9. Rating Agencies

Question 1

Credit rating agencies (CRAs) definition

Answer 1

Companies specialized in assigning credit ratings over the creditworthiness of issuers of debt obligations and debt instruments

Question 2

Three CRA’s control for around 95% of the rating market:

Answer 2

1. Standard & Poor’s: 40%
2. Moody’s: 40%
3. Fitch: 15%

Question 3

We need CRAs to ..

CRAs are originated in the early 1900s in the US to ..

Answer 3

• Overcome information asymmetries between borrowers (issuers of debt obligations) and lenders
• Assess creditworthiness of bond market

Question 4

A credit rating is an .., with discrete grades from AAA to D

It is expressed in terms of .. below a rating.

Answer 4

• Opinion of the credit risk of a security

- Level of subordination

Question 5

SBBB- = 5% means that ..

Answer 5

• 95% of bonds in the MBS deal have rating of BBB- or higher

Question 6

Higher subordination means that ..

Answer 6

• The MBS deal has a higher risk with riskier mortgages

Question 7

Why did CRA’s get so much power?

Answer 7

• Banks were forced by law, to use the judgement of the CRAs, giving a huge responsibility to CRAs
• The SEC decided that firms need to be using bond ratings as risk indicators. These bonds were eventually rated by the CRAs
• The business model of CRAs changed from investor pays to issuer pays. This led to agency problems. The CRAs might inflate the rating to keep the issuer happy

Question 8

Reasons that there are not more/new CRAs

Answer 8

• It is costly to enter this market

- The current CRAs are supported by the government (SEC).

Question 9

Doubts about the CRAs

Answer 9

• Issuers pay high fees
• Issuers prefer not to be downgraded
• Investor’s needs are only relevant if they have bargaining power