Credit rating agencies assess the relative
credit risk of specific
debt securities or
structured finance instruments and borrowing entities (
issuers of debt), and in some cases the
creditworthiness of governments and their
securities. By serving as information
intermediaries, CRAs theoretically reduce information costs, increase the pool of potential borrowers, and promote
liquid markets. These functions may increase the supply of available
risk capital in the market and promote economic growth. In market practice, a significant bond issuance generally has a rating from one or two of the Big Three agencies. CRAs theoretically provide investors with an independent evaluation and assessment of
debt securities' creditworthiness. However, in recent decades the paying customers of CRAs have primarily not been buyers of securities but their issuers, raising the issue of conflict of interest (see below). In addition, rating agencies have been liable—at least in US courts—for any losses incurred by the inaccuracy of their ratings only if it is proven that they knew the ratings were false or exhibited "reckless disregard for the truth". Otherwise, ratings are simply an expression of the agencies' informed opinions, protected as "free speech" under the
First Amendment. As one rating agency disclaimer read: The ratings ... are and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities. Under an amendment to the 2010
Dodd-Frank Act, this protection has been removed, but how the law will be implemented remains to be determined by rules made by the SEC and decisions by courts. To determine a bond's
rating, a credit rating agency analyzes the accounts of the issuer and the legal agreements attached to the bond to produce what is effectively a forecast of the bond's chance of
default, expected loss, or a similar metric. For corporate obligations, Fitch's ratings incorporate a measure of investor loss in the event of default, but its ratings on structured, project, and public finance obligations narrowly measure default risk. The process and criteria for rating a
convertible bond are similar, although different enough that bonds and convertible bonds issued by the same entity may still receive different ratings. Some bank loans may receive ratings to assist in wider
syndication and attract institutional investors. Fitch and S&P use (from the most creditworthy to the least) AAA, AA, A, and BBB for investment-grade long-term credit risk and BB, CCC, CC, C, and D for "speculative" long-term credit risk. Moody's long-term designators are Aaa, Aa, A, and Baa for investment grade and Ba, B, Caa, Ca, and C for speculative grade. However, some studies have estimated the average risk and reward of bonds by rating. One study by Moody's claimed that over a "5-year time horizon", bonds that were given its highest rating (Aaa) had a "cumulative default rate" of just 0.18%, the next highest (Aa2) 0.28%, the next (Baa2) 2.11%, 8.82% for the next (Ba2), and 31.24% for the lowest it studied (B2). (See "Default rate" in "Estimated spreads and default rates by rating grade" table to right.) Over a longer time horizon, it stated, "the order is by and large, but not exactly, preserved". Another study in the
Journal of Finance calculated the additional interest rate or "spread" that corporate bonds pay over that of "riskless" US Treasury bonds, according to the bonds rating. (See "Basis point spread" in the table to right.) Looking at rated bonds from 1973 through 1989, the authors found a AAA-rated bond paid only 43 "
basis points" (or 43/100ths of a percentage point) more than a Treasury bond (so that it would yield 3.43% if the Treasury bond yielded 3.00%). A CCC-rated "junk" (or speculative) bond, on the other hand, paid over 4% more than a Treasury bond on average (7.04% if the Treasury bond yielded 3.00%) over that period. and
savings and loan associations from investing in securities rated below BBB. CRAs provide "surveillance" (ongoing review of securities after their initial rating) and may change a security's rating if they feel its creditworthiness has changed. CRAs typically signal in advance their intention to consider rating changes. Fitch, Moody's, and S&P all use negative "outlook" notifications to indicate the potential for a downgrade within the next two years (one year in the case of speculative-grade credits). Negative "watch" notifications are used to indicate that a downgrade is likely within the next 90 days. In the 2001
Enron accounting scandal, the company's ratings remained at investment grade until four days before bankruptcy—though Enron's stock had been in sharp decline for several months—when "the outlines of its fraudulent practices" were first revealed. Critics complained that "not a single analyst at either Moody's or S&P lost his job as a result of missing the Enron fraud" and "management stayed the same". During the subprime crisis, when hundreds of billion of dollars' worth and "provided little or no value". Ratings of preferred stocks also fared poorly. Despite over a year of rising mortgage delinquencies, Moody's continued to rate
Freddie Mac's preferred stock triple-A until mid-2008, when it was downgraded to one tick above the
junk bond level. In February 2018, an investigation by the
Australian Securities and Investments Commission found a serious lack of detail and rigour in many of the ratings issued by agencies. ASIC examined six agencies, including the Australian arms of Fitch, Moody's and S&P Global Ratings (the other agencies were Best Asia-Pacific, Australia Ratings and Equifax Australia). It said agencies had often paid lip service to compliance. In one case, an agency had issued an annual compliance report only a single page in length, with scant discussion of methodology. In another case, a chief executive officer of a company had signed off on a report as though a board member. Also, overseas staff of ratings agencies had assigned credit ratings despite lacking the necessary accreditation.
Explanations of flaws Defenders of credit rating agencies complain of the market's lack of appreciation. Argues Robert Clow, "When a company or sovereign nation pays its debt on time, the market barely takes momentary notice ... but let a country or corporation unexpectedly miss a payment or threaten default, and bondholders, lawyers and even regulators are quick to rush the field to protest the credit analyst's lapse." Others say that bonds assigned a low credit rating by rating agencies have been shown to default more frequently than bonds that receive a high credit rating, suggesting that ratings still serve as a useful indicator of credit risk. A number of explanations of the rating agencies' inaccurate ratings and forecasts have been offered, especially in the wake of the subprime crisis: For instance, a 2008 report by the
Financial Stability Forum singled out methodological shortcomings—especially inadequate historical data—as a contributing cause in the underestimating of the risk in structured finance products by the CRAs before the
subprime mortgage crisis. • The ratings process relies on subjective judgments. This means that governments, for example, that are being rated can often inform and influence credit rating analysts during the review process • The rating agencies' interest in pleasing the issuers of securities, who are their
paying customers and benefit from high ratings, creates a
conflict with their interest in providing accurate ratings of securities for investors buying the securities. Issuers of securities benefit from higher ratings in that many of their customers—
retail banks,
pension funds,
money market funds,
insurance companies—are prohibited by law or otherwise restrained from buying securities below a certain rating. • Agency analysts may be underpaid relative to similar positions at
investment banks and
Wall Street firms, resulting in a migration of credit rating analysts and the analysts' inside knowledge of rating procedures to higher-paying jobs at the banks and firms that issue the securities being rated, and thereby facilitating the manipulation of ratings by issuers. • The functional use of ratings as regulatory mechanisms may inflate their reputation for accuracy.
Excessive power Conversely, the complaint has been made that agencies have too much power over issuers and that downgrades can even force troubled companies into bankruptcy. The lowering of a credit score by a CRA can create a
vicious cycle and a
self-fulfilling prophecy: not only do interest rates on securities rise, but other contracts with financial institutions may also be affected adversely, causing an increase in financing costs and an ensuing decrease in creditworthiness. Large loans to companies often contain a clause that makes the loan due in full if the company's credit rating is lowered beyond a certain point (usually from investment grade to "speculative"). The purpose of these "ratings triggers" is to ensure that the loan-making bank is able to lay claim to a weak company's assets before the company declares
bankruptcy and a
receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; if the company is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called
death spiral). These ratings triggers were instrumental in the collapse of
Enron. Since that time, major agencies have put extra effort into detecting them and discouraging their use, and the US
SEC requires that public companies in the United States disclose their existence.
Reform laws The 2010
Dodd–Frank Wall Street Reform and Consumer Protection Act mandated improvements to the regulation of credit rating agencies and addressed several issues relating to the accuracy of credit ratings specifically. Under Dodd-Frank rules, agencies must publicly disclose how their ratings have performed over time and must provide additional information in their analyses so investors can make better decisions. The
Economist magazine credits the free speech defence at least in part for the fact that "41 legal actions targeting S&P have been dropped or dismissed" since the crisis. In the
European Union, there is no specific legislation governing contracts between issuers and credit rating agencies. Credit ratings for structured finance instruments may be distinguished from ratings for other debt securities in several important ways. • These securities are more complex and an accurate prognoses of repayment more difficult than with other debt ratings. This is because they are formed by pooling debt — usually consumer credit assets, such as mortgages, credit card or auto loans — and structured by "slicing" the pool into multiple "
tranches", each with a different priority of payment. Tranches are often likened to buckets capturing cascading water, where the water of monthly or quarterly repayment flows down to the next bucket (tranche) only if the one above has been filled with its full share and is overflowing. The higher-up the bucket in the income stream, the lower its risk, the higher its credit rating, and lower its interest payment. This means the higher-level tranches have more credit worthiness than would a conventional unstructured, untranched bond with the same repayment income stream, and allows rating agencies to rate the tranches triple A or other high grades. Such securities are then eligible for purchase by
pension funds and
money market funds restricted to higher-rated debt, and for use by banks wanting to reduce costly capital requirements. • CRAs are not only paid for giving ratings to structured securities, but may be paid for advice on how to structure tranches • Credit rating agencies employ varying methodologies to rate structured finance products, but generally focus on the type of pool of financial assets underlying the security and the proposed capital structure of the trust. This approach often involves a
quantitative assessment in accordance with mathematical models, and may thus introduce a degree of
model risk. However, bank models of risk assessment have proven less reliable than credit rating agency models, even in the base of large banks with sophisticated risk management procedures. Aside from investors mentioned above—who are subject to ratings-based constraints in buying securities—some investors simply prefer that a structured finance product be rated by a credit rating agency. has described the Big Three rating agencies as "key players in the process" of mortgage
securitization, Credit rating agencies began issuing ratings for mortgage-backed securities in the mid-1970s. In subsequent years, the ratings were applied to securities backed by other types of assets. Growth was particularly strong and profitable in the structured finance industry during the 2001-2006 subprime mortgage boom, and business with finance industry accounted for almost all of the revenue growth at at least one of the CRAs (Moody's). From 2000 to 2007, Moody's rated nearly 45,000 mortgage-related securities as triple-A. In contrast only six (private sector) companies in the United States were given that top rating. Rating agencies were even more important in rating
collateralized debt obligations (CDOs). These securities mortgage/asset backed security tranches lower in the "waterfall" of repayment that could not be rated triple-A, but for whom buyers had to be found or the rest of the pool of mortgages and other assets could not be securitized. Rating agencies solved the problem by rating 70% to 80% of the CDO tranches triple-A. Still another innovative structured product most of whose tranches were also given high ratings was the "
synthetic CDO". Cheaper and easier to create than ordinary "cash" CDOs, they paid insurance premium-like payments from
credit default swap "insurance", instead of interest and principal payments from house mortgages. If the insured or "referenced" CDOs defaulted, investors lost their investment, which was paid out much like an insurance claim.
Conflict of interest However, when it was discovered that the mortgages had been sold to buyers who could not pay them, massive numbers of securities were downgraded, the securitization "seized up" and the
Great Recession ensued. Critics blamed this underestimation of the risk of the securities on the conflict between two interests the CRAs have—rating securities accurately, and serving their customers, the security issuers who need high ratings to sell to investors subject to ratings-based constraints, such as
pension funds and
life insurance companies. the importance of structured finance to CRA profits, and pressure from issuers who began to 'shop around' for the best ratings brought the conflict to a head between 2000 and 2007. A small number of arrangers of structured finance products—primarily
investment banks—drive a large amount of business to the ratings agencies, and thus have a much greater potential to exert undue influence on a rating agency than a single corporate debt issuer. A 2013
Swiss Finance Institute study of structured debt ratings from
S&P,
Moody's, and
Fitch found that agencies provide better ratings for the structured products of issuers that provide them with more overall bilateral rating business. This effect was found to be particularly pronounced in the run-up to the
subprime mortgage crisis. As a result of the
2008 financial crisis, various legal requirements were introduced to increase the transparency of structured finance ratings. The
European Union now requires credit rating agencies to use an additional symbol with ratings for structured finance instruments in order to distinguish them from other rating categories. Sovereign borrowers are the largest debt borrowers in many financial markets. Governments from emerging and developing markets may also choose to borrow from other government and international organizations, such as the
World Bank and the
International Monetary Fund. The rating methodologies used to assess sovereign credit ratings are broadly similar to those used for corporate credit ratings, although the borrower's
willingness to repay receives extra emphasis since national governments may be eligible for debt immunity under international law, thus complicating repayment obligations. National governments may solicit credit ratings to generate investor interest and improve access to the international capital markets. However, credit rating agencies were criticized for failing to predict the
1997 Asian financial crisis and for downgrading countries in the midst of that turmoil. detailing how credit ratings are used in U.S. regulation and the policy issues this use raises. Partly as a result of this report, in June 2003, the SEC published a "concept release" called "Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws" that sought public comment on many of the issues raised in its report. Public comments on this concept release have also been published on the SEC's website. In December 2004, the
International Organization of Securities Commissions (IOSCO) published a Code of Conduct for CRAs that, among other things, is designed to address the types of conflicts of interest that CRAs face. All of the major CRAs have agreed to sign on to this Code of Conduct and it has been praised by regulators ranging from the European Commission to the US SEC.
Use by government regulators Regulatory authorities and legislative bodies in the United States and other jurisdictions rely on credit rating agencies' assessments of a broad range of debt issuers, and thereby attach a regulatory function to their ratings. This regulatory role is a derivative function in that the agencies do not publish ratings for that purpose. The use of credit ratings by regulatory agencies is not a new phenomenon. The
Credit Rating Agency Reform Act of 2006 created a voluntary registration system for CRAs that met a certain minimum criteria, and provided the SEC with broader oversight authority. The practice of using credit rating agency ratings for regulatory purposes has since expanded globally. The
Basel III accord, a global bank capital standardization effort, relies on credit ratings to calculate minimum capital standards and minimum liquidity ratios. Against this background and in the wake of criticism of credit rating agencies following the
subprime mortgage crisis, legislators in the United States and other jurisdictions have commenced to reduce rating reliance in laws and regulations. The
2010 Dodd–Frank Act removes statutory references to credit rating agencies, and calls for federal regulators to review and modify existing regulations to avoid relying on credit ratings as the sole assessment of creditworthiness. ==Industry structure==