Rating Agencies Flashcards
What are Credit Rating Agencies? (CRA)
Companies specialized in assigning credit ratings over the creditworthiness of;
- issuers of debt obligations (companies, countries)
- debt instruments
(government bonds, corporate bonds, MBS)
What three CRAs control most of the market?
Standard & Poor’s
Moody’s
Fitch
Why do we need credit ratings?
To overcome information asymmetries between borrowers and lenders
How did rating agencies arise in the early 1900s?
To provide investors with financial information about the growing railroad industry which was too costly for each investor to process alone.
What is a credit rating?
Opinion of the credit risk of a security that combines statistical modeling and subjective judgement.
In 1936, bank regulators were worried about the stability of the banking system after the Great Depression. What did they do concerning rating manuals?
The bank regulators prohibited banks from investing in speculative (below BBB-) investment securities as determined by recognized rating manuals. Therefore, banks were forced by law to use the judgement of the publishers of the recognized rating manuals; S&P, Moody’s, Fitch
In 1975, the SEC modified minimum capital requirements for major investment banks and securities firms. Where do the rating agencies come in in this story?
These capital requirements had to be sensitive to riskiness of their asset portfolios so they used bond ratings as risk indicators. The SEC only accepted bond ratings from the Nationally Recognized Statistical Rating Organizations (NRSRO) which were only; S&P, Moody’s, Fitch
How did the business model of CRAs changed in 1970?
It changed from investor pays to issuer pays.
Initially, investors paid for the ratings to assess the creditworthiness of bonds and other debt securities before deciding to invest in them.
Then, the model shifted and the issuers of bonds and securities started paying the CRAs to rate their debt in order to attract investors and to comply with requirements.
Why did the CRA business model change from investor pays to issuer pays?
- Once a bond rating was public, every investor could ‘free ride’ on this information without paying for it. Therefore, the change in business model was to avoid free-riders.
- The new capital requirements for corporations required them to use ratings from the NRSROs. This new demand made it logical for the issuer to pay for the service.
When the issuers started paying to CRAs, which agency problems might arise?
Since the rating agency is paid by the issuer, the rating agency might be incentivized to inflate the bond’s rating to keep the issuer happy and ensure future business. This could result in biased ratings, with bonds receiving higher ratings than their actual risk level would warrant.
What are the short and long term consequences of the potential agency problem at rating agencies?
Short-term benefit for the CRA. By giving a more favorable rating, the CRA retains the issuer as a client and gains more business.
However, if these inflated ratings result in bond defaults or market failures, this undermines the CRAs credibility in the long run.
Why do CRAs have lots of market power?
- High entry barriers in rating market
- Economies of scale for large rating agencies.
- Experience advantage for large rating agencies.
- Brand reputation for large rating agencies. - Opaque designation of NRSROs by SEC
- The application process to be allowed in the NRSRO is very intransparent which makes it almost impossible for new entrants to enter this market.
There were some controversies in the reliability of CRAs in the 2000s with f.e. Enron and Lehman Brothers. The rating agencies rated them A until bankruptcy day. What was the CRAs response?
Rating through-the-cycle strategy. This implies that there are delays in perceiving movements.
What are four potential reasons for unreliable ratings?
- Both investors and issuers prefer ratings that are stable over time and don’t fluctuate frequently. Constant changes in ratings can be costly. Therefore, CRAs might avoid making frequent adjustments to ratings.
- Investors seeking higher yields might favor securities with inflated ratings because these securities promise better returns while appearing less risky than they actually are. Also, issuers benefit from higher ratings because it allows them to issue debt at lower interest rates. An inflated rating therefore can satisfy both investor and issuer.
- Since issuers pay high fees for their ratings, they may exert pressure on CRAs to avoid downgrading their securities.
- The bargaining power of issuers plays a significant role in driving unreliable ratings. When issuers are large and have substantial influence (securitization cases) - they have leverage to negotiate more favorable ratings.
What are two consequences of unreliable ratings?
When CRAs provide ratings that are inaccurate, it can lead to mispricing of risk in the market. Problematic in 2008.
Unreliable ratings contribute to systemic risk by creating instability in the financial system. When the true risk of a security eventually comes to light, it can lead to sudden drops in value, triggering broader market disruptions.