credit rating - docshare01.docshare.tipsdocshare01.docshare.tips/files/9346/93469953.pdf · 5...
TRANSCRIPT
CREDIT RATING
AN ANALYSIS OF THE CREDIT RATING AGENCIES
ANSHUMAN DUTTA,
1YR DoMS, NITT
ROLL NO-215111070
1
CONTENTS
INTRODUCTION--------------------------------------------------------------------------2
ROLE OF CREDIT RATING ON COUNTRIES------------------------------------3
ECONOMIC RESILIENCY--------------------------------------------------------------3
FINANCIAL ROBUSTNESS-------------------------------------------------------------3
STANDARD & POOR---------------------------------------------------------------------5
MOODY’S CORPORATION------------------------------------------------------------7
FITCH-----------------------------------------------------------------------------------------8
USES OF RATING-------------------------------------------------------------------------8
METHODS OF RATING-----------------------------------------------------------------9
RATING USED IN STRUCTURED FINANCE------------------------------------10
CRITICISM------------------------------------------------------------------------------- 10
KEY FACTS ON RATING-------------------------------------------------------------15
CONCLUSION----------------------------------------------------------------------------16
REFERENCE------------------------------------------------------------------------------18
2
INTRODUCTION
Credit rating agencies (CRA) are companies that assign credit ratings for issuers of certain types
of debt obligations as well as the debt and in certain cases the services of the underlying debt are
also provided ratings.
The impact of credit rating agencies on financial markets has become one of the most important
policy concerns facing the international financial architecture. Ratings indicate a relative credit
risk and serve as an important metric by which many investors and regulations measure credit
risk.
A major problems faced by developing countries is the difficulty in mobilizing funds to increase
investment. The level of income is often too low to generate sufficient savings, and the domestic
financial system often does a poor job of directing those funds back into domestic capital
formation. This makes access to international capital markets an important resource for obtaining
funds to raise the level and accelerate the pace of investment and growth. In order to gain access,
developing countries must first obtain a favorable rating of their creditworthiness by one or more
credit rating agencies.
The credit rating represents the credit rating agency's evaluation of qualitative and quantitative
information for a company or government; including non-public information obtained by the
credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead,
credit rating agencies use their judgment and experience in determining what public and private
information should be considered in giving a rating to a particular company or government.
A poor credit rating indicates a credit rating agency's opinion that the company or government
has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of
long term economic prospects.
The credit score does not take into account future prospects or changed circumstances.
HISTORY
The use of credit ratings arose in the U.S. out of the desire by the growing investing class to have
more information about the many new securities – especially railroad bonds – that were being
issued and traded. In the middle of the 19th century, the U.S. railroad industry began expanding
3
across the continent and into undeveloped territories. The industry’s demand for capital exceeded
the ability or willingness of banks and direct investors to provide it. In order to reach a broader
and deeper capital market, railroads and other corporations began raising new capital through the
market for private corporate bonds.
Role of credit ratings on countries
Countries can issue government bonds denoted in the country’s currency in order to raise capital.
Bonds can also be issued in foreign currency, referred to as sovereign bonds. Bonds are often
referred to as risk free due to the fact that they are government owned and hence, governments
can at any time raise taxes or create extra currency in order to redeem their bonds upon maturity.
However, as we have seen recently, the issue of Greece counters this statement.
Bonds are rated on various parameters such as:
Economic Resiliency
The country’s economic strength, captured in particular by the GDP per capita – the
single best indicator of economic robustness and, in turn, shock-absorption capacity.
Institutional strength of the country, the key question being whether or not the quality of
a country’s institutional framework and governance – such as the respect of property
right, transparency, the efficiency and predictability of government action, the degree of
consensus on the key goals of political action – is conducive to the respect of contracts.
Financial Robustness
The financial strength of the government. The question is to determine what must be
repaid and the ability of the government to mobilize resources: raise taxes, cut spending,
sell assets, and obtain foreign currency.
The susceptibility to event risk – that is the risk of a direct and immediate threat to debt
repayment, and, for countries higher in the rating scale, the risk of a sudden multi-notch
downgrade. The issue is to determine whether the debt situation may be (further)
endangered by the occurrence of adverse economic, financial or political events.
Combining these indicators rating agencies determine degrees of financial robustness and
4
refine the positioning of the country on the rating scale- very high, high, moderate, low or
very low.
5
Standard & Poor's
Henry Varnum Poor first published the "History of Railroads and Canals in the United States
in1860, the forerunner of securities analysis and reporting to be developed over the next century.
Standard & Poor’s (S&P) was created in 1941 through the merger with Standard Statistics and
Poor’s Publishing. The company provides a wide range of information on financial products and
markets. Standard & Poor’s sells investment data, valuations, analysis and opinions. The flagship
product is their S&P 500, an index that tracks the high capitalization equity markets in the
United States. McGraw-Hill Companies acquired Standard & Poor’s in 1966. In 2001, McGraw
Hill Companies had sales of $4.6 billion and income of $377 million. Standard & Poor’s
contributed to the total with sales of almost $1.5 billion and operating profit of $435 million.
Table 2: Standard and Poor's sovereign ratings methodology profile Poor's sovereign
ratings methodology profile
Political risk
• Stability and legitimacy of political institutions;
• Popular participation in political processes;
• Orderliness of leadership successions;
• Transparency in economic policy decisions and objectives;
• Public security; and
• Geopolitical risk.
Income and economic structure
• Prosperity, diversity and degree to which economy is market-oriented;
• Income disparities;
• Effectiveness of financial sector in intermediating funs availability of credit;
• Competitiveness and profitability of non-financial private sector;
• Efficiency of public sector;
• Protectionism and other non-market influences; and
• Labour flexibility.
Economic growth prospects
• Size and composition of savings and investment; and
6
• Rate and pattern of economic growth.
Fiscal flexibility
• General government revenue, expenditure, and surplus/deficit trends;
• Revenue-raising flexibility and efficiency;
• Expenditure effectiveness and pressures;
• Timeliness, coverage and transparency in reporting; and
• Pension obligations.
General government burden
• General government gross and net (of assets) debt as a per cent of GDP;
• Share of revenue devoted to interest;
• Currency composition and maturity profile; and
• Depth and breadth of local capital markets.
Offshore and contingent liabilities
• Size and health of NFPEs; and
• Robustness of financial sector.
Monetary flexibility
• Price behaviour in economic cycles;
• Money and credit expansion;
• Compatibility of exchange rate regime and monetary goals;
• Institutional factors such as central bank independence; and
• Range and efficiency of monetary goals.
External liquidity
• Impact of fiscal and monetary policies on external accounts;
• Structure of the current account;
• Composition of capital flows; and
• Reserve adequacy.
External debt burden
• Gross and net external debt, including deposits and structured debt;
• Maturity profile, currency composition, and sensitivity to interest rate changes;
7
• Access to concessional lending; and
• Debt service burden.
Source: Standard and Poor's (October 2006). ―Sovereign Credit Ratings: A Primer.
Notes: NFPEs: Non-Financial Public Sector Enterprises
Moody's Corporation
John Moody and Company first published "Moody's Manual" in 1900. The manual published
basic statistics and general information about stocks and bonds of various industries. In 1909
Moody began publishing "Moody's Analyses of Railroad Investments", which added analytical
information about the value of securities. Expanding this idea led to the 1914 creation of
Moody's Investors Service. By the 1970s Moody's began rating commercial paper and bank
deposits, becoming the full-scale rating agency that it is today.
Table 3: Moody’s Sovereign Categories
1. Economic Structure and Performance
- GDP, inflation, population, GNP per capita, unemployment, imports and exports
2. Fiscal Indicators
- Government revenues, expenditures, balance, debt all as percentage of GDP
3. External Payments and Debt
- Exchange rate, labor costs, current account, foreign currency debt and debt service ratio
4. Monetary and Liquidity Factors
- Short-term interest rates, domestic credit, M2/foreign exchange reserves, maturing
debt/foreign exchange reserves, liabilities of banks/assets of banks
8
Fitch Rating
John Knowles Fitch founded the Fitch Publishing Company in 1913. Fitch published financial
statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The
Fitch Bond Book."
In 1924, Fitch introduced the AAA through the rating system that has become the basis for
ratings throughout the industry. With plans to become a full-service global rating agency, in the
late 1990s Fitch merged with IBCA of London.
Fitch Ratings provides ratings and research to over 75 countries
Uses of ratings
Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments.
For investors, credit rating agencies increase the range of investment alternatives and provide
independent, easy-to-use measurements of relative credit risk; this generally increases the
efficiency of the market, lowering costs for both borrowers and lenders. This in turn increases
the total supply of risk capital in the economy, leading to stronger growth. It also opens the
capital markets to categories of borrower who might otherwise be shut out altogether: small
governments, startup companies, hospitals, and universities.
A poor credit rating indicates a credit rating agency's opinion that the company or government
has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of
long term economic prospects. A poor credit score indicates that in the past, other individuals
with similar credit reports defaulted on loans at a high rate. The credit score does not take into
account future prospects or changed circumstances.
Methods of Credit Ratings:
The key measure in credit risk models is the measure of the Probability of Default (PD) but
exposure is also determined by the expected timing of default and by the Recovery Rate (RE)
after default has occurred:
9
Standard and Poor's ratings seek to capture only the forward-looking probability of the
occurrence of default. They provide no assessment of the expected time of default or
mode of default resolution and recovery values.
By contrast, Moody's ratings focus on the Expected Loss (EL) which is a function of
both Probability of Default (PD) and the expected Recovery Rate (RE). Thus EL =PD
(1- RE).
Fitch's ratings also focus on both PD and RE (Bhatia, 2002). They have a more
explicitly hybrid character in that analysts are also reminded to be forward looking and
to be alert to possible discontinuities between past track records and future trends.
The credit ratings of Moody's and Standard and Poor's are assigned by rating
committees and not by individual analysts.
There is a large dose of judgement in the committees’ final ratings.
Rating’s use in structured finance
Credit rating agencies may also play a key role in structured financial transactions. Unlike a
"typical" loan or bond issuance, where a borrower offers to pay a certain return on a loan,
CRAs provide little guidance as to how they assign relative weights to each factor, though
they do provide information on what variables they consider in determining sovereign
ratings.
Identifying the relationship between the CRAs' criteria and actual ratings is difficult, in part
because some of the criteria used are neither quantitative nor quantifiable but qualitative.
The analytical variables are interrelated and the weights are not fixed either across
sovereigns or over time.
Even for quantifiable factors, determining relative weights is difficult because the agencies
rely on a large number of criteria and there is no formula for combining the scores to
determine ratings.
10
structured financial transactions may be viewed as either a series of loans with different
characteristics, or else a number of small loans of a similar type packaged together into a series
of "buckets" (with the "buckets" or different loans called "tranches"). Credit ratings often
determine the interest rate or price ascribed to a particular tranche, based on the quality of loans
or quality of assets contained within that grouping.
Companies involved in structured financing arrangements often consult with credit rating
agencies to help them determine how to structure the individual tranches so that each receives a
desired credit rating. For example, a firm may wish to borrow a large sum of money by issuing
debt securities. However, the amount is so large that the return investors may demand on a single
issuance would be prohibitive. Instead, it decides to issue three separate bonds, with three
separate credit ratings—A (medium low risk), BBB (medium risk), and BB (speculative) (using
Standard & Poor's rating system).
The firm expects that the effective interest rate it pays on the A-rated bonds will be much less
than the rate it must pay on the BB-rated bonds, but that, overall, the amount it must pay for the
total capital it raises will be less than it would pay if the entire amount were raised from a single
bond offering. As this transaction is devised, the firm may consult with a credit rating agency to
see how it must structure each tranche—in other words, what types of assets must be used to
secure the debt in each tranche—in order for that tranche to receive the desired rating when it is
issued.
Criticism
Credit rating agencies have been subject to the following criticisms:
Credit rating agencies do not downgrade companies promptly enough. For example,
Enron's rating remained at investment grade four days before the company went
bankrupt, despite fact that credit rating agencies had been aware of the company's
problems for months. Or, for example, Moody's gave Freddie Mac preferred stock the top
rating until Warren Buffett talked about Freddie on CNBC and on the next day Moody's
downgraded Freddie to one tick above junk bonds.
11
Large corporate rating agencies have been criticized for having too familiar a relationship
with company management, possibly opening themselves to undue influence or the
vulnerability of being misled. These agencies meet frequently in person with the
management of many companies, and advise on actions the company should take to
maintain a certain rating. Furthermore, because information about ratings changes from
the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs
charge debt issuers, rather than investors, for their ratings. This has led to accusations that
these CRAs are plagued by conflicts of interest that might inhibit them from providing
accurate and honest ratings. At the same time, more generally, the largest agencies
(Moody's and Standard & Poor's) are often seen as promoting a narrow-minded focus on
credit ratings, possibly at the expense of employees, the environment, or long-term
research and development.
While often accused of being too close to company management of their existing clients,
CRAs have also been accused of engaging in heavy-handed "blackmail" tactics in order
to solicit business from new clients, and lowering ratings for those firms. For instance,
Moody's published an "unsolicited" rating of Hannover Re, with a subsequent letter to the
insurance firm indicating that "it looked forward to the day Hannover would be willing to
pay". When Hannover management refused, Moody's continued to give Hannover
ratings, which were downgraded over successive years, all while making payment
requests that the insurer rebuffed. In 2004, Moody's cut Hannover's debt to junk status,
and even though the insurer's other rating agencies gave it strong marks, shareholders
were shocked by the downgrade and Hannover lost $175 million USD in market
capitalization.
The lowering of a credit score by a CRA can create a vicious cycle, as not
only interest rates for that company would go up, but other contracts with
financial institutions may be affected adversely, causing an increase in
expenses and ensuing decrease in credit worthiness. In some cases, large loans
to companies contain a clause that makes the loan due in full if the companies'
12
credit rating is lowered beyond a certain point (usually a "speculative" or "junk
bond" rating).
The purpose of these "ratings triggers" is to ensure that the bank is able to lay claim to a
weak company's assets before the company declares bankruptcy and a receiver is
appointed to divide up the claims against the company.
The effect of such ratings triggers, however, can be devastating: under a worst-case
scenario, once the company's debt is downgraded by a CRA, the company's loans become
due in full; since the troubled company likely is incapable of paying all of these loans in
full at once, it is forced into bankruptcy (a so-called "death spiral"). These rating triggers
were instrumental in the collapse of Enron. Since that time, major agencies have put extra
effort into detecting these triggers and discouraging their use, and the U.S. Securities and
Exchange Commission requires that public companies in the United States disclose their
existence.
Agencies are sometimes accused of being oligopolists, because barriers to market entry
are high and rating agency business is itself reputation-based (and the finance industry
pays little attention to a rating that is not widely recognized). Of the large agencies, only
Moody's is a separate, publicly held corporation that discloses its financial results without
dilution by non-ratings businesses, and its high profit margins (which at times have been
greater than 50 percent of gross margin) can be construed as consistent with the type of
returns one might expect in an industry which has high barriers to entry.
Credit Rating Agencies have made errors of judgment in rating structured products,
particularly in assigning AAA ratings to structured debt, which in a large number of cases
has subsequently been downgraded or defaulted. The actual method by which Moody's
rates CDOs has also come under scrutiny. If default models are biased to include
arbitrary default data and "Ratings Factors are biased low compared to the true level of
expected defaults, the Moody’s [method] will not generate an appropriate level of
average defaults in its default distribution process. As a result, the perceived default
probability of rated tranches from a high yield CDO will be incorrectly biased downward,
providing a false sense of confidence to rating agencies and investors.
13
Little has been done by rating agencies to address these shortcomings indicating a lack
of incentive for quality ratings of credit in the modern CRA industry. This has led to
problems for several banks whose capital requirements depend on the rating of the
structured assets they hold, as well as large losses in the banking industry. AAA rated
mortgage securities trading at only 80 cents on the dollar, implying a greater than 20%
chance of default, and 8.9% of AAA rated structured CDOs are being considered for
downgrade by Fitch, which expects most to downgrade to an average of BBB to BB-.
These levels of reassessment are surprising for AAA rated bonds, which have the same
rating class as US government bonds.[20][21] Most rating agencies do not draw a
distinction between AAA on structured finance and AAA on corporate or government
bonds (though their ratings releases typically describe the type of security being rated).
Many banks, such as AIG, made the mistake of not holding enough capital in reserve in
the event of downgrades to their CDO portfolio. The structure of the Basel II agreements
meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios
vulnerable to multiple downgrades, essentially precipitating a large margin call. For
example under Basel II, a AAA rated securitization requires capital allocation of only
0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a
52% allocation. For a number of reasons (frequently having to do with inadequate staff
expertise and the costs that risk management programs entail), many institutional
investors relied solely on the ratings agencies rather than conducting their own analysis
of the risks these instruments posed. (As an example of the complexity involved in
analyzing some CDOs, the Aquarius CDO structure has 51 issues behind the cash CDO
component of the structure and another 129 issues that serve as reference entities for $1.4
billion in CDS contracts for a total of 180. In a sample of just 40 of these, they had on
average 6500 loans at origination. Projecting that number to all 180 issues implies that
the Aquarius CDO has exposure to about 1.2 million loans.) Pimco founder William
Gross urged investors to ignore rating agency judgments, describing the agencies as "an
idiot savant with a full command of the mathematics, but no idea of how to apply them.
Ratings agencies, in particular Fitch, Moody's and Standard and Poors have been
implicitly allowed by governments to fill a quasi-regulatory role, but because they are
14
for-profit entities their incentives may be misaligned. Conflicts of interest often arise
because the rating agencies, are paid by the companies issuing the securities — an
arrangement that has come under fire as a disincentive for the agencies to be vigilant on
behalf of investors. Many market participants no longer rely on the credit agencies ratings
systems, even before the economic crisis of 2007-8, preferring instead to use credit
spreads to benchmarks like Treasuries or an index. However, since the Federal Reserve
requires that structured financial entities be rated by at least two of the three credit
agencies, they have a continued obligation.
Many of the structured financial products that they were responsible for rating, consisted
of lower quality 'BBB' rated loans, but were, when pooled together into CDOs, assigned
an AAA rating. The strength of the CDO was not wholly dependent on the strength of the
underlying loans, but in fact the structure assigned to the CDO in question. CDOs are
usually paid out in a 'waterfall' style fashion, where income received gets paid out first to
the highest tranches, with the remaining income flowing down to the lower quality
tranches i.e. <AAA. CDOs were typically structured such that AAA tranches which were
to receive first lien (claim) on the BBB rated loans cash flows, and losses would trickle
up from the lowest quality tranches first. Cash flow was well insulated even against
heavy levels of home owner defaults. Credit rating agencies only accounted for a ~5%
decline in national housing prices at worst, allowing for a confidence in rating the many
of these CDOs that had poor underlying loan qualities as AAA. It did not help that an
incestuous relationship between financial institutions and the credit agencies developed
such that, banks began to leverage the credit ratings off one another and 'shop' around
amongst the three big credit agencies until they found the best ratings for their CDOs.
Often they would add and remove loans of various quality until they met the minimum
standards for a desired rating, usually, AAA rating. Often the fees on such ratings were
$300,000 - $500,000, but ran up to $1 million.
It has also been suggested that the credit agencies are conflicted in assigning sovereign
credit ratings since they have a political incentive to show they do not need stricter
regulation by being overly critical in their assessment of governments they regulate.
15
Rating agencies have come under criticism for a narrow-minded view of government
default from investors' perspective. A government that does not run a sustainable budget
might be forced to print money to meet credit payments, this will then inflate the
economy and devalue the currency. USA is for example thought to be unlikely to default
on their payments since they have the printing power of the dollar, which a country like
Greece does not have for its currency, the Euro. However the Euro, which was introduced
in year 1999 on an even exchange rate with the dollar, was trading almost 50% higher
than the dollar only 10 years after its launch. At that time, because of investor fear for a
default in the peripheral states of EU, Greece's government bond credit rating was in the
junk bond category, while the USA credit rating was still in the top category. The
criticism escalated in summer, 2011, when the European Commission and EC President
and former Portuguese premier José Manuel Barroso, respectively, criticized Moody's
downgrade of Portuguese bonds.
After Moody's reported a surge in "toxic" municipal debt (money owed to banks by
municipalities) in China in summer, 2011, Bank of America Merrill Lynch economist
Ting Lu deemed the assessment ―too pessimistic," saying he disagreed with the
assumptions and the math and the translation-of-terms used by the rating agency.
Moody's had also estimated that "between 8% to 12% of loans extended by Chinese
banks could eventually be classed as non-performing," according to a news report.
Key facts about credit ratings
Credit ratings are only opinions about the relative credit risk of the subject
Credit ratings are not investment advice, or buy, hold, or sell recommendations. They are just one factor investors ‘might consider’ in making investment decisions
Credit ratings are not indications of the market liquidity of a debt security or its price
in the secondary market.
Credit ratings are not guarantees of credit quality or of future credit risk
16
VI. Conclusions
CRAs play a key role in financial markets by helping to reduce the informative
asymmetry between lenders and investors, on one side, and issuers on the other side,
about the creditworthiness of companies (corporate risk) or countries (sovereign risk).
CRAs' role has expanded with financial globalization and has received an additional
boost from Basel II which incorporates the ratings of CRAs into the rules for setting
weights for credit risk.
In making their ratings, CRAs analyse public and non-public financial and accounting
data as well as information about economic and political factors that may affect the
ability and willingness of a government or firms to meet their obligations in a timely
manner. However, CRAs lack transparency and do not provide clear information about
their methodologies.
Ratings tend to be sticky, lagging markets, and then to overreact when they do change.
This overreaction may have aggravated financial crises in the recent past, contributing to
financial instability and cross-country contagion(downgrade of US credit rating).
Moreover, the action of countries which strive to maintain their rating grades through
tight macroeconomic policies may be counterproductive for long-term investment and
growth.
The recent bankruptcies of Enron, WorldCom, and Parmalat have prompted legislative
scrutiny of the agencies. Criticism has been especially directed towards the high degree
of concentration of the industry, which in the United States has reflected a registration
and certification process in the form of NRSRO designation biased against new entrants.
The effect of such concentration has been the absence of the discipline enforced by
competition and a low level of innovation.
17
In the United States, policy action has included the 2006 Credit Rating Agency Reform
Act which has overhauled the regulatory framework by prescribing procedural
requirements for NRSRO registration and certification and by strengthening the powers
of the SEC.
At international level, the main initiative has been the publication by IOSCO of its Code
of Conduct. This Code aims at developing governance rules for CRAs to ensure the
quality and integrity of the rating process, the independence of the process and the
avoidance of conflict of interest and greater transparency. In its 2005 Technical Advice to
the European Commission on possible Measures Concerning Credit Rating Agencies, the
CESR recommended the implementation of the IOSCO Code and adoption of a "wait and
see" attitude.
Definitive assessment of these initiatives would still be premature. The industry will
receive a fillip from implementation of Basel II. The major CRAs will undoubtedly seek
a substantial share of the new business which will result. Promotion of competition may
require policy action at national level to encourage the establishment of new agencies and
to channel business generated by new regulatory requirements in their direction.
Regulatory action at the national level may also be necessary to ensure that the agencies
operate in accord with levels of accountability and transparency matching the
recommendations of the IOSCO Code.
Ratings agencies do serve a purpose in financial markets. Their value in assessing default risk
and thereby affecting credit spreads plays a critical role in financial markets and especially the
flow of capital to developing countries. Improvements can be made by encouraging more
accurate ratings and requiring more timely ratings. Additional improvement can come through
investor education about the method and meaning of credit ratings, and greater transparency by
the agencies to level the playing field for all investors. Increasing competition may be one
strategy to increase investment and more accurate ratings, but its potential negative
consequences will need to be monitored and supervised to prevent "rate shopping."
18
References:-
http://www.investopedia.com/
http://www.forexpromos.com/what-are-credit-rating-companies-and-their-impact-on-the-
economy
CREDIT RATING AGENCIES AND THEIR POTENTIAL IMPACT ON
DEVELOPING COUNTRIES,Marwan Elkhoury,No. 186,January 2008