What is a rating agency?
- 20 October 2014
- From the section Business
AAA, Ba3, Ca, CCC... they look like some kind of hyper-active school report.
They are, indeed, a marking system, and one that is designed to inform interested parties.
The ratings are given to large-scale borrowers, whether companies or governments, and are an indication to buyers of this debt how likely they are to be paid back.
The score card can also affect the amount that companies or governments are charged to borrow money.
If a country is deemed to have suffered a downturn in fortunes and its rating is lowered, investors may demand higher returns to lend to it, as it is judged a riskier bet.
Borrowers in the news with downgraded scorecards now include the UK, most eurozone governments, and the US. Just two of the G7 countries, Canada and Germany, retain a top AAA rating.
But the companies doing the marking are nowhere near as familiar.
They are credit-rating agencies, which exist to assess the creditworthiness of bond issuers - companies or, as in this case, countries who borrow money by issuing IOUs known as bonds.
But who are they? Do we need them and how do they work out whether to give the top-of-the-class AAA or a lower grade, such as CCC, which - sticking with the schools analogy - means the issuer is suspected of planning the financial equivalent of bunking off?
Poor and Moody
Standard & Poor's (S&P), as the oldest, comes first. It was begun in 1860 by Henry Poor, who wrote a history of the finances of railroads and canals in the United States as a guide for investors.
The "Standard" part came into being in 1906, when the Standard Statistics Bureau was set up to examine finances of non-railroad companies.
The two businesses joined forces in the 1940s.
Moody's was started in 1909 by John Moody, who published an analysis of the tangled and uncertain world of railway finances, grading the value of its stocks and bonds.
These are now mighty concerns, with operating income in the high hundred million dollars.
They each have 40% apiece of the business of rating major companies and countries.
Fitch, with another eponymous founder, John Fitch, was set up in 1913 and is a smaller version of the other two.
There are hosts of other ratings agencies, whose names rarely appear even within the darker corners of the financial pages - so why are these three businesses the ones everyone watches?
Part of the answer lies with the Securities and Exchange Commission (SEC), the US financial watchdog.
In 1975, it acknowledged these three as Nationally Recognized Statistical Rating Organizations (NRSRO).
An endorsement from an NRSRO makes life quicker and easier for countries and financial institutions wishing to issue bonds. It basically tells investors a firm has a track record and indicates how likely it is to be able to pay back the money.
Further impetus for NRSROs comes from the fact that certain regulated investment funds are required by the SEC to hold only those bonds that have a very high rating from accredited agencies.
An insurance company's strength is also judged by the ratings applied to the investment reserves it holds.
A downgrade of an issuers' rating typically pushes down the value of a bond and raises its interest rate. It can mean regulated funds must now sell these bonds.
But this can cause a vicious circle.
If lots of funds are forced to sell, the price of the bond reduces further. That means a higher interest rate must be paid, which puts an even bigger strain on the borrower.
The SEC actually has 10 NRSROs on its approved list, including a Canadian agency and two Japanese ones. The big three - Standard & Poor's, Moody's and Fitch - remain the industry standard-bearers.
This is partly because they make their ratings available freely to investors - making their money from charging the organisations who want their bonds rated - something some believe can create a conflict of interest.
As a statement from the European Commission put it: "As a rating agency has a financial interest in generating business from the issuer that seeks the rating, this could lead to assigning a higher rating than warranted in order to encourage the issuer to contract them again in the future."
The products to be rated vary hugely in design.
Investment banks issuing complex products - like those that included sub-prime debt - often structure the products to make them appear as safe as possible in an attempt to attract a top rating.
This does not apply to government bonds, which are straightforward IOUs.
So how do the agencies form their judgments?
Standard & Poor's says a committee of between five and eight people decides the actual rating.
They base their assessment on a range of financial and business attributes that might influence the repayment, some of which may depend on the issuer of the bond (i.e. the borrower).
When asked why it changes ratings, S&P responded: "The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment - or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue."
S&P gave a long list of indicators it might use, including "economic, regulatory and geopolitical influences, management and corporate governance attributes, and competitive position".
That seems to cover everything.
But since the credit crisis began in 2007, these agencies have come in for heavy criticism.
The US SEC is tightening up on the way they behave. One move would stop individuals on their sales and marketing side from taking part in the actual rating.
The EU is not happy either.
The potential for a downgrade to destabilise a country was so feared that the European Parliament this year agreed a set of rules designed to rein them in.
They state that agencies can issue ratings on countries no more than three times a year, and only after markets have closed.
Europe also wants to dilute the power of the Big Three rating agencies by encouraging financial firms and others to do their own credit assessments.
The Internal Market Commissioner, Michel Barnier, said: "Ratings have a direct impact on the markets and the wider economy and thus on the prosperity of European citizens. They are not just simple opinions. And rating agencies have made serious mistakes in the past."
After all, lots of mortgage-backed securities - the investments that were backed by mortgages that were either never going to be paid back or were even fraudulent - were given the very best grade by the three supposed experts in rating the likelihood of the money being paid back.
These financial products turned out to be virtually worthless. And the sudden realisation that they were rubbish, rather than gold-plated investments, triggered the worst financial crisis in decades.
But the agencies' power does not always cause mass market upheaval.
More recent downgrades have not prompted swings in investor behaviour.
After the mighty US received its downgrade in 2011, rather than its cost of borrowing going up, it actually went down, as lenders decided that the US government was still one of the safest bets in the world.
And although the UK government long spoke of the importance of maintaining its triple-A status, when it was downgraded for the first time in more than 30 years, economists suggested that it would have limited impact.
Moody's was just catching up with what the financial world already knew - that the UK economy, in line with many others, will take longer to recover from the aftermath of the financial crisis than expected.