What are Credit Ratings Agencies?

Published by Thomas Herold in Corporate Finance, Economics, Investments

'Credit Ratings Agencies' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Credit Ratings Agencies are those companies whose purpose is to consider and report on the financial strength which firms and government agencies demonstrate. They report on national as well as international corporations and agencies in this capacity. Their reports are most interested in the ability of the entities in question to fulfill their obligations for both principal and interest repayments of their bonds and other kinds of debts. Besides this, the various ratings agencies carefully examine and review the conditions and terms on every debt issue.

The end result of the agencies’ work is to release a credit rating on both the debt issues in particular and the debt issuers more generally. When they agencies have high confidence that the issuer will be able to meet their debt servicing of principal and interest as promised, they will issue a high credit rating. When the opposite is true, the credit rating will be lower. It is entirely possible for a particular issue of debt to receive a differing credit rating from the issuer. This heavily depends on the particular terms of the issuer.

The impacts of these debt issue ratings are enormous in the industry and for the specific issuers in question. Those debt issues that obtain the best credit ratings will receive the most attractive interest rates from the credit markets. This is because the confidence of investors in an entity’s capability of making their various payment obligations comes down to the credit ratings agencies review, analyses and especially ratings. Since the interest rates which investors demand for a specific debt issue will be inversely correlated to the borrower’s particular creditworthiness, weaker borrowers will have to pay more while the stronger ones will enjoy paying less.

In this way, the credit ratings agencies act on behalf of businesses in much the same capacity as the consumer credit bureaus do for individual consumers. Such credit scores which the credit bureaus develop for individual people will greatly impact the interest rates at which individuals are able to borrow money.

The downside to these credit ratings agencies and their work is that they have been made the scapegoat for company and government defaults in recent years. Their research quality in particular has been the target of heavy criticism from observers and analysts who point out companies which they rated highly suddenly collapsed. Governments in Europe on which they provided high credit ratings defaulted or almost defaulted on their debts, as with Greece in particular.

This caused third party observers to argue that the various credit ratings agencies are actually poor at financial forecasting, at uncovering growing and negative trends for the debt issuers they follow, and also are overly late in revising down their ratings. Besides this, critics point to the many conflicts of interest of the ratings agencies. This is because the debt issuers are able to pick out and pay the ratings agencies for the reviews of their bonds. In a survey conducted in 2008, 11 percent of the various investment professionals surveyed by the CFA Institute responded that they had observed personally instances where the major ratings agencies had actually upgraded their given ratings on bonds when they were pressured by the debt issuers in question.

There are only three firms today which dominate the space, and this is part of the problem. The Wall Street Journal provided the ratings shares of the big 3 agencies in their 2011 report. Of the 2.8 million ratings they issue collectively (with the other seven minor agencies), S&P 500 controls the greatest market share with 42.2 percent. Moody’s holds 36.9 percent of the market. Fitch rounds out the top three with 17.9 percent.

The article claimed that fully 95 percent of all revenues in this industry were earned by the big three. Only 2.9 percent of the ratings issued came from the other seven firms. The other seven credit ratings agencies were A.M. Best, DBRS, Japan Credit Rating Agency, Rating and Investment Info., Egan-Jones Ratings, Morningstar Credit Ratings, and Kroll Bond Rating Agency.

Between the top two issuers Moody’s and Standard & Poor’s, they provide ratings for roughly 80 percent of all municipal and corporate bond issues. They are typically regarded as a level higher than Fitch. One particular example speaks volumes. While Egan-Jones had downgraded the U.S. Federal government debt to the second highest rating years earlier, it was ignored largely by the markets and world. When Standard & Poor’s took the same action by downgrading the Federal government of the United States debt to AA+ on August 5th of 2011, this shook the world bond, currency, and stock markets. It demonstrates the clout S&P and Moody’s especially enjoy over all of their various credit ratings agencies rivals.

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The term 'Credit Ratings Agencies' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.