Credit Rating

ACKNOWLEDGEMENT
I take this opportunity to express my profound gratitude and deep regards to my project guide Mr. Lokesh Tardalkar for his exemplary guidance, monitoring and constant encouragement throughout the course of this project. The blessing, help and guidance given by him time to time shall carry me a long way in the journey of life on which I am about to embark. I also take this opportunity to express a deep sense of gratitude to the principal Dr. Minu Thomas for her cordial support and guidance, which helped me in completing this task through various stages. I am obliged to my course coordinator Mrs. Shailashri Uchil, for the valuable information provided by her in respective fields. I am grateful for their cooperation during the period of my assignment. Lastly, I thank almighty, my parents, brother, sisters and friends for their constant encouragement without which this assignment would not be possible.

(Name of the student) (Mudaliyar Vineeth Rajkumar)

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INDEX Sr.no Topic Page no. 3 5 9 11 15 23 28 31 33

1. 2. 3. 3. 4. 5. 6. 7. 8.

Introduction to Credit Rating Functions, Advantages & Disadvantages Rating Methodology Indian Rating Agencies Credit Rating Agencies in the USA US Subprime Mortgage Crisis Role of Credit Rating Agencies in the Crisis SEC’s Report Bibliography

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INTRODUCTION
An assessment of the credit worthiness of individuals and corporations is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities. Credit is important since individuals and corporations with poor credit will have difficulty finding financing, and will most likely have to pay more due to the risk of default. A credit rating evaluates the credit worthiness of a debtor, especially a business (company) or a government. It is an evaluation made by a credit rating agency of the debtor's ability to pay back the debt and the likelihood of default. Credit ratings are determined by credit ratings 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. The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations. 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 credit rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower‟s overall credit history. A credit rating is also known as an evaluation of a potential borrower‟s ability to repay debt, prepared by a credit bureau at the request of the lender. Credit ratings are calculated from financial history and current assets & liabilities. A credit rating tells a lender or investor the probability of the subject being able to pay back a loan. A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high Interest rates or the refusal of a loan by the creditor.

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A Credit Rating Agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.) Who needs Credit Rating 1. Commercial Banks 2. Mutual Funds 3. Investment Banks 4. Leasing companies 5. Insurance companies 6. Bond Issuers

Why the need of Credit Rating As said earlier, credit rating is an opinion expressed by an independent professional organization, after making a detailed study of all relevant factors. Such an opinion is of great assistance to investors in making investment decisions. It also helps the issuers of debt instruments to price their issues correctly and to reach out to investors and win their confidence. Regulators like Reserve Bank of India (RBI) and Securities & Exchange Board of India (SEBI) often use credit rating to determine eligibility criteria for some instruments. For example, the RBI has stipulated a minimum credit rating by an approved agency for issue of Commercial Paper. Credit Rating also proves as a valuable input in establishing business relationships of various types.

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FUNCTIONS, ADVANTAGES & DISADVANTAGES
Benefits of Credit Ratings: To Corporates: For corporates, a good credit rating enables them to have lower interest costs, win confidence of investors. Also there is a compulsion from the regulators to have credit rating assigned to certain debt issues. To Investors: 1. Safety of investments. Credit rating gives an idea in advance to the investors about the degree of financial strength of the issuer company. Based on rating he decides about the investment. A highly rated issue gives assurance to the investors of safety of Investments and minimizes his risk. 2. Recognition of risk and returns. Credit rating symbols indicate both the returns expected and the risk attached to a particular issue. It becomes easier for the investor to understand the worth of the issuer company just by looking at the symbol because the issue is backed by the financial strength of the company. 3. Freedom of investment decisions. Investors need not seek advice from the stock brokers, merchant bankers or the portfolio managers before making investments. Investors today are free and independent to take investment decisions themselves. They base their decisions on rating symbols attached to a particular security. Each rating symbol assigned to a particular investment suggests the creditworthiness of the investment and indicates the degree of risk involved in it. 4. Wider choice of investments. As it is mandatory to rate debt obligations for every issuer company, at any particular time, wide range of credit rated instruments are available for making investment. Depending upon his own ability to bear risk, the investor can make choice of the securities in which investment is to be made. 5. Dependable credibility of issuer. Absence of any link between the rater and rated firm ensures dependable credibility of issuer and attracts investors. As rating agency has no vested interest in issue to be rated, and has no business connections or links with the Board of Directors. In other words, it operates independent of the issuer company; the rating given by it is always accepted by the investors.
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6. Easy understanding of investment proposals. Investors require no analytical knowledge on their part about the issuer company. Depending upon rating symbols assigned by the rating agencies they can proceed with decisions to make investment in any particular rated security of a company.

7. Relief from botheration to know company. Credit agencies relieve investors from botheration of knowing the details of the company, its history, nature of business, financial position, liquidity and profitability position, composition of management staff and Board of Directors etc. Credit rating by professional and specialized analysts reposes confidence in investors to rely upon the credit symbols for taking investment decisions.

8. Advantages of continuous monitoring. Credit rating agencies not only assign rating symbols but also continuously monitor them. The Rating agency downgrades or upgrades the rating symbols following the decline or improvement in the financial position respectively. For investors it is a boon since they can take informed investment decisions, can rely on the issues / offers, they get an ease of selection of investment products. Given the benefits of credit ratings, recently, the role of rating agencies has come under the scanner during the global financial crisis, as many companies and their issues collapsed despite high rating. Reasons for this being like, abnormally high payment of fees to the rating agencies for getting a high / good rating, biasedness of agencies in analysis and judgement, etc. Disadvantages of Credit Rating Credit rating suffers from the following limitations: 1. Non-disclosure of significant information. Firm being rated may not provide significant or material information, which is likely to affect the investor‟s decision as to investment, to the investigation team of the credit rating company. 2. Static study. Rating is a static study of present and past historic data of the company at one particular point of time. Number of factors including economic, political, environment, and government policies has direct bearing on the working of a company. 3. Rating is no certificate of soundness. Rating grades by the rating agencies are only an opinion about the capability of the company to meets its interest obligations. Rating symbols do not pinpoint towards quality of products or management or staff etc. In other words rating
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does not give a certificate of the complete soundness of the company. Users should form an independent view of the rating symbol. 4. Rating may be biased. Personal bias of the investigating team might affect the quality of the rating. The companies having lower grade rating do not advertise or use the rating while raising funds from the public. In such a case the investors cannot get the true information about the risk involved in the instrument. 5. Rating under unfavorable conditions. Rating grades are not always representative of the true image of a company. A company might be given low grade because it was passing through unfavorable conditions when rated. Thus, misleading conclusions may be drawn by the investors which hamper the company‟s interest. Functions of a Credit Rating Agency The primary function of the credit rating agencies is to provide credit ratings to the service providers of various forms of debt products and services. They are also meant to provide ratings to the debt instruments being provided by these service providers. The clients of the credit rating agencies are those entities that deal in the provision of debt products and services. At times, it has been observed that the companies that provide debt products and services are rating the debt instruments by themselves. The providers of securities like the companies, the governmental organizations at the state and central level and special purpose entities are the major clients of the credit rating agencies. The non-profit seeking organizations and the national governments also avail the services of the credit rating agencies. A credit rating agency serves following functions: 1. Provides unbiased opinion: An independent credit rating agency is likely to provide an unbiased opinion as to relative capability of the company to service debt obligations because it has no vested interest in an issue unlike brokers, financial intermediaries.

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2. Provides quality and dependable information: A credit rating agency is in a position to provide quality information on credit risk which is more authenticated and reliable because: a. It has highly trained and professional staff that has better ability to assess risk. b. It has access to a lot of information which may not be publicly available. 3. Provides information at low cost: Most of the investors rely on the ratings assigned by the ratings agencies while taking investment decisions. These ratings are published in the form of reports and are available easily on the payment of negligible price. It is not possible for the investors to assess the creditworthiness of the companies on their own.

4. Provide easy to understand information: Rating agencies first of all gather information, and then analyze the same. At last these interpret and summarize complex information in a simple and readily understood formal manner. Thus in other words, information supplied by rating agencies can be easily understood by the investors. They need not go into details of the financial statements. 5. Provide basis for investment: An investment rated by a credit rating enjoys higher confidence from investors. Investors can make an estimate of the risk and return associated with a particular rated issue while investing money in them. 6. Healthy discipline on corporate borrowers: Higher credit rating to any credit investment enhances corporate image and builds up goodwill and hence it induces a healthy/ discipline on corporate. 7. Formation of public policy: Once the debt securities are rated professionally, it would be easier to formulate public policy guidelines as to the eligibility of securities to be included in different kinds of institutional port-folio.
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RATING METHODOLOGY
A certain methodology is adopted by rating agencies to ascertain the credit worthiness of the debt issuers. In brief, following aspects are taken into consideration while assigning a rating:
o o o o o o o o o

Industry Risk Market position Ownership Earnings & Performance Cash flows Management structure and composition Capital & Debt Structure Corporate Governance Other factors like (for financial institutions): Capital adequacy & Liquidity, Quality of asset, Asset/Liability structure, Sourcing of funds, cost of funds.

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Business Analysis
•Actual & estimated Demand/Supply •No. of firms and potential entrance in the industry •Govt. Policy •Performance of industry & future Prospects •Market share of the firm •Strength & weaknesses •Product & Customers

Industry Risk

Market Position in the Industry

Operating Efficiency
•Company structure •Locational advantage •Labour relationship •Input availability & Prices

Legal Position
•Accuracy of Information •Regulatory authority

Financial Analysis
•Inventory valuation •Depreciation Policy •Off- balance Liability •Profitability Ratio •Earning growth

Accounting Quality

Earning Protection

•Working Capital Need •Future budgeting

Adequacy of CashFlow

Financial Flexibility

•Alternative Plan in development •Feasibility of such plan

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INDIAN CREDIT AGENCIES
CRISIL CRISIL is the largest credit rating agency in India. It was established in 1987. The world‟s largest rating agency Standard & Poor's now holds majority stake in CRISIL. Till date it has rated more than 5178 SMEs across India and has issued more than 10,000 SME ratings.

Rating scale for Long-Term Instruments CRISIL (Highest Safety) AAA Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. CRISIL (High Safety) AA Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. CRISIL (Adequate Safety) A Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk. CRISIL BBB Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk. CRISIL (Moderate Risk) CRISIL (High Risk) CRISIL (Very High Risk) CRISIL Default BB Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligations. B Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligations. C Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations. D Instruments with this rating are in default or are expected to be in default soon.

(Moderate Safety)

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CARE: CREDIT ANALYSIS & RESEARCH LTD. Incorporated in 1993, Credit Analysis and Research Limited (CARE) is a credit rating, research and advisory committee promoted by Industrial Development Bank of India (IDBI), Canara Bank, Unit Trust of India (UTI) and other financial and lending institutions. CARE has completed over 7,564 rating assignments since its inception in 1993. Symbols: CARE AAA- Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. CARE AA- Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. CARE A- Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk. CARE BBB- Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk. CARE BB- Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligations. CARE B- Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligations. CARE C- Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations. CARE D- Instruments with this rating are in default or are expected to be in default soon.

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ICRA - INVESTMENT INFORMATION AND CREDIT RATING AGENCY OF INDIA LIMITED, ASSOCIATE OF MOODY’S INVESTORS SERVICE ICRA was established in 1993 by Mr. Sonu Mirchandani as a rating agency. It analyzes data and provides rating solutions for Individuals and Small and Medium Enterprises (SMEs). ONICRA has an extensive experience in operating a wide range of business processes in areas such as Finance, Accounting, Back-end Management, Application Processing, Analytics, and Customer Relations. It has rated more than 2500 SMEs. ICRA’s Long-Term Rating Scale LAAA- The highest credit quality rating assigned by ICRA. The rated instrument carries the lowest credit risk. LAA - The high credit-quality rating assigned by ICRA. The rated instrument carries low credit risk. LA- The adequate credit quality rating assigned by ICRA. The rated instrument carries average credit risk. LBBB- The moderate credit quality rating assigned by ICRA. The rated instrument carries higher than average credit risk. LBB- The inadequate credit quality rating assigned by ICRA. The rated instrument carries high credit risk. LB- The risk prone credit quality rating assigned by ICRA. . The rated instrument carries very high credit risk. LC- The poor credit quality rating assigned by ICRA. The rated instrument has limited prospects of recovery. LD- The lowest credit quality rating assigned by ICRA. The rated instrument has very low prospects of recovery.

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ICRA’s Medium-Term Rating Scale (only for Public Deposits) Medium-Term Rating Scale: All Public Deposit Programme. MAAA- The highest credit quality rating assigned by ICRA. The rated deposits programme carries the lowest credit risk MAA-The high-credit quality rating assigned by ICRA. The rated deposits programme carries low credit risk. MA- The adequate credit quality rating assigned by ICRA. The rated deposits programme carries average credit risk. MB- The inadequate credit quality rating assigned by ICRA. The rated deposits programme carries high credit risk. MC- The risk prone credit quality rating assigned by ICRA. The rated deposits programme carries very high credit risk. MD- The lowest-credit-quality rating assigned by ICRA. The rated instrument has very low prospects of recovery. ICRA’s Short-Term Rating Scale Short-Term Rating Scale: All instruments with original maturity within one year. A1- The highest-credit quality rating assigned by ICRA to short term debt instruments. Instruments rated in this category carry the lowest credit risk in the short term. Within this category, certain instruments are assigned the rating of A1+ to reflect their relatively stronger credit quality. A2- The above average credit quality rating assigned by ICRA to short term debt instruments. However, instruments rated in this category carry higher credit risk than instruments rated A1. A3- The moderate credit quality rating assigned by ICRA to short term debt instruments. However, instruments rated in this category carry higher credit risk than instruments rated A2 and A1. A4- The risk prone credit quality rating assigned by ICRA to short term debt instruments. Instruments rated in this category carry high credit risk. A5- The lowest credit quality rating assigned by ICRA to short term debt instruments. Instruments rated in this category have very low prospect of recovery.

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CREDIT RATING AGENCIES IN USA
MOODY’S CORP. Moody‟s Corporation, through its subsidiaries, provides credit ratings and related research, data, and analytical tools; quantitative credit risk measures, risk scoring software, and credit portfolio management solutions; and securities pricing software and valuation models principally in the United States and Europe. The company operates through two segments, MIS and MA. The MIS segment publishes credit ratings on a range of debt obligations, including various corporate and governmental obligations, structured finance securities, and commercial paper programs, as well as the entities that issue such obligations in markets worldwide. This segment provides ratings in approximately 110 countries. Its ratings are disseminated via press releases to the public through a range of print and electronic media, including the Internet and real-time information systems, which is used by securities traders and investors. As of December 31, 2008, MIS had ratings relationships with approximately 13,000 corporate issuers and approximately 26,000 public finance issuers. Additionally, the company rated and monitored ratings on approximately 109,000 structured finance obligations. The MA segment develops a range of products and services that support the credit risk management activities of institutional participants in financial markets. These offerings include quantitative credit risk scores, credit processing software, economic research, analytical models, financial data, securities pricing software, and valuation models, and specialized consulting services. It also distributes investor-oriented research and data, including in-depth research on debt issuers, industry studies, and commentary on topical events developed by MIS as part of its rating process. The company was founded in 1900 and is headquartered in New York, New York. STANDARD & POOR’S Standard & Poor's (S&P) is one of the world's preeminent providers of credit ratings, indices, risk evaluation, investment research and data. It also provides a wide range of other products and services designed to help individuals and institutions make better-informed financial decisions. Range of services provided by Standard & Poor's does include advice on asset allocation, portfolio strategies, fund recommendations and research.

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Standard and Poor‟s was formed in 1941 with the merger of Standard Statistics and Poor's Publishing Company. Standard and Poor's has an unrivalled depth and breadth in coverage and analysis. Standard & Poor's has the world's largest network of credit ratings analysts. Over $1 trillion in investors' assets is directly tied to S&P indexes - more than all other index providers combined. Standard & Poor's indices include the premier U.S. portfolio index, the S&P 500. Standard & Poor's has a long history of creating standards for the financial industry. S&P has several firsts to its credit. Standard & Poor's was the first to rate Securitized financings, Bond insured transactions, Letters of credit, The financial strength of non-U.S. insurance companies, Bank holding companies, Financial guaranty companies. Standard & Poor's issues credit ratings for the debt of corporations be they public or private. It has been designated a Nationally Recognized Statistical Rating Organization by the U.S. Securities and Exchange Commission. S&P issues both short-term and long-term credit ratings. FITCH AND CO. Fitch Ratings, one of the top three credit rating agencies in the world (alongside Moody's and Standard & Poor's), issues ratings for thousands of banks, financial institutions, insurance companies, corporations, and governments. With dual headquarters in New York and London and about 50 offices worldwide, Fitch Ratings engages in the politically charged business of rating the debt of nations; it covers companies and governments in more than 90 nations. The company is part of the Fitch Group, which is a majority-owned subsidiary of France-based Fimalac.

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Rating tables Moody’s Long-term obligation ratings Moody's long-term obligation ratings are opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more. They address the possibility that a financial obligation will not be honored as promised. Such ratings reflect both the likelihood of default and the probability of a financial loss suffered in the event of default. Investment grade  Aaa - highest quality, smallest degree of risk  Aa1, Aa2, Aa3 - high quality, subject to very low credit risk, "their susceptibility to long-term risks appears somewhat greater”  A1, A2, A3 - low credit risk, susceptible to impairment over the long term"  Baa1, Baa2, Baa3 - moderate credit risk, medium-grade, characteristically unreliable. Speculative grade (Also known as High Yield or 'Junk')  Ba1, Ba2, Ba3 - questionable credit quality  B1, B2, B3 - speculative, high credit risk, generally poor credit quality  Caa1, Caa2, Caa3 - poor standing, very high credit risk, extremely poor credit quality, may be in default  Ca - highly speculative, usually in default on their deposit obligations  C - lowest rated class of bonds, typically in default, potential recovery values are low. Special  WR -Withdrawn Rating  NR -Not Rated  P -Provisional Short-term taxable ratings Moody's short-term ratings for taxable securities are opinions of the ability of issuers to honor short-term financial obligations. Ratings may be assigned to issuers, short-term programs or to individual short-term debt instruments. Such obligations generally have an original maturity not exceeding thirteen months, unless explicitly noted.

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Moody's employs the following designations to indicate the relative repayment ability of rated issuers: P-1 Issuers (or supporting institutions) rated Prime-1 have a superior ability to repay short-term debt for the obligations. P-2 Issuers (or supporting institutions) rated Prime-2 have a strong ability to repay shortterm debt obligations. P-3 Issuers (or supporting institutions) rated Prime-3 have an acceptable ability to repay short-term obligations. NP Issuers (or supporting institutions) rated Not Prime do not fall within any of the Prime rating categories.
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Note: Canadian issuers rated P-1 or P-2 have their short-term ratings enhanced by the senior-most long-term rating of the issuer, its guarantor or support-provider.

Short-term tax-exempt ratings Unlike S&P, Moody's has separate categories for short term municipal bonds. The ratings categories largely overlap, though, and have the same implications for the ability to repay short-term obligations. Individual bank ratings Moody's also rates each bank's financial strength. These ratings differ from deposit ratings in that they measure how likely the bank is to need assistance from third parties. A B C D "superior intrinsic financial strength" "strong intrinsic financial strength" "adequate intrinsic financial strength" "modest intrinsic financial strength, potentially requiring some outside support at times" E “very modest intrinsic financial strength, with a higher likelihood of periodic outside support"

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S&P Credit ratings Standard & Poor's, as a credit rating agency (CRA), issues credit ratings for the debt of public and private corporations. It is one of several CRAs that have been designated a Nationally Recognized Statistical Rating Organization by the U.S. Securities and Exchange Commission. It issues both short-term and long-term credit ratings. Long-term credit ratings S&P rates borrowers on a scale from AAA to D. Intermediate ratings are offered at each level between AA and CCC (i.e., BBB+, BBB and BBB-). For some borrowers, S&P may also offer guidance (termed a "credit watch") as to whether it is likely to be upgraded (positive), downgraded (negative) or uncertain (neutral). Investment Grade  AAA : the best quality borrowers, reliable and stable (many of them governments)  AA : quality borrowers, a bit higher risk than AAA  A : economic situation can affect finance  BBB : medium class borrowers, which are satisfactory at the moment Non-Investment Grade (also known as junk bonds)  BB : more prone to changes in the economy  B : financial situation varies noticeably  CCC : currently vulnerable and dependent on favorable economic conditions to meet its commitments  CC : highly vulnerable, very speculative bonds  C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations  CI : past due on interest  R : under regulatory supervision due to its financial situation  SD : has selectively defaulted on some obligations  D : has defaulted on obligations and S&P believes that it will generally default on most or all obligations  NR : not rated

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Short-term issue credit ratings S&P rates specific issues on a scale from A-1 to D. Within the A-1 category it can be designated with a plus sign (+). This indicates that the issuer's commitment to meet its obligation is very strong. Country risk and currency of repayment of the obligor to meet the issue obligation are factored into the credit analysis and reflected in the issue rating.  A-1 : obligor's capacity to meet its financial commitment on the obligation is strong  A-2 : is susceptible to adverse economic conditions however the obligor's capacity to meet its financial commitment on the obligation is satisfactory  A-3 : adverse economic conditions are likely to weaken the obligor's capacity to meet its financial commitment on the obligation  B: has a significant speculative characteristic. The obligor currently has the capacity to meet its financial obligation but faces major ongoing uncertainties that could impact its financial commitment on the obligation  C: currently vulnerable to nonpayment and is dependent upon favorable business, financial and economic conditions for the obligor to meet its financial commitment on the obligation  D: is in payment default. Obligation not made on due date and grace period may not have expired. The rating is also used upon the filing of a bankruptcy petition. Stock market indices Standard & Poor's publishes a large number of stock market indices, covering every region of the world, market capitalization level, and type of investment (e.g. indices for REITs and preferred stocks). These indices include:  S&P 500 -- value weighted index of the prices of 500 large-cap common stocks actively traded in the United States.  S&P 400 Mid Cap Index  S&P 600 Small Cap Index

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Fitch Co. Long-term credit ratings Fitch Rating' long-term credit ratings are set up along a scale from 'AAA' to 'D', first introduced in 1924 and later adopted and licensed by S&P. Moody's also uses a similar scale, but names the categories differently. Like S&P, Fitch also uses intermediate modifiers for each category between AA and CCC (i.e., AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBBetc.). Investment grade  AAA : the best quality companies, reliable and stable  AA : quality companies, a bit higher risk than AAA  A : economic situation can affect finance  BBB : medium class companies, which are satisfactory at the moment Non-investment grade (also known as junk bonds)  BB : more prone to changes in the economy  B : financial situation varies noticeably  CCC : currently vulnerable and dependent on favorable economic conditions to meet its commitments  CC : highly vulnerable, very speculative bonds  C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations  D : has defaulted on obligations and Fitch believes that it will generally default on most or all obligations  NR : not publicly rated

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Short-term credit ratings Fitch's short-term ratings indicate the potential level of default within a 12-month period.  F1+ : best quality grade, indicating exceptionally strong capacity of obligor to meet its financial commitment  F1 : best quality grade, indicating strong capacity of obligor to meet its financial commitment  F2 : good quality grade with satisfactory capacity of obligor to meet its financial commitment  F3 : fair quality grade with adequate capacity of obligor to meet its financial commitment but near term adverse conditions could impact the obligor's commitments  B : of speculative nature and obligor has minimal capacity to meet its commitment and vulnerability to short term adverse changes in financial and economic conditions  C : possibility of default is high and the financial commitment of the obligor are dependent upon sustained, favourable business and economic conditions  D : the obligor is in default as it has failed on its financial commitments.

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US SUBPRIME MORTGAGE CRISIS
Charity begins at home, it is said. Here, crisis began at home, or more exactly, home loans. Housing prices began spiraling upwards in the US in the early years of this decade and continued through mid-2006, with the borrowing and lending rates extremely low which helped boost the demand for and supply of new and existing houses. Many institutions offered home loans to borrowers with poor or no credit histories by requiring higher than normal repayment levels — creating what is now referred to as “subprime mortgages” —attracting investment banks and hedge fund owners to bet big on this emerging aspect of the US economy. A retrospect does help when the market is in a crisis. The countdown began on June 30, 2004, when the Federal Reserve (the central bank in the US) began a cycle of interest rate hikes that raised the cost of borrowing from the lowest levels registered since the 1950s. It increased the interest rates seventeen times and paused only in June 2006 when the borrowing cost touched 5.25 per cent. The US housing market began sliding in August 2005 and that continued through 2006. Building rates and housing prices tumbled. Yes. Several sub-prime mortgage holders defaulted on their loans and the first sign of a “crisis” emerged in March 2007 when shares in New Century Financial, one of the largest sub-prime lenders in the US, were suspended amid fears that the firm could be heading for bankruptcy. Another US-based sub-prime firm Accredited Home Lenders Holding said it would pass on $2.7 billion of its loans at a heavy discount. On April 2, 2007, New Century Financial filed for bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of bad loans. The sub-prime mortgage crisis went on to affect major global investment banks as well. Shares in Bear Stearns came under pressure in May 2007 because of the bank‟s exposure to the US sub-prime market. In June, Merrill Lynch seized and sold $800 millions of bonds used as collateral for loans made to Bear Stearns‟ hedge funds that were used to bet on the sub prime mortgage market. In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business it bought in 2004. Goldman Sachs also announced financial support for one of its struggling hedge funds hit by the defaulting sub-prime mortgages.

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Given the dominance of US financial markets in other developed and developing economies, the sub-prime mortgage market crisis affected markets and institutions all over the globe. CAUSES OF THE SUBPRIME MORTGAGE CRISIS Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the instance of subprime mortgage woes, there is no single entity or individual to point the finger at. Instead, this mess is a collective creation of the world's central banks, homeowners, lenders, credit rating agencies and underwriters, and investors. The economy was at risk of a deep recession after the dotcom bubble burst in early 2000; this situation was compounded by the September 11 terrorist attacks that followed in 2001. In response, central banks around the world tried to stimulate the economy. They created capital liquidity through a reduction in interest rates. In turn, investors sought higher returns through riskier investments. Lenders took on greater risks too, and approved subprime mortgage loans to borrowers with poor credit. Consumer demand drove the housing bubble to all-time highs in the summer of 2005, which ultimately collapsed in August of 2006. The end result of these key events was increased foreclosure activity, large lenders and hedge funds declaring bankruptcy, and fears regarding further decreases in economic growth and consumer spending. So who's to blame? Let's take a look at the key players. Biggest Culprit: The Lenders Most of the blame should be pointed at the mortgage originators (lenders) for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default. When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.

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In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments. Partners in Crime: Home Buyers While we're on the topic of lenders, we should also mention the home buyers. Many were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages) that offered low introductory rates and minimal initial costs such as "no down payment". Their hope lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in other spending. However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly. As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgage at higher rates, which many could not afford. Many homeowners were simply forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007. In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may have given the impression that there was no risk to these mortgages and that the costs weren't that high; however, at the end of the day, many borrowers simply assumed mortgages they couldn't reasonably afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable. Exacerbating the situation, lenders and investors of securities backed by these defaulting mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left with property that was worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy. Investment Bankers Worsen the Situation The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased
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liquidity even more. The snowball began to build momentum. A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs. Rating Agencies: Possible Conflict of Interest A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. Moreover, some have pointed to the conflict of interest between rating agencies, which receive fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not rated. Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market demand. Final Culprit: Hedge Funds Another party that added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem. To illustrate, there is a type of hedge fund strategy that can be best described as "credit arbitrage". It involves purchasing subprime bonds on credit and hedging these positions with credit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage

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was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs. Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls. Plenty of Blame to Go Around Overall, it was a mix of factors and participants that precipitated the current subprime mess. Ultimately, though, human behavior and greed drove the demand, supply and the investor appetite for these types of loans. Hindsight is always 20/20, and it is now obvious that there was a lack of wisdom on the part of many. However, there are countless examples of markets lacking wisdom, most recently the dotcom bubble and ensuing "irrational exuberance" on the part of investors. It seems to be a fact of life that investors will always extrapolate current conditions too far into the future - good, bad or ugly.

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ROLE OF CREDIT RATING AGENCIES IN THE CRISIS
Credit rating agencies played an important role at various stages in the subprime crisis. They have been highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Impact on the crisis Credit rating agencies are now under scrutiny for giving investment-grade, "money safe" ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. These high ratings encouraged a flow of global investor funds into these securities, funding the housing bubble in the U.S. An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007. These mortgages could be bundled into MBS and CDO securities that received high ratings and therefore could be sold to global investors. Higher ratings were believed justified by various credit enhancements including over-collateralization (i.e., pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. Economist Joseph Stiglitz stated: "I view the rating agencies as one of the key culprits...They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies." Without the AAA ratings, demand for these securities would have been considerably less. Bank write downs and losses on these investments totaled $523 billion as of September 2008. Competitive pressure to lower rating standards The rating of these securities was a lucrative business for the rating agencies, accounting for just under half of Moody's total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices. The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business. Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards. Interviews with rating agency senior managers indicate the competitive pressure to rate the CDO's favorably was strong within the firms. This rating business was their "golden goose" (which laid the proverbial golden egg or wealth) in the words of one manager.

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Author Upton Sinclair (1878-1968) famously stated: "It is difficult to get a man to understand something when his job depends on not understanding it." This competitive pressure and the resulting profits gave a personal financial incentive to management to lower standards. Internal rating agency emails from before the time the credit markets deteriorated, discovered and released publicly by U.S. congressional investigators; suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce negative results. For example, one email between colleagues at Standard & Poor's states "Rating agencies continue to create and [sic] even bigger monster--the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters." Conflicts of interest Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks. John C. Bogle wrote in 2005 that there is an inherent conflict of interest when a professional firm is also publiclytraded, as the pressure to grow and increase profits is relatively stronger, which may detract from the quality of work performed. Moody's became a public firm in 2001, while Standard & Poor's is part of the publicly-traded McGraw-Hill Companies. SEC Investigation On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities. The proposal would, among other things, prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available, prohibit credit rating agencies from structuring the same products that they rate, and require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. The last proposed requirement is designed to facilitate "unsolicited" ratings of structured securities by rating agencies not compensated by issuers. Rating actions during the crisis Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008, another indicator that their initial ratings were not accurate. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this
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involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressure MBS and stock prices lower. As of July 2008, Standard & Poor's (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A;" 466 of those downgrades of "triple-A" securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS and CDOs of ABS originally rated by S&P. Since certain types of institutional investors are allowed to only carry investment-grade (e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause further devaluation. Actions taken to improve rating approach Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt. In addition, rating agencies have begun taking action to address perceived or actual conflicts of interest, including additional internal monitoring programs, third party reviews of rating processes, and board updates.

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SEC REPORT ON RATING AGENCIES ROLE IN SUBPRIME CRISIS
The Securities & Exchange Commission (SEC) published its „Summary Report of Issues Identified in the Commission Staff‟s Examination of Select Credit Rating Agencies‟ [NRSROs]. The SEC concluded (in a year-long study released on July 8th), that rating agencies improperly managed conflicts of interest and violated internal procedures in granting top ratings to structured securities. The SEC report lists eight major areas of deficiencies in processes, procedures and conflict of interest, including:  The massive volume and complexity of deals overwhelmed NRSROs‟ resources, leading to errors and shortcuts in procedures and documentation.  Aspects of the rating process were not always disclosed. There was a lack of consistency in documentation on rating processes, models and rating committee meetings.  As to the quality of information underlying the ratings, there was no obligation for rating agencies to verify the information provided by arrangers.  Significant aspects of the rating process, including rationale for rating committee actions and decisions, were not always documented.  No due diligence on information was provided to NRSROs.  The surveillance process used appears to have been less robust than it should have been.  There were issues in the management of conflicts, for instance, with analysts taking part in pricing.  Internal audit process varied significantly between rating agencies and were ineffective in part due to lack of documentation.

Implications: Tighter regulations are now inevitable, but rating agencies are pushing back stating that some of the recommendations are too costly and beyond the current mandate of the SEC. However it is important to note that the NRSROs are proceeding with the implementation of many of the recommendations made by the SEC. There are many proponents for a tighter regulatory regime, here in the USA and on the other side of the Atlantic at the European Commission. But there are others who caution that the NRSROs are not the only participants in the value chain of bringing financial securities to the market. There is along route from origination to investors all of which have to be part of a „credit system overhaul‟. In regard to entrusting NRSROs to European regulators the Financial

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Times wrote recently: “If the world‟s best-paid financiers did not spot subprime, is it fair to entrust this tasks to Europe‟s supervisors?” BIIA suspected all along that there was disconnect with regard to the use of consumer information. The USA has the highest penetration of credit due to the availability of reliable information, and based on this fact the subprime debacle should not have happened. It is now evident that there was wholesale misrepresentation, misuse of information and outright fraud in the origination process of subprime mortgages. FICO scores appeared to have been imprecise because the absence of underlying credit performance of subprime candidates (no loan history). Experts are now questioning the reliability of credit scores. Others counter by proposing a greater use of nonfinancial data (for example utility payments etc.) to compensate for the absence of previous credit performance data from the financial sector) to improve the performance of „subprime credit scores‟.

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BIBLIOGRAPGHY
 http://www.iloveindia.com/finance/encyclopedia/crisil.html  http://small.in/%20/fund-your-business%20/credit-rating%20/msme-rating%20/ratingagencies-india  http://www.psnacet.edu.in/courses/MBA/Financial%20services/16.pdf  http://taxguru.in/finance/all-about-credit-rating-in-brief.html  http://crisil.com/ratings/credit-rating-scale.html  http://www.careratings.com/Portals/0/Content/Bank%20Loan%20Rating.pdf  http://www.icra.in/files/content/ratingsscale-2008.pdf  http://www.fitchratings.com/web_content/ratings/fitch_ratings_definitions_and_scales.pf  http://www.psnacet.edu.in/courses/MBA/Financial%20services/16.pdf  http://taxguru.in/finance/all-about-credit-rating-in-brief.html  Reuters.com  Standardandpoors.com  Fitch.com  Moodys.com  BIIA.com

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