Rating Agencies
Content
CREDIT RATING AGENCIES (CRA’s)
What is a Credit Rating
• A credit rating is an opinion on the creditworthiness of a debt issue or issuer. • The rating does not provide guidance on other aspects essential for investment decisions, such as market liquidity or price volatility. • According to rating agencies, ratings are opinions and not recommendations to purchase, sell, or hold any security.
Why are CRAs key to capital markets?
Ratings are an essential lubricant for financial markets as they reduce information
asymmetry that investors undergo vis-à-vis issuers; they determine the cost of
borrowing Though perfectible ratings greatly enhance market information on issuers: unexpected rating changes affect level-volatility of bond-share price (Kliger & Sarig
2000) and credit default swaps (Hull et al. 2004; Norden and Weber 2004); bond
downgrades cause negative abnormal stock returns (Dichev & Piotroski 2001, Ferri & Lacitignola, 2007)
Boot et al. (2004): in multiple equilibria states the rating is a coordinating mechanism, providing a “focal point” for firms and investors, thanks to the implicit
contract relationship (monitor-renegotiate) but Carlson & Hale (2004) reach opposite conclusions.
Regulators
• U.S. regulators first used credit ratings in the 1930s to limit the riskiness of assets held by regulated entities, though the practice has expanded significantly since the 1970s (Levich, Majnoni, and Reinhart 2002).
Financial Markets
Interaction with financial markets To reduce information asymmetries in financial markets, CRAs issue credit ratings on sovereigns, other public entities, banks, corporates and structured finance (SF) products.
The rating is an estimate of the issuer’s ability to honor its future interest and capital payments
For issuers, ratings affect interest rate spreads (Ederington et al, 1987; Sy, 2002; Gonzalez at al, 2004) & the extent of available investment flows To the latter extent, it is key whether the rating is investment grade or not (speculative grade)
Regulation of rating agencies before the financial crisis
• International Organization of Securities Commissions. – IOSCO • The U.S. Securities and Exchange Commission (SEC) in 1975 began an informal process of recognizing rating agencies—by giving them the designation nationally recognized statistical rating organizations (NRSROs) • European Securities Regulators depend on the Capital Requirements Directive (2000/12/EC), which adopted the Basel II framework in the European Union, allows the use of external credit assessments—to be provided by external credit assessment institutions recognized by national authorities.
In the United States and Europe faulty credit ratings and flawed rating processes are widely perceived as being among the key contributors to the global financial crisis.
That has brought them under intense scrutiny and led to proposals for radical reforms.
Regulatory reforms in response to the financial crisis
• IOSCO - In response to the role of rating agencies in the structured finance debacle, IOSCO revised the Code of Conduct Fundamentals for Credit Rating Agencies in 2008 by strengthening each of the four categories of principles. G20 - In the April 2009 Declaration on Strengthening the Financial System the G-20 leaders agreed that all credit rating agencies whose ratings are used for regulatory purposes should be subject to an oversight regime that includes registration and is consistent with the IOSCO Code. SEC - In 2009 the U.S. Securities and Exchange Commission (SEC) amended its regulations for rating agencies to require enhanceddisclosure of performance statistics and rating methodologies. •
•
•
EU - A regulation on credit rating agencies was approved in April 2009 by the European Parliament and was followed by a communication on financial supervision by the EU Commission in May 2009. All rating agencies that would like their credit ratings to beused in the European Union will need to apply for registration to the Committee of European Securities Regulators (CESR) and besupervised by it and the relevant home member state.
MAJOR AGENCIES and THEIR Categories
• 1916—Standard Co. began grading bonds. • 1920s—Poor and Fitch began bond rating. • Standard & Poor’s (S&P) was created in 1941 through the merger with Standard Statistics and Poor’s Publishing. • 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. • Currently, $1.5 trillion dollars in investor’s assets are tracking the S&P 500 along with other Standard & Poor’s indices. • In 2008 alone, Standard & Poor's Ratings Services published more than 1,150,000 ratings, including new and revised ratings; 8,500 employees; it covers 70% of global market capitalization.
Standard & Poor’s Sovereign Categories
• •
•
1. Political risk - Stability, predictability and transparency of political institutions, Public and national security, Responsiveness to change and adapt 2. Income and Economic Structure - Degree economy is market-oriented , Extent of property rights , Per-Capita GDP
3. Economic Growth Prospects - Changes in standard of living, Income distribution
•
4. Fiscal Flexibility - Tax revenues, expenditures and past performance in balancing budgets, Methods of deficit financing and their inflationary impact, Growth friendly tax system and the ease of which it can be changed, Efficiency of expenditures 5. Government Debt Burden - Extent to which government can pay and manage its debt
•
•
Standard & Poor’s Sovereign Categories
6. Off-Budget and Contingent Liabilities - Size and health of non-financial public sector enterprises , Health of financial and banking system ,
•
7. Monetary Stability - Credit trends , Price behavior in past economic cycles , Level, currency and maturity of public sector debt , Money and credit expansion , Independence of central bank , Compatibility of exchange rate regime with monetary policy , The range and efficiency of monetary policy tools , Depth and breadth of capital markets
8. External Liquidity - Structure of merchandise trade, service, income and transfers , Vulnerability to changes in investor sentiment , Gross external financing as a percentage of official foreign exchange reserves 9. Private Sector Debt Burdens - Residents assets and liabilities 10. Public Sector Debt Burdens - Trends in public sector debt , Contingent liabilities, Foreign exchange reserves
•
• •
Standard & Poor’s Sovereign Categories
McGraw-Hill Companies acquired Standard & Poor’s in 1966. Along with Standard & Poor’s, McGraw Hill Companies has two more units, Education and Information & Media Services.
Moody’s
Moody’s: (founded 1909) Moody, John. Manual of Railroad Securities, 1909. Provided operating statistics for 200 railroads and their securities. Gross income ($ billion): 1.2 in 2009; 1.19 in 2008; 1.63 in 2007; 0.6 in 2000 Net income ($ million): 402 in 2009; 457 in 2008; 701.5 in 2007; 289 in 2002: 66% from US, 23% from Europe Over 30,000 rated entities (sovereigns, banks & corporates) 1,700 employees of which 1,000 analysts.
Berkshire Hathaway owns 15%
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
Fitch - FIMALAC
Fitch: (founded 1913, merged with Fimalac in 1997) Net income (€ million): 350; 3,000 ratings on Sovereigns, Banks & Corporates; 1,200 employees of which 700 analysts. • The third major rating agency, Fitch Ratings provides ratings and research to over 75 countries. Similar to the other agencies, Fitch Ratings covers a wide range of debt securities offered by corporations, financial institutions, municipal government, insurance companies and sovereign nations. At present they have ratings on 69 sovereign nations. In 1997 Fitch Ratings was fully acquired by Fimalac, a provider of business support services headquartered in Paris. FIMALAC earned 1.4 billion euros in 2001 and Fitch Ratings was responsible for 25% of sales or approximately 350 million euros.
• •
Other CRA’s
DBR: (Canada based, NRSRO since 2003) Other NRSRO agencies: A.M. Best (2005), R&I (2007), JCR (2007), Egan-Jones (2007), LACE (2008), Realpoint (2008) GCRAs are very profitable: pundits accuse NRSRO regulatory franchise
Moody’s and S&P Notation
Proposed Weights Under Basal II Capital Accord
Summary Of Sovereign Defaults Rated by Moody’s
Regional CRAs & capital market development
• In light of the shortcomings of the GCRAs & of the fact that they are even less accountable abroad than in the US & European market, Regional CRAs are needed for capital market development.
Main features of GRAs and NRAs
• GRAs (established since 1909): - Apply a “standardized” rating methodology across countries regardless the environment in which firms operate • NRAs (established since 1985): - Have a comparative advantage to access more appropriate knowledge of local environment (Packer, 2000) - Originated with the support of regulation (Kurosawa, 1999) - Lower fees than those applied by GRAs (JCIF, 2001) - Less independent, most of them are owned by financial institutions (Kurosawa, 1999)
• Only Asia features a significant presence of NRAs, elsewhere (e.g. EU) NRAs have been acquired by GRAs
MARKET SHARE (% ) OF NATIONAL RAs
100,0
90,1
90,0 80,0 70,0
82,4 69,0 61,0 65,8
60,0 50,0 40,0 30,0 20,0 10,0
25,3
0,0
0,0
0,0
In di a
0,0
Is ra el In do ne sia or ea al ay sia ak is
0,0
ta n hi lip pi ne s
0,0
in ga po re
0,0
a Th ai la nd
0,0
Tu rk ey
0,0
ie tn am V
Ko ng -C hi na
la nd
Source - Bloomberg
H on g
C hi
Ta ip ei -C hi n
ai n
K
na -M
M
P
P
S
NRAs issue numerous ratings compared to GRAs
Number of issued ratings from both NRAs and GRAs
100 90 80 70 60 50 40 30 20 10 0 INDIA SOUTH KOREA MALAYSIA JAPAN NRAs GRAs
Source - Bloomberg
Who are the GRAs and the NRAs?
•GRAs: Moody’s, S&P and Fitch
•NRAs (example in 4 Asian countries): Japan: JCR, R&I, Mikuni South Korea: KIS, KR, NICE Malaysia: MARC and RAM India: ICRA, CRISIL and CARE
In the rest of the world there are about 60 rating agencies (Ferri & Lacitignola 2009)
What is a Credit Rating
• A credit rating is an opinion on the creditworthiness of a debt issue or issuer. • The rating does not provide guidance on other aspects essential for investment decisions, such as market liquidity or price volatility. • According to rating agencies, ratings are opinions and not recommendations to purchase, sell, or hold any security.
Why are CRAs key to capital markets?
Ratings are an essential lubricant for financial markets as they reduce information
asymmetry that investors undergo vis-à-vis issuers; they determine the cost of
borrowing Though perfectible ratings greatly enhance market information on issuers: unexpected rating changes affect level-volatility of bond-share price (Kliger & Sarig
2000) and credit default swaps (Hull et al. 2004; Norden and Weber 2004); bond
downgrades cause negative abnormal stock returns (Dichev & Piotroski 2001, Ferri & Lacitignola, 2007)
Boot et al. (2004): in multiple equilibria states the rating is a coordinating mechanism, providing a “focal point” for firms and investors, thanks to the implicit
contract relationship (monitor-renegotiate) but Carlson & Hale (2004) reach opposite conclusions.
Regulators
• U.S. regulators first used credit ratings in the 1930s to limit the riskiness of assets held by regulated entities, though the practice has expanded significantly since the 1970s (Levich, Majnoni, and Reinhart 2002).
Financial Markets
Interaction with financial markets To reduce information asymmetries in financial markets, CRAs issue credit ratings on sovereigns, other public entities, banks, corporates and structured finance (SF) products.
The rating is an estimate of the issuer’s ability to honor its future interest and capital payments
For issuers, ratings affect interest rate spreads (Ederington et al, 1987; Sy, 2002; Gonzalez at al, 2004) & the extent of available investment flows To the latter extent, it is key whether the rating is investment grade or not (speculative grade)
Regulation of rating agencies before the financial crisis
• International Organization of Securities Commissions. – IOSCO • The U.S. Securities and Exchange Commission (SEC) in 1975 began an informal process of recognizing rating agencies—by giving them the designation nationally recognized statistical rating organizations (NRSROs) • European Securities Regulators depend on the Capital Requirements Directive (2000/12/EC), which adopted the Basel II framework in the European Union, allows the use of external credit assessments—to be provided by external credit assessment institutions recognized by national authorities.
In the United States and Europe faulty credit ratings and flawed rating processes are widely perceived as being among the key contributors to the global financial crisis.
That has brought them under intense scrutiny and led to proposals for radical reforms.
Regulatory reforms in response to the financial crisis
• IOSCO - In response to the role of rating agencies in the structured finance debacle, IOSCO revised the Code of Conduct Fundamentals for Credit Rating Agencies in 2008 by strengthening each of the four categories of principles. G20 - In the April 2009 Declaration on Strengthening the Financial System the G-20 leaders agreed that all credit rating agencies whose ratings are used for regulatory purposes should be subject to an oversight regime that includes registration and is consistent with the IOSCO Code. SEC - In 2009 the U.S. Securities and Exchange Commission (SEC) amended its regulations for rating agencies to require enhanceddisclosure of performance statistics and rating methodologies. •
•
•
EU - A regulation on credit rating agencies was approved in April 2009 by the European Parliament and was followed by a communication on financial supervision by the EU Commission in May 2009. All rating agencies that would like their credit ratings to beused in the European Union will need to apply for registration to the Committee of European Securities Regulators (CESR) and besupervised by it and the relevant home member state.
MAJOR AGENCIES and THEIR Categories
• 1916—Standard Co. began grading bonds. • 1920s—Poor and Fitch began bond rating. • Standard & Poor’s (S&P) was created in 1941 through the merger with Standard Statistics and Poor’s Publishing. • 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. • Currently, $1.5 trillion dollars in investor’s assets are tracking the S&P 500 along with other Standard & Poor’s indices. • In 2008 alone, Standard & Poor's Ratings Services published more than 1,150,000 ratings, including new and revised ratings; 8,500 employees; it covers 70% of global market capitalization.
Standard & Poor’s Sovereign Categories
• •
•
1. Political risk - Stability, predictability and transparency of political institutions, Public and national security, Responsiveness to change and adapt 2. Income and Economic Structure - Degree economy is market-oriented , Extent of property rights , Per-Capita GDP
3. Economic Growth Prospects - Changes in standard of living, Income distribution
•
4. Fiscal Flexibility - Tax revenues, expenditures and past performance in balancing budgets, Methods of deficit financing and their inflationary impact, Growth friendly tax system and the ease of which it can be changed, Efficiency of expenditures 5. Government Debt Burden - Extent to which government can pay and manage its debt
•
•
Standard & Poor’s Sovereign Categories
6. Off-Budget and Contingent Liabilities - Size and health of non-financial public sector enterprises , Health of financial and banking system ,
•
7. Monetary Stability - Credit trends , Price behavior in past economic cycles , Level, currency and maturity of public sector debt , Money and credit expansion , Independence of central bank , Compatibility of exchange rate regime with monetary policy , The range and efficiency of monetary policy tools , Depth and breadth of capital markets
8. External Liquidity - Structure of merchandise trade, service, income and transfers , Vulnerability to changes in investor sentiment , Gross external financing as a percentage of official foreign exchange reserves 9. Private Sector Debt Burdens - Residents assets and liabilities 10. Public Sector Debt Burdens - Trends in public sector debt , Contingent liabilities, Foreign exchange reserves
•
• •
Standard & Poor’s Sovereign Categories
McGraw-Hill Companies acquired Standard & Poor’s in 1966. Along with Standard & Poor’s, McGraw Hill Companies has two more units, Education and Information & Media Services.
Moody’s
Moody’s: (founded 1909) Moody, John. Manual of Railroad Securities, 1909. Provided operating statistics for 200 railroads and their securities. Gross income ($ billion): 1.2 in 2009; 1.19 in 2008; 1.63 in 2007; 0.6 in 2000 Net income ($ million): 402 in 2009; 457 in 2008; 701.5 in 2007; 289 in 2002: 66% from US, 23% from Europe Over 30,000 rated entities (sovereigns, banks & corporates) 1,700 employees of which 1,000 analysts.
Berkshire Hathaway owns 15%
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
Fitch - FIMALAC
Fitch: (founded 1913, merged with Fimalac in 1997) Net income (€ million): 350; 3,000 ratings on Sovereigns, Banks & Corporates; 1,200 employees of which 700 analysts. • The third major rating agency, Fitch Ratings provides ratings and research to over 75 countries. Similar to the other agencies, Fitch Ratings covers a wide range of debt securities offered by corporations, financial institutions, municipal government, insurance companies and sovereign nations. At present they have ratings on 69 sovereign nations. In 1997 Fitch Ratings was fully acquired by Fimalac, a provider of business support services headquartered in Paris. FIMALAC earned 1.4 billion euros in 2001 and Fitch Ratings was responsible for 25% of sales or approximately 350 million euros.
• •
Other CRA’s
DBR: (Canada based, NRSRO since 2003) Other NRSRO agencies: A.M. Best (2005), R&I (2007), JCR (2007), Egan-Jones (2007), LACE (2008), Realpoint (2008) GCRAs are very profitable: pundits accuse NRSRO regulatory franchise
Moody’s and S&P Notation
Proposed Weights Under Basal II Capital Accord
Summary Of Sovereign Defaults Rated by Moody’s
Regional CRAs & capital market development
• In light of the shortcomings of the GCRAs & of the fact that they are even less accountable abroad than in the US & European market, Regional CRAs are needed for capital market development.
Main features of GRAs and NRAs
• GRAs (established since 1909): - Apply a “standardized” rating methodology across countries regardless the environment in which firms operate • NRAs (established since 1985): - Have a comparative advantage to access more appropriate knowledge of local environment (Packer, 2000) - Originated with the support of regulation (Kurosawa, 1999) - Lower fees than those applied by GRAs (JCIF, 2001) - Less independent, most of them are owned by financial institutions (Kurosawa, 1999)
• Only Asia features a significant presence of NRAs, elsewhere (e.g. EU) NRAs have been acquired by GRAs
MARKET SHARE (% ) OF NATIONAL RAs
100,0
90,1
90,0 80,0 70,0
82,4 69,0 61,0 65,8
60,0 50,0 40,0 30,0 20,0 10,0
25,3
0,0
0,0
0,0
In di a
0,0
Is ra el In do ne sia or ea al ay sia ak is
0,0
ta n hi lip pi ne s
0,0
in ga po re
0,0
a Th ai la nd
0,0
Tu rk ey
0,0
ie tn am V
Ko ng -C hi na
la nd
Source - Bloomberg
H on g
C hi
Ta ip ei -C hi n
ai n
K
na -M
M
P
P
S
NRAs issue numerous ratings compared to GRAs
Number of issued ratings from both NRAs and GRAs
100 90 80 70 60 50 40 30 20 10 0 INDIA SOUTH KOREA MALAYSIA JAPAN NRAs GRAs
Source - Bloomberg
Who are the GRAs and the NRAs?
•GRAs: Moody’s, S&P and Fitch
•NRAs (example in 4 Asian countries): Japan: JCR, R&I, Mikuni South Korea: KIS, KR, NICE Malaysia: MARC and RAM India: ICRA, CRISIL and CARE
In the rest of the world there are about 60 rating agencies (Ferri & Lacitignola 2009)
