A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor’s ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments,[1]and in some cases, of the servicers of the underlying debt,[2] but not of individual consumers.
The debt instruments rated by CRAs include government bonds, corporate bonds, CDs, municipal bonds, preferred stock, and collateralized securities, such as mortgage-backed securities and collateralized debt obligations.[3]
The issuers of the obligations or securities may be companies, special purpose entities, state or local governments, non-profit organizations, or sovereign nations.[3] A credit rating facilitates the trading of securities on a secondary market. It affects the interest rate that a security pays out, with higher ratings leading to lower interest rates. Individual consumers are rated for creditworthiness not by credit rating agencies but by credit bureaus (also called consumer reporting agencies or credit reference agencies), which issue credit scores.
The value of credit ratings for securities has been widely questioned. Hundreds of billions of securities that were given the agencies’ highest ratings were downgraded to junk during the financial crisis of 2007–08.[4][5][6] Rating downgrades during the European sovereign debt crisis of 2010–12 were blamed by EU officials for accelerating the crisis.[3]
Credit rating is a highly concentrated industry, with the “Big Three” credit rating agencies controlling approximately 95% of the ratings business.[3] Moody’s Investors Service and Standard & Poor’s (S&P) together control 80% of the global market, and Fitch Ratings controls a further 15%.
Role in capital markets
Credit rating agencies assess the relative credit risk of specific debt securities or structured finance instruments and borrowing entities (issuers of debt),[51] and in some cases the creditworthiness of governments and their securities.[52][53] By serving as information intermediaries, CRAs theoretically reduce information costs, increase the pool of potential borrowers, and promote liquid markets.[54][55][56]These functions may increase the supply of available risk capital in the market and promote economic growth.[51][56]
Ratings use in bond market
Credit rating agencies provide assessments about the creditworthiness of bonds issued by corporations, governments, and packagers of asset-backed securities.[57][58] In market practice, a significant bond issuance generally has a rating from one or two of the Big Three agencies.[59]
CRAs theoretically provide investors with an independent evaluation and assessment of debt securities‘ creditworthiness.[60] However, in recent decades the paying customers of CRAs have primarily not been issuers of securities but buyers, raising the issue of conflict of interest (see below).[61]
In addition, rating agencies have been liable—at least in US courts—for any losses incurred by the inaccuracy of their ratings only if it is proven that they knew the ratings were false or exhibited “reckless disregard for the truth”.[12][62][63] Otherwise, ratings are simply an expression of the agencies’ informed opinions,[64] protected as “free speech” under the First Amendment.[65][66] As one rating agency disclaimer read:
The ratings … are and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities.[67]
Under an amendment to the 2010 Dodd-Frank Act, this protection has been removed, but how the law will be implemented remains to be determined by rules made by the SEC and decisions by courts.[68][69][70][71]
To determine a bond’s rating, a credit rating agency analyzes the accounts of the issuer and the legal agreements attached to the bond[72][73] to produce what is effectively a forecast of the bond’s chance of default, expected loss, or a similar metric.[72] The metrics vary somewhat between the agencies. S&P’s ratings reflect default probability, while ratings by Moody’s reflect expected investor losses in the case of default.[74][75] For corporate obligations, Fitch’s ratings incorporate a measure of investor loss in the event of default, but its ratings on structured, project, and public finance obligations narrowly measure default risk.[76] The process and criteria for rating a convertible bond are similar, although different enough that bonds and convertible bonds issued by the same entity may still receive different ratings.[77] Some bank loans may receive ratings to assist in wider syndication and attract institutional investors.[73]
The relative risks—the rating grades—are usually expressed through some variation of an alphabetical combination of lower- and uppercase letters, with either plus or minus signs or numbers added to further fine-tune the rating.[78][79]
Fitch and S&P use (from the most creditworthy to the least) AAA, AA, A, and BBB for investment-grade long-term credit risk and BB, CCC, CC, C, and D for “speculative” long-term credit risk. Moody’s long-term designators are Aaa, Aa, A, and Baa for investment grade and Ba, B, Caa, Ca, and C for speculative grade.[78][79] Fitch and S&P use pluses and minuses (e.g., AA+ and AA-), and Moody’s uses numbers (e.g., Aa1 and Aa3) to add further gradations.[78][79]