Unveiling the Past of Credit Rating Agencies
Credit ratings serve as valuable tools for both retail and institutional investors, aiding them in assessing the ability of bond issuers and debt instrument providers to fulfill their obligations. Credit rating agencies (CRAs) play a significant role in this process by issuing objective letter grades and providing independent analyses of companies and countries issuing such securities. Let's explore the history of these ratings and agencies in the U.S., which have expanded to assist investors globally.
Basics
Credit rating agencies offer crucial insights to investors on bond and debt issuer capabilities. They also provide valuable information on sovereign debt for countries. The industry is concentrated with three major agencies: Moody's, Standard & Poor's, and Fitch. Regulations, like the Credit Rating Agency Reform Act of 2006, oversee their internal processes, record-keeping, and business practices. Due to their involvement in the financial crisis and Great Recession, these agencies faced intense scrutiny and regulatory pressure.
Decoding Credit Ratings: Sovereign and Debt Evaluations
Sovereign credit ratings gauge a country's creditworthiness, considering economic conditions, foreign investments, political stability, and more. Institutional investors rely on these ratings to assess investment prospects. Likewise, credit ratings are assigned to companies and specific securities, analyzing short-term and long-term obligations. These evaluations aid investors in making informed decisions about various investment options.
Dominant Players in Credit Rating
In the credit rating industry, three major agencies, namely Moody's, Standard & Poor's, and Fitch, hold significant control over the market. Their pivotal role is to offer reliable and accurate information to both borrowers and lenders about the risks linked to specific types of debt, fostering confidence in the market.
Fitch: A Leading Credit Rating Agency
As one of the top three global credit rating agencies, Fitch has operations in New York and London. It assesses company debt and its susceptibility to factors like interest rate changes. Additionally, countries seek evaluations from Fitch and other agencies to gauge their financial status, political stability, and economic conditions.
Fitch's investment grade ratings span from AAA to BBB, signifying minimal to low risk of debt default. On the other hand, non-investment grade ratings range from BB to D, with D indicating a debtor's default.
The Journey of Fitch: From Pioneering Publications to Global Rating Agency
Fitch Publishing Company, founded by John Knowles Fitch in 1913, offered essential financial statistics through "The Fitch Stock and Bond Manual" and "The Fitch Bond Book" for the investment industry.
In 1923, Fitch introduced the pioneering AAA through D rating system, which later became the industry standard.
In the late 1990s, Fitch embarked on its mission to become a comprehensive global rating agency. It merged with IBCA of London, a subsidiary of Fimalac, a French holding company. Additionally, Fitch acquired market competitors Thomson BankWatch and Duff & Phelps Credit Ratings.
From 2005 onwards, Fitch expanded its operations, establishing subsidiaries specializing in enterprise risk management, data services, and finance-industry training. This expansion began with the acquisition of Algorithmics, a Canadian company, leading to the creation of Fitch Solutions and Fitch Training (now Fitch Learning).
The World of Moody's: Assessing Debt Grades
Moody's Investors Service employs a unique approach to assign letter grades for countries and company debt. Investment grade debt spans from the highest grade, Aaa, to Baa3, indicating the debtor's capability to repay short-term debt. Speculative grade debt, known as high-yield or junk, falls below investment grade and ranges from Ba1 to C, with repayment likelihood declining as the letter grade descends.
Moody's Investors Service: A Journey Through Time
In 1900, John Moody and Company introduced "Moody's Manual," offering vital statistics and general data on stocks and bonds from various industries. The manual became a national publication until 1907's stock market crash. In 1909, Moody expanded with "Moody's Analyses of Railroad Investments," providing analytical information on securities' value. This laid the foundation for Moody's Investors Service in 1914, offering ratings for numerous government bond markets. Over the next decade, Moody's expanded its services significantly. By the 1970s, it ventured into rating commercial paper and bank deposits, evolving into the prominent rating agency it is today.
Standard & Poor's: Defining Debt Ratings
Standard & Poor's (S&P) evaluates corporate and sovereign debt using 17 different ratings. Debt rated AAA to BBB- falls under the investment grade category, signifying a strong ability to repay debt. Ratings from BB+ to D are labeled speculative, indicating a higher risk of default, with D being the lowest rating.
Evolution of Standard & Poor's
In 1860, Henry Varnum Poor introduced the "History of Railroads and Canals in the United States," laying the foundation for future securities analysis. Standard Statistics emerged in 1906, publishing ratings for corporate, sovereign, and municipal bonds. In 1941, it merged with Poor's Publishing to become Standard and Poor's Corporation. In 1966, The McGraw-Hill Companies acquired Standard and Poor's. Today, it is renowned for its S&P 500 index, a vital tool for investors and a U.S. economic indicator.
Evolution of Nationally Recognized Statistical Rating Organizations (NRSROs)
In the 1970s, the credit ratings industry underwent significant changes. Ratings agencies recognized the value of objective credit ratings, benefiting both issuers and investors. To cover costs and meet the demand for statistical and analytical services, agencies began charging fees for ratings.
In 1975, to ease capital and liquidity requirements set by the SEC, nationally recognized statistical ratings organizations (NRSROs) were established. Financial institutions could meet their capital needs by investing in securities with favorable NRSRO ratings, backed by increased regulatory oversight. This led to the industry's growth and expansion.
Credit Rating Agencies: Regulation and Legislation
Regulation and legislation for large CRAs operate on an international scale. The Credit Rating Agency Reform Act of 2006 granted the SEC authority to regulate internal processes, record-keeping, and certain business practices. The Dodd-Frank Act of 2010 expanded SEC powers, requiring disclosure of credit rating methodologies.
The EU lacks a singular agency for CRA regulation, relying on various directives like the Capital Requirements Directive of 2006. The European Securities and Markets Authority oversees most directives and regulations.
Credit Rating Agencies and the Financial Crisis
The financial crisis and Great Recession of 2007-2009 led to intense scrutiny and regulation for credit rating agencies (CRAs). Their overly positive ratings on mortgage-backed securities (MBSs) were blamed for bad investments and contributed to the subprime mortgage market collapse. Critics accused CRAs of prioritizing profits and market share over accuracy.
Furthermore, the agencies' handling of European sovereign debt ratings came under scrutiny, particularly after downgrading ratings for countries like Greece and Portugal during the debt crisis. Some argue that regulatory rules have created an oligopoly in the industry, hindering smaller agencies.
In the EU, new regulations hold CRAs accountable for improper or negligent ratings that cause investor damage.
Conclusion
Investors rely on credit rating agencies to provide objective and accurate information based on sound analytical methods. These agencies comply with reporting procedures set forth by governing bodies to ensure transparency and reliability.
The analyses and assessments from multiple credit rating agencies offer valuable insights, enabling investors to assess risks and opportunities in different investment environments. Armed with this information, investors can make well-informed decisions about countries, industries, and securities for their investments.