Risk and Reward: The Role of Rating Agencies
Originally published on February 20, 2018
In 2011, the United States credit rating was downgraded from AAA to AA+ by Standard & Poor’s. The large reaction by politicians, news anchors, and many others brought into question what those letters and symbols really meant. While no one could really explain the tangible repercussion of the downgrade, they panicked nonetheless. Six years later, and we’re still going strong with one of the best markets in years. So what was all the fuss about? These ratings that affect the reputations and financial power of both governments and corporations alike were originated in the early 1900s as a way for companies to make money by offering their opinions on bonds. John Moody was the first to release a list of bond ratings that dealt mostly with railroad bonds. Shortly thereafter, he was followed by Poor’s Publishing, Standard Statistics Company, and Fitch Publishing Company. Through a series of mergers, these original companies would become the main three agencies we have today: Fitch, Standard & Poor’s, and Moody’s. The first model of these bond rating releases was “investor pays.” This model meant that if someone wanted to invest in a bond they would be responsible for buying the ratings and then using that information to invest.
Although rating agencies were first started as a way to make money off of people’s natural aversion to risk, they soon became a required element in the world of investing. In 1936, the Office of the Comptroller of the Currency, an agency that regulates and supervises banks within the US decided that it was so bad for banks to be investing in very risky securities that they enlisted the help of the current rating agencies to provide a firm cut-off line. The Office of the Comptroller of the Currency told banks that they could not invest in any “speculative” securities. In practice, this meant that banks could only hold securities that were rated the equivalent of BBB or better on the Standard & Poor’s scale. This action taken by the Office of the Comptroller of the Currency is very important, as it gave a non-governmental body the power of law.
While credit rating agencies gained more power throughout the 20th century, their legitimacy was brought into question. The Securities and Exchange Commission (SEC) became concerned that there could possibly be rating agencies who did not provide ratings with the same standards as others. To combat this, the SEC created the designation of Nationally Recognized Statistical Rating Organizations (NRSROs).” Moody’s, S&P, and Fitch were the first to be given this designation. While other firms were also given the NRSRO designation by the SEC, mergers and acquisitions in the late 1990's brought the final count back down to the original three.
Another important development happened in the 1970's. The “investor pays” model changed to an “issuer pays” model. This model means that the issuer of the bonds also pays for the rating placed on the bonds by submitting these new securities to the rating agencies for them to be rated before being put in front of investors. Many argue that this model shift was a huge contribution to the conflict of interest that played a part in the 2007-2008 financial crisis. The argument is that rating agencies may rate more favorably for a repeat issuer who pays well than they would for someone else with the same bond.
Along with creating more regulation, the SEC also created more barriers to entry in the world of credit rating agencies. Those firms who got in early and gained the advantage of economies of scale have so far been able to drive out any potential smaller competitors.
Though some may see credit ratings as a glorified grading system, the three agencies claim that there is an intricate system which results in the ratings. After all, the ratings given have a large effect on the business of the issuer of the securities in question.
Standard & Poor’s is quite transparent with the process by which they assign ratings. S&P states that there is a committee of between five and eight members who look at a large number of indicators. They also explain that ratings indeed may be changed due to fluctuations in economic, industry, or market conditions. This shows an interesting part of indicator ratings: some of them are almost completely out of the hands of the issuer. Just like the arbitrary nature of the indicators themselves, each rating agency also has their own opinions and processes which play a part in achieving a rating.
The process by which ratings are given is also rather streamlined. When an organization would like to issue securities, they place a bid which then triggers the evaluation process within the credit rating agency chosen by the organization. It is also important to note that companies issuing securities must be aware of how many ratings they are required to have. They also need to consider potential rating preferences depending on their location and/or sector.
The effects of a rating given by an agency can be broken down into three parts: effects on the issuer, effects on the market, and effects on the consumer.
The issuer of the securities is the first to be affected by the rating given. Ratings stamped on securities directly affect the cost the issuer must incur to borrow those funds. In other words, a company who issues securities with a very low rating will be forced to pay higher returns to investors in order to compensate for the bigger risk.
The effects of ratings on the markets is likely more subtle, but just as important as the other effects. Ratings placed on individual companies in each sector have a cumulative effect that can make an impression on the U.S. economy as a whole and even the global markets, as they relate directly to a number of confidence investors will have investing in those markets.
The ratings placed on securities are something that purchasers of securities should always pay attention to. Depending on the investor’s aversion to risk, they might choose to focus on higher-rated securities in order to avoid risk, or they might choose to invest primarily in “junk” bonds (speculative grade) to take advantage of the potential for a higher return.
During the financial crisis of 2007-2008, the opinions of credit rating agencies were brought into question. The top three agencies were accused of misrepresenting the amount of risk associated with bundles of low-quality mortgages. While it was true that the bundles contained some very safe mortgages, they also contained an exponentially larger number of subprime mortgages, which are loans that come with a much higher risk of default. The risk was exacerbated by the trend of NINJA (no income, no job, no assets) loans being given out freely. Borrowers were not required to provide proof of income or assets, and even if they did do so, no one verified the information. Many argue that the rating agencies also deliberately failed to account for the potential downturn in the housing market when making their analyses. The other question that came out of this crisis was the complicated nature of the algorithms used by agencies to assign ratings. Some say that having such complicated means of determining risk makes the process less transparent and therefore less reliable. As evidence of the gilded nature of many ratings before the crisis, Moody’s downgraded 83% of the $869 billion in mortgage securities that were once rated AAA once the market collapsed.
Going back to the downgrade of 2011, there were likely good reasons for people to be concerned, but the problem still remains that no one could really explain what those reasons were. While ratings may be a good general indicator of risk, it seems that by digging deeper into their implications we find that they should be considered in conjunction with other factors.
CFR.org Staff. "The Credit Rating Controversy." Cfr.org. Council on Foreign Relations, 19 Feb. 2015. Web. 10 Oct. 2016.
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Marston, Rebecca. "What Is a Rating Agency?" BBC News. BBC News, 20 Oct. 2014. Web. 11 Oct. 2016.
Smith, Kalen. "History of Credit Rating Agencies and How They Work." Money Crashers. MoneyCrashers.com, n.d. Web. 11 Oct. 2016.