A credit rating measures the ability and willingness of a borrower to pay back its debts. The greater creditworthiness a borrower has, the higher the rating it will receive on its debt. The level of interest for a company with an AAA rating (the highest possible) will be considerably lower than for a firm assigned a relatively weak BBB score. So it is in the interest of the borrower to obtain as high a rating as possible as this will allow it to receive a better, that is, lower rate of interest on the amount it borrows.
Who carries out the rating?
Credit rating agencies (CRAs) analyse the creditworthiness of institutions and countries and issue a rating based on a series of mathematical algorithms. Once it has allocated a rating the CRA will monitor the ongoing performance of the organisation in question and will be permitted to raise or lower its original rating at specific intervals. While CRAs offers valuable guidance to investors on the creditworthiness of a borrower, they are not legally permitted to issue direct buy/sell recommendations.
CRAs employ large numbers of financial analysts to carry out research into companies and institutions in order to assess their creditworthiness. When rating national debt, much of the work is done with the assistance of economists and political risk analysts.
What do they rate?
Any individual or institution which is able to borrow money through official means will be subject to a rating. On the lowest scale, all citizens in the UK will be given a personal credit score as soon as they become party to a transaction based on their ability to repay an amount which they have borrowed from a bank or another type of lender. Transactions where a credit rating may be required include signing a mobile phone contract, paying for an item or service by direct debit, using a credit card or arranging a mortgage.
On a corporate level, most companies will at some point be required to borrow money in order to pay for stock, expand their business or to overcome cash flow difficulties. Before lenders are willing to issue them a loan, they need to assess the borrower's ability to repay the debt and will often contract a CRA to make this assessment. Rated borrowers are usually corporates, but countries, known in this context as sovereigns, are also rated.
Who are the main CRAs?
The corporate ratings sphere is dominated by three major players: Standard & Poor's (S&P), Moody's Corporation and Fitch Ratings. Together these control around 95 per cent of the ratings market.
*How are companies rated? *
Credit ratings typically fall into two categories: investment grade and speculative grade. The first category refers to companies whose creditworthiness is deemed to be satisfactory or higher. In the scale used by S&P and Fitch, investment grades run from AAA (the highest) to BBB.
The second category, speculative grade, refers to debt which has a less than satisfactory chance of being repaid. In S&P and Fitch's gradings, these ratings run from BB down to D (the lowest).
CRAs and the financial crisis
In the months following the breakdown of the global financial system, the CRAs were among the institutions to find themselves singled out for blame for having caused the worst economic catastrophe of the modern era.
To assess the role of CRAs in the financial crisis it is necessarily to go back to events that led to the collapse of the US housing market. At the centre of the collapse were a new form of debt security, a type of collaterised debt obligation (CDO) known as mortgage-backed securities.
Banks and other investors recognised that one of the main untapped sectors of the US economy was the sub-prime mortgage market. There were tens of millions of individuals with a desire to own their own home but, because many of them were sub-prime (meaning they had poor or non-existent credit scores), they lacked access to the financing or loans to do so. One of the major turning points in the US economy was the decision by banks and mortgage lenders to begin specifically targeting this previously off-limits market. Because many of these individuals had questionable financial circumstances it was accepted that many would default on their mortgages. The question was how investors could gain access to this lucrative yet risky market without shouldering any of its risks themselves? The answer came in the form of the mortgage-backed security, which allowed firms to buy up sub-prime mortgage contracts in bulk. Banks were then able to create new, supposedly safe, products out of these by blending mortgages likely to remain unpaid together with other, safer loans which diluted the overall riskiness of the product.
This is where the CRAs came in. It was their job to pass these bundles of loans off as safe from an investment perspective so they could then be sold on through the markets. Many mortgage-backed securities consequently received AAA or other high ratings. Traditionally, CRAs had always been relied on by investors to provide and unbiased assessment of credit securities. Indeed, governments an global financial regulators had always actively encouraged financial institutions to use the ratings agencies where possible. The fact that their clients included the US government itself made them appear safer still and most investors took their word to be sacrosanct.
History now tells us that the institutions that bought up many of the mortgage-backed securities on the basis of the ratings they had received from the CRAs were wrong to do so as the mortgage borrowers tied up in the mortgage-backed securities defaulted in far greater number than had originally been anticipated, causing the value of these financial products to collapse almost overnight. This collapse then sent further shockwaves through the financial industry. As more and more mortgage buyers defaulted, the CRAs began to re-evaluate the creditworthiness of all the CDOs which they had deemed to be of sound investment grade just a few months before. With formerly AAA-rated products now reduced to junk bond status, the whole ratings industry was thrown into doubt. Investors no longer found themselves able to trust the ratings stamped on most debt securities. Without the cast-iron assurances of old, investors in their thousands decided to play it safe. They stopped lending to the market and rushed to get rid of the now-tainted investments they already had on their balance sheets. In this climate of uncertainty, companies which had long relied on a mixture of short and long-term loans to keep cashflow and expenses ticking over were faced with the biggest money market seize-up in a generation. The era now referred to as the credit crunch had begun.
Two main accusations have been made against the CRAs. There are those who claim the CRAs failed to accurately gauge the credit risks of mortgage-backed securities; that is, they neglected to grasp the complexity of these new and exotic financial products. Moreover, they failed to understand the fragility of the sub-prime market on which these products were based, least of all the behaviour of borrowers who, with little or no equity invested in their homes, had little incentive to keep up with payments.
An alternative hypothesis, meanwhile, is that the CRAs faced a conflict of interest between their supposed duty to assess the real risks of CDOs and a desire to protect the interests of the banks and other companies issuing them. In 98 per cent of cases, it is the issuer of a debt product who asks the CRA to provide a rating on the product, meaning that CRAs tended to side with issuers and award high grades to CDOs in order to gain further access down the line to this rapidly expanding business line for them. Moreover, at the time the CRAs were known to have enjoyed close working relationships with the major mortgage-backed security issuers. Indeed, the ratings agencies were often themselves reportedly involved in engineering the securities, meaning they were able to advise clients on how to achieve the highest possible grades on their products. The accusation is therefore that issuers and CRAs together created a system that produced AAA-rated products every time for mutual benefit and with little regard for the real risks involved.
Now, two years since the height of the lending freeze, markets are starting to thaw. But there remains a general mistrust of the CRAs. If they could get it so badly wrong once, then what's to stop them doing it again?
Sovereign credit ratings explained
One of the most discussed aspects of the credit rating industry is its role in assessing sovereign credit risk. Sovereign credit ratings represent the CRASs' views on the risk of non-payment of government debt. Governments borrow money from a variety of sources including companies, individuals and other countries by selling debt securities known as government bonds. As with corporate bonds, countries are given a rating between AAA and D depending on their perceived creditworthiness. Countries are then rigorously monitored for signs of economic or political developments which may threaten their ability, or willingness, to repay their borrowings.
While the idea of a country defaulting on its debt may seem somewhat far-fetched, it is in fact a relatively frequent occurrence. Iceland and Argentina are among the countries to have been forced to default on their borrowing in recent years while a number of others, including Greece, have come perilously close. The UK itself narrowly avoided defaulting on its borrowings in 1976 before eventually being bailed out by the International Monetary Fund (IMF), commonly regarded as the lender of last resort.
The recent eurozone debt crisis has provided what may yet prove to be the most significant sovereign credit shake-up of recent times. Since the beginning of the crisis, there has been growing panic surrounding the possibility of mass default by a number of eurozone states. The economies of the European Economic Community are tied together so closely that the failure of one country to repay its debts could easily lead to the collapse of another.
Following its much-chronicled debt worries, Greece was the first country to see its credit rating downgraded, dropping to BB+ (the highest speculative or junk bond grade) by S&P in April 2010. Soon to follow were Spain, Ireland and Portugal. While these states are likely to be subject to further credit rating cuts over the coming months, other, hitherto "safe bets" have also come under the radar of the agencies. Among those currently under scrutiny are Italy and the currently AAA grade UK and France. Meanwhile Scandinavian countries, which remained relatively unscathed by the global economic downturn, continue to top global credit rating tables with Norway, Sweden, Finland and Denmark placed among the worlds ten most creditworthy states, according to Business Week.
Outside of Europe, a number of countries are also bucking the trend and are seeing their ratings boosted by the three major CRAs. For example the Philippines saw its rating elevated from BB- to BB by S&P and Moody's. However Japan, with much in common with currently struggling European economies, was recently downgraded from AA to AA- by S&P.
The contrasting fortunes of emerging market and more mature economies in the ratings tables illustrates the changing tastes of global bond investors. Only a few years ago, countries outside the West were seen to be politically and economically unstable by investors, often rendering their debt too high a risk. While the emerging markets typically enjoy weaker credit ratings than their Western counterparts, it looks like it won't be long before they are on a par with Europe's so-called elite.