wallstreet2

WTF: Credit Rating Agencies

Photo courtesy of Mayeesherr via Flickr.

Credit rating agencies are responsible for determining the creditworthiness of borrowers by rating their ability to pay back their debt. Here’s a look at how rating agencies work, and how they enabled the financial crisis of 2008.

wtfbanner

What The Finance is your “dummies guide” to understanding the basics of everyday financial topics. In our W.T.F. series we’ll help you explore every level of business and finance, from what a security is, to how companies hedge their risk–without forcing you to wade through pools of financial jargon.

What are ratings agencies, and what do they do?

A credit rating agency, according to the Securities Industry and Financial Markets Association (SIFMA), is a company that objectively analyzes the creditworthiness of large-scale borrowers, indicating their quality of credit and ability to pay back debt.

Rating agencies provides opinions in the form of grades, or credit ratings: scorecards that mark borrowers as reliable, or risky.

Chart courtesy of Wikimedia commons.

Standards and Poor’s (S&P), one of the most prominent rating agencies, notes that these credit risk opinions (based on analyses by experienced professionals) are made in regards to the ability and willingness of an issuer, such as a corporation, state or city government, to meet its financial obligations, and evaluate their likelihood of default.

S&P states that such ratings are intended to provide investors and market participants with proper information about the relative credit risk of issuers. However, they insist their grades should not solely indicate investment merit, as there are other factors investors must consider.

Who are “The Big Three,” and what sets them apart?

While there are many rating agencies, you’ll seldom hear of any but three: S&P, Moody’s, and Fitch. According to the BBC, S&P was established first, in 1860, followed by Moody’s in 1906. Both control roughly 40% of the rating business, while Fitch, founded in 1913, a smaller version of the two, controls 13%.

In 1975, the Securities and Exchange Commission (SEC) acknowledged these three as Nationally Recognized Statistical Rating Organizations (NRSRO). Being endorsed by an NRSRO is extremely helpful for investors and borrowers alike, making it especially easy and quick to issue bonds, BBC reports.

Even though there are a total of 10 NRSROs, these three stand apart by reputation, and dominate 95% of the industry, leaving very little space for competition.

What role did CRAs play in the financial crisis?

Many have been blamed for what lead to the financial crisis in 2008, including regulators, the Federal Reserve, and big Wall Street banks, all of which played roles in this disturbing play. While we can continue to point fingers at each villain involved, there is no denying that these agencies were key enablers to the financial meltdown, as well.

An April 2013 U.S. Congressional report concluded that credit agencies S&P and Moody’s (Fich was not included in the study) were the main trigger for the financial crisis when they were forced to downgrade the inflated ratings that they had been handing out to unstable mortgage-backed securities, even months after the housing market started to collapse.

These CRAs, according to incriminating findings from lawsuits filed against them (as reported by Rolling Stone), had essentially been giving high ratings in exchange for money, despite knowing they were “ticking timebombs.”

If these credit agencies had not given high ratings to faulty mortgage-related securities, they would not have been bought and sold by investors, who rely on them heavily and often blindly for risk evaluation. The resulting downgrades meant complete devastation for the market, as values plummeted across the board.

Have the CRAs changed?

Since the financial crisis, new rules have been implemented to have rating agencies better regulated. These rules have been implemented in the form of The Dodd-Frank Wall Street Reform and Consumer Protection Act.

Requirements include annual reports on internal controls, rules regarding conflicts of interests, and full disclosure of performance statistics and rating methodologies, as outlined by the SEC.

Do you think the CRAs have learned their lesson? Tweet us @curiousmatic! 

We measure success by the understanding we deliver. If you could express it as a percentage, how much fresh understanding did we provide?
Jennifer Markert