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746 Credit Rating Process

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Tania Mendis

on 8 August 2013

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Transcript of 746 Credit Rating Process

The Corporate Credit Rating Process
What are Credit Ratings?
Tools that investors can use
Opinions about credit risk
Speak to the credit quality
Ratings provided by credit rating agencies

Credit Ratings are Forward Looking
• Evaluate current and historical information
• Assess the potential impact of foreseeable future events.
Example: may factor in anticipated ups and downs in the business cycle.
• HOWEVER credit ratings do not guarantee that an investment will pay out or that it will not default.

Credit Rating Agencies
Formulate and disseminate ratings opinions that are used by investors and other market participants who may consider credit risk in making their investment and business decisions.
Because rating agencies are not directly involved in capital market transactions, both investors and issuers view/viewed them as impartial, independent providers of opinions on credit risk.


How Regulation Plays a Part
The 1980s saw changes to financial markets and growth in structured finance, allowing government regulators to play a key role in the credit rating agency industry.

Did not seek to regulate CRAs directly, but rather used credit ratings as a means to oversee the financial markets.

Securities and Exchange Commission regulators wrote many rules that specifically identified CRAs, thereby indirectly creating a regulatory framework reliant on CRAs.

Government regulatory use of credit ratings inflated the market demand for Nationally Recognized Statistical Rating Organizations NRSRO ratings, despite the decreasing informational value of credit ratings.
Sub-prime Debt Crisis
• The Big Three were criticized for:
Their triple-A pre-crisis ratings of big financial institutions such as Lehman Brothers
Allegedly sacrificing quality ratings to win a bigger share of the booming structured products business
Miscalculating the risks associated with mortgage-related securities
Creating complex models to calculate the probability of default for individual mortgages

• February 2013, the U.S. government filed a civil suit against S&P in a California court, seeking damages of $5 billion

Kristen Manikas, Tania Mendis, Jen Polyzotis & Brooke Soto
• The ratings are not buy, sell, or hold recommendations, or a measure of asset value.
• Not intended to signal the suitability of an investment.
• Speak to one aspect of an investment decision: credit quality.

Credit ratings do not indicate investment merit
• The assignment of credit ratings is not an exact science.
• Not intended as guarantees of credit quality or as exact measures.
• Ratings express relative opinions about the creditworthiness from strongest to weakest.

Credit ratings are not absolute measures of default probability
• Enabling corporations and governments to raise money in the capital markets.
• May facilitate the process of issuing and purchasing bonds by providing a measure of relative credit risk.
• May use ratings as a screening device to match the relative credit risk of an issuer with their own risk guidelines in making investment and business decisions.

Why are Credit Ratings Useful?
Investors
• To help assess credit risk and compare different issuers and debt issues
• To evaluate the purchase of a bond from a risk tolerance perspective.
• Use credit ratings to supplement their own credit analysis of specific debt issues.
• To establish thresholds for credit risk and investment guidelines.

Intermediaries
• Benchmark the relative credit risk of different debt issues and set the initial pricing.
• Arrangers of special debt issues – establish special entities which they then market to investors.

Who uses Credit Ratings?
Standard & Poor's
Credit Rating Process
In forming their opinions of credit risk, rating agencies typically use primarily analysts or mathematical models, or a combination of the two.
Model driven ratings
A small number of credit rating agencies focus almost exclusively on quantitative data, which they incorporate into a mathematical model.
Analyst driven rating
In rating a corporation or municipality, agencies using the analyst driven approach generally assign an analyst, often in conjunction with a team of specialists, to take the lead in evaluating the entity’s creditworthiness.

The Big Three
As of 2013 they hold a collective global market share of "roughly 95 percent" with Moody's and Standard & Poor's having approximately 40% each, and Fitch around 15%.

Moody's Corporation
Fitch Group
Credit rating grades provide a simple, efficient way to communicate creditworthiness and credit quality.
ABC's of Rating Scales
Credit rating industry began in the 19th century with financial publishing.

The Mercantile Agency, one of the first credit reporting agencies, was formed in 1841 to collect information on operating statistics, business standing, and creditworthiness on businesses.

At the turn of the 20th century, publishers, such as John Moody and Henry Poor, began collecting financial and operating statistics on the railroad bond market and selling the information to subscribers.

History of Credit Rating Agencies
History of Credit Rating Agencies
What we would now recognize as credit ratings were first issued by Moody’s Analyses Publishing Company in 1909, H. V. and H. W. Poor Company in 1916, Standard Statistics Company in 1922, and Fitch Publishing Company in 1924.

Prior to 1970, performance of research and analyses were a normal part of development of published credit ratings and investors paid no fees for this service - After the early 1970s, credit ratings began charging investors for this information
Given the importance of our capital infrastructure and the power of credit rating agencies in our financial markets, and despite the good intentions of the uses of the NRSRO designation, it is not worth the cost and should be abolished.

Regulators should work to eliminate regulatory reliance on credit ratings for financial safety and soundness. These regulatory reforms will, in turn, reduce CRA oligopolistic power and the artificial demand for their ratings.
Conclusion
Controversies
Eurozone Crisis
• EU officials blame the rating agencies for accelerating the European sovereign debt crisis
• S&P’s decision to downgrade Greece's debt to junk status, accelerated the eurozone sovereign debt crisis in April, 2010
• In January 2012, while the Eurozone was still in a state of instability, S&P downgraded nine eurozone countries, stripping France and Austria of their triple-A ratings
Controversies
Compensation
• Rating companies receive their compensation from the companies whose structured securities they rate
• The fact that the ratings companies obtain fees from the companies that issue structured securities may make the ratings agencies give high ratings that aren’t deserved

Competition
• The “Big Three” occupy approximately 95 per cent of the market
• Many European officials have called for the creation of an independent, European rating agency to counter the influence of the Big Three
• New rating agencies probably wouldn’t be able to compete with the well-established Big Three agencies because of their oligopoly over the market.

Controversies
Discussion Questions
1. Do you think there should be restrictions about how much control credit rating agencies have in the market? (Re: “The Big 3”)

2. When speaking to the 2008 subprime debt crisis do you put the onus on the credit rating agencies? Or should the blame be placed somewhere else?

3. Are rating agencies actually lending any significant information? Can we trust them moving forward?


Preferential Treatment & Biases
• European officials have publicly accused the Big Three of showing preferential treatment to the United States
• The EU has also criticized the U.S.’s rating agencies speculation over European debt, as many European nations were implementing concrete budgetary policies

Controversies
1. Credit Ratings
2. History of Credit Ratings
3. Credit Rating Agencies
4. Controversies
4. Regulation
5. Conclusion & Class Discussion
Agenda
Full transcript