

Investors who invest in complex securities such as collateral debt obligations (CDO’s) relied sluggishly on CRA’s evaluation of the credit quality of the assets they held in their portfolios. Wherefore, most analysts qualified CRA’s as major players of the current financial turmoil and some of them just saying that they are completely responsible of the crisis.

It is clear that by the beginning of 2007 the subprime mortgage market was in a total stress with the two major rating agencies (Standard and Poor’s and Moody) , they start warning the operators of the financial system of worsening situation and the uncertainty of the subprime market, then they began to downgrade their ratings ( Stuart, Michel and Robert, 2008).

The different issues in sub-prime mortgages led to a huge downgrade for these securities.

This situation showed evidence on rating agencies errors in the judgement and assessment of the characteristic of these securities. In fact, since the beginning of this financial turmoil, rating agencies have come under investigation for their high rating on these securities which did not reflect the real financial stability of the borrowers.


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Credit Rating Agencies. Still credible?
The impact of Credit Rating Agencies on the economic crisis 2008/9
Kingston University London
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Ahmed Harfouf (Author), 2011, Credit Rating Agencies. Still credible?, Munich, GRIN Verlag,


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