The removal of strict regulatory framework in recent years has led to a spurt in the number of companies borrowing directly from the capital markets. There have been several instances in the recent past where the "fly-by-night operators have cheated unwary investors. In such a situation, it has become increasingly difficult for an ordinary investor to distinguish between 'safe and good investment opportunities' and 'unsafe and bad investments'. Investors find that a borrower's size or names are no longer a sufficient guarantee of timely payment of interest and principal. Investors perceive the need of an independent and credible agency, which judges impartially and in a professional manner, the credit quality of different companies and assist investors in making their investment decisions. Credit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders to form an opinion on -the relative capacities of the borrowers to meet their obligations. These Credit Rating Agencies, thus, assist and form an integral part of a broader programme of financial disintermediation and broadening and deepening of the debt market.
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Credit rating is used' extensively fqr evaluating debt instruments. These include long-term instruments, like bonds and debentures as will as short-term obligations, like Commercial Paper. In addition, certificates of deposits, inter-corporate deposits, structured obligations including non-convertible portion of partly Convertible Debentures (PCDs) and preferences shares are also rated. The Securities and Exchange Board of India (SEBI), the regulator of Indian Capital Market, has now decided to enforce mandatory rating of all debt instruments irrespective of their maturity.
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 and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.
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.
These are some of the types of credit ratings:
- Personal credit ratings
- Corporate credit ratings
- Sovereign credit ratings
- Short term ratings
Why we need a credit Rating agency
- Increase investor acceptance
- Current economic development
- Current capital market environment
- Bottom line: Lower interest cost
Sectors where Credit rating plays a vital role
- Commercial banks
- Mutual Funds
- Investment Banks
- Leasing companies
- Insurance companies
- Bonds & securitization etc.
Credit rating Agencies- 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.)
The value of such ratings has been widely questioned after the 2008 financial crisis. In 2003 the Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.
Agencies that assign credit ratings for corporations include:
- Brickwork Ratings India Private Ltd. (BWR) - (India)
- SME Rating Agency of India Ltd (SMERA) - (India)
- CRISIL - (India)
- Credit Analysis and Research Ltd (CARE) - (India)
- ICRA - (India)
- A. M. Best - (U.S.)
- Baycorp Advantage - (Australia)
- Credit Rating Agency of Bangladesh Ltd (CRAB) - (Bangladesh)
- Dominion Bond Rating Service - (Canada)
- Fitch Ratings - (U.S.)
- Japan Credit Rating Agency - (Japan)
- Malaysian Rating Corporation - (Malaysia)
- Moody's - (U.S.)
- Standard & Poor's - (U.S.)
- Pacific Credit Rating - (Peru)
- Global Rating Intelligence Services - (Middle-East and Africa)
- Rating Agency Malaysia - (Malaysia)
- Egan-Jones Rating Company - (U.S.)
- Capital Intelligence Ltd - (Cyprus)
- Brickwork Ratings India Private Ltd. (BWR) - (India)
- SME Rating Agency of India Ltd (SMERA) - (India)
- Credit Rating Information & Services Limited (CRISL) - (Bangladesh)
- The Pakistan Credit Rating Agency Limited (PACRA) - (Pakistan)
THE DETERMINANTS OF RATINGS
Always on Time
Marked to Standard
The default-risk assessment and quality rating assigned to an issue are primarily determined by three factors -
- The issuer's ability to pay,
- 'The strength of the security owner's claim on the issue, and
- The economic significance of the industry and market place of the issuer.
The Rating Process
- Step 1-Decision & documents
- Step 2-Rating Presentations-meetings, conference calls and/or site visits
- Step 3-Rating Committee, communication, press release, report
- Step 4-Appeal process, if necessary
- Step 5-Surveillance
RATING AND DEFAULT RISK:
Most investors prefer to use credit ratings to assess default risk. Internationally acclaimed credit rating agencies such as Moody's, Standard and Poor's and Duff and Phelps have been offering rating services to bond issuers over a very long time. The bond issuers pay the rating agency to evaluate the quality of the bond issue in order to increase the information flow to investors and hopefully increase the demand for their bonds. The rating agency determines the appropriate bond rating by assessing various factors. For
example, Standard and Poor's judges the credit quality of corporate bonds largely by looking at the bond indenture, asset protection, financial resources, future earning power,
and management. More specifically, Standard and Poor's focuses on cash flows to judge a firm's financial viability. The bond categories are assigned letter grades. The highest grade bonds, whose risk of default is felt to be negligible, are rated triple A (Aaa or AAA). The rating agencies assign pluses or minuses (e.g. Aa + A+) when appropriate to show the relative standing within the major rating categories. The following table gives the rating symbols and their explanation as employed by Moody's and S & P, the well known rating agencies.
CREDIT RATING SYMBOLS
Credit Rating Agencies rate an instrument by assigning a definite symbol. Each symbol has a definite meaning. These symbols have been explained in descending order of safety or in ascending order of risk of non-payment. For example, CRISIL has prescribed the following symbols for debenture issues:
AkM indicates highest safety of timely payment of interest and principal.
AA indicates high safety of timely payment of interest and principal.
A indicates adequate safety of timely payment of interest and principal.
BBB offers sufficient safety of payment of interest and principal for the present.
BB offers inadequate safety of timely payment of interest and principal.
B indicates great susceptibility to default.
C indicates vulnerability to default. Timely payment of interest and payment is possible-nly if favourable circumstances continue.
D indicates that the debenture is in default in payment of arrears of interest or principal or is expected to default on maturity.
You will note that as the value of symbol is reduced say from AAA to AA, the safety of timely payment of interest and principal is decreased. While AAA indicates highest safety of timely repayment, D indicates actual default or expected default on maturity. Different symbols indicate different degrees of risk of repayment of principal and interest. It is the 'assessment of the Rating Agency based on the methodology already explained. Other ratings are given in the Appendix to this Unit for your information.
Symbols For Long Term Ratings :
(Triple A) Highest Safety
Instruments rated 'AAA' are judged to offer the highest degree of safety with regard to timely payment of financial obligations. Any adverse changes in circumstances are most unlikely to affect the payments on the instrument
(Double A) High Safety
Instruments rated 'AA' are judged to offer a high degree of safety with regard to timely payment of financial obligations. They differ only marginally in safety from `AAA' issues.
Instruments rated 'A' are judged to offer an adequate degree of safety with regard to timely payment of financial obligations. However, changes in circumstances can adversely affect such issues more than those in the higher rating categories.
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(Triple B) Moderate Safety
Instruments rated 'BBB' are judged to offer moderate safety with regard to timely payment of financial obligations for the present; however, changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for instruments in higher rating categories.
(Double B) Inadequate Safety
Instruments rated 'BB' are judged to carry inadequate safety with regard to timely payment of financial obligations; they are less likely to default in the immediate future than instruments in lower rating categories, but an adverse change in circumstances could lead to inadequate capacity to make payment on financial obligations.
Instruments rated 'B' are judged to have high likelihood of default; while currently financial obligations are met, adverse business or economic conditions would lead to lack of ability or willingness to pay interest or principal.
Instruments rated 'C' are judged to have factors present that make them vulnerable to default; timely payment of financial obligations is possible only if favourable circumstances continue.
Instruments rated 'D' are in default or are expected to default on scheduled payment dates.
Instruments rated 'NM' have factors present in them, which render the outstanding rating meaningless. These include reorganisation or liquidation of the issuer, the obligation being under dispute in a court of law or before a statutory authority etc.
Symbols For Short Term Instruments :
This rating indicates that the degree of safety regarding timely payment on the instrument is very strong.
This rating indicates that the degree of safety regarding timely payment on the instrument is strong; however, the relative degree of safety is lower than that for instruments rated 'P1'.
This rating indicates that the degree of safety regarding timely payment on the instrument is adequate; however, the instrument is more vulnerable to the adverse effects of changing circumstances than an instrument rated in the two higher categories.
This rating indicates that the degree of safety regarding timely payment on the instrument is minimal and it is likely to be adversely affected by short-term adversity or less favourable conditions.
This rating indicates that the instrument is expected to be in default on maturity or is in default.
Instruments rated 'NM' have factors present in them, which render the rating outstanding meaningless. These include reorganisation or liquidation of the issuer, the obligation being under dispute in a court of law or before a statutory authority etc.
Corporate Credit Rating Scale:
("CCR Triple A")
A 'CCR AAA' rating indicates highest degree of strength with regard to honoring debt obligations.
("CCR Double A")
A 'CCR AA' rating indicates high degree of strength with regard to honoring debt obligations.
A 'CCR A' rating indicates adequate degree of strength with regard to honoring debt obligations.
A 'CCR BBB' rating indicates moderate degree of strength with regard to honoring debt obligations.
A 'CCR BB' rating indicates inadequate degree of strength with regard to honouring debt obligations.
A 'CCR B' rating indicates high risk and greater susceptibility with regard to honouring debt obligations
A 'CCR C' rating indicates substantial risk with regard to honouring debt obligations.
A 'CCR D' rating indicates that the entity is in default of some or all of its debt obligations.
A 'CCR SD' rating indicates that the entity has selectively defaulted on a specific issue or class of debt obligations but will continue to meet its payment obligations on other issues or classes of debt obligations.
CRISIL may apply "+" (plus) or "-" (minus) modifiers for ratings from 'CCR AA' to 'CCR C' to reflect comparative standing within the category.
How credit ratings are determined
Credit ratings are determined differently in each country, but the factors are similar, and may include:
- Payment history - A record of delinquent payments, generally being more than 30 days, will lower the credit rating.
- Control of debt - Lenders want to see that borrowers are not living beyond their means. Experts estimate that non-mortgage credit payments each month should not exceed more than 15 percent of the borrower's after-tax income.
- Signs of responsibility and stability - Lenders perceive things such as longevity in the borrower's home and job (at least two years) as signs of stability.
- Re-Aging - Through re-aging, the date of last action on the account is changed. This can dramatically alter the credit score. In 2000, the Federal Financial Institutions Examination Council (FFEIC) clarified guidelines on re-aging accounts for delinquent borrowers.  (PDF)
- Utilization—Lenders ascribe increased risk to accounts with balances near their limits.
- Credit inquiries - An inquiry is noted every time a company requests some information from a consumer's credit file. There are several kinds of inquiries that may or may not affect one's credit score. Inquiries that have no effect on the creditworthiness of a consumer (also known as "soft inquiries") are:
- Pre-screening inquiries where a credit bureau may sell a person's contact information to an institution that issues credit cards, loans and insurance based on certain criteria that the lender has established.
- A creditor also checks its customers' credit files periodically.
- A credit counselling agency, with the client's permission, can obtain a client's credit report with no adverse action.
- A consumer can check his or her own credit report without impacting credit worthiness.
- Inquiries that do have an effect on the creditworthiness of a consumer (also known as "hard inquiries") are made by lenders when consumers are seeking credit or a loan, in connection with permissible purpose. Lenders, when granted a permissible purpose, as defined by the Fair Credit Reporting Act, can "pull" a consumer file for the purposes of extending credit to a consumer. Hard inquiries from lenders directly affect the borrower's credit score. Keeping credit inquiries to a minimum can help a person's credit rating. A lender may perceive many inquiries over a short period of time on a person's report as a signal that the person is in financial difficulty, and may consider that person a poor credit risk.
- Credit cards that are not used - Although it is believed that having too many credit cards can have an adverse effect on a credit score, closing these lines of credit will not necessarily improve your score. Many risk models consider the difference between the amount of credit a person has and the amount being used: closing one or more accounts will reduce your total available credit, lower the percentage of available credit, and possibly lower your credit score. Risk models also factor in account age: closing an account with several years of history that is in good standing will most likely negatively affect your score.
Rating is a search for long-term fundamentals and the probabilities for changes in the fundamentals. Each agency's rating process usually includes fundamental analysis of public and private issuer-specific data, 'industry analysis, and Financial and Investment presentations by the issuer's senior executives, statistical Institutions 'in India classification models, and judgement. Typically, the rating agency is privy to the issuer's short and long-range plans and budgets. The analytical framework followed for rating methodology is divided into two interdependent segments.
The first segment deals with operational characteristics and the second one with the financial characteristics. Besides, quantitative and objective factors; qualitative aspects, like assessment of management capabilities play a very important role in arriving at the rating for an instrument. The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer.
Key areas considered in a rating include the following:
- Business Risk : To ascertain business risk, the rating agency considers Industry's characteristics, performance and outlook, operating position (capacity, market share, distribution system, marketing network, etc.), technological aspects, business cycles, size and capital intensity.
- Financial Risk :To assess financial risk, the rating agency takes into account various aspects of its Financial Management (e.g. capital structure, liquidity position, financial flexibility and cash flow adequacy, profitability, leverage, interest coverage), projections with particular emphasis on the components of cash flow and claims thereon, accounting policies and practices with particular reference to practices of providing depreciation, income recognition, inventory valuation, off-balance sheet claims and liabilities, amortization of intangible assets, foreign currency transactions, etc.
- Management Evaluation :Management evaluation includes consideration of the background and history of the issuer, corporate strategy and philosophy, organisational structure, quality of management and management capabilities under stress, personnel policies etc.
- Business Environmental Analysis : This includes regulatory environment, operating environment, national economic outlook, areas of special significance to the company, pending litigation, tax status, possibility of default risk under a variety of scenarios. Rating is not based on a predetermined formula, which specifies the relevant variables as well as weights attached to each one of them. Further, the emphasis on different aspects varies from agency to agency. Broadly, the rating agency assures itself that there is a good congruence between assets and liabilities of a company and downgrades the rating if the quality of assets depreciates. The rating agency employs qualified professionals to ensure consistency and reliability. Reputation of the Credit Rating Agency creates confidence in the investor. Rating Agency earns its reputation by assessing the client's operational performance, managerial competence, management and organizational set-up and financial structure. It should be an independent company with its own identity. It should have no government interference. Rating of an instrument does not give any fiduciary status to the credit rating agency.
It is desirable that the rating be done by more than one agency for the same kind of instrument. This will attract investor's confidence in the rating symbol given.
A rating is a quality label that conveniently summarizes the default risk of an issuer. The credibility of the issuer's proposed payment schedule is complemented by the credibility of the rating agency. Rating agencies perform this certification role by exploiting the economies of scale in processing information and monitoring the issuer. There is an ongoing debate about whether the rating agencies perform an information role in addition to a certification role. Whether agencies have access to superior (private) information, or if II agencies are superior processors of information; security ratings provide information to investors, rather than merely summarizing existing information. Empirical research confirms the information role of rating agencies by demonstrating that news of actual and proposed rating changes affects the price of issuer's securities. Most studies document numerically larger price effects for downgrades than for upgrades, consistent with the perceived predilection, of management for delaying bad news.
Apart from these, there are several other major factors which influence the credit rating process. Some of these are given below:
- Industry risk
- Market position
- Ownership & support
- Earning & performance
- Cash Flows
- Management Evaluation
- Capital & debt structure
- Funding & Flexibility
- Corporate governance
- Additional factors for financial institutions
CREDIT RATING AGENCIES IN INDIA
In India, at present, there are four credit Rating Agencies:
- Credit Rating and Information Services of India Limited (CRISIL).
- Investment Information and Credit Rating Agency of India Limited (ICRA) .
- Credit Analysis and Research Limited (CARE).
- Duff and Phelps Credit Rating of India (Pvt.) Ltd.
- CRISIL: This was set-up by ICICI and UTI in 1988, and rates debt instruments. Nearly half of its ratings on the instruments are being used. CRISIL's market share is around 75%. It has launched innovative products for credit risks assessment viz., counter party ratings and bank loan ratings. CRISIL rates debentures, fixed deposits, commercial papers, preference shares and structured obligations. Of the total value of instruments rated, debentures' accounted for 31.196, deposits for 42.3% and commercial paper 6.6%. CRISIL publishes CRISIL rating in SCAN that is a quarterly publication in Hindi and Gujarati, besides English. CRISIL evaluation is carried out by professionally qualified persons and includes data collection, analysis and meeting with key personnel in the company to discuss strategies, plans and other issues that may effect ,evaluation of the company. The rating process ensures confidentiality. , Once the company decides to use rating, CRISIL is obligated to monitor the rating over the life of the debt instrument.
- ICRA: ICRA was promoted by IFCI in 1991. During the year 1996-97, ICRA rated 261 debt instruments of manufacturing companies, finance companies and financial institutions equivalent to Rs. 12,850 crore as compared to 293 instruments covering debt volume of Rs. 75,742 crore in 1995-96. This showed a decline of 83.0% over the year in the volume of rated debt instruments. Of the total amount rated cumulatively until March-end 1997, the share in terms of number of instruments was 28.5% for debentures (including long tern instruments), 49.4% for Fixed Deposit programme (including medium- term instruments), and 22.1% for Commercial Paper Programme (including short- term instruments). The corresponding figures of amount involved for these three broad rated categories was 23.8% for debentures, 52.2% for fixed deposits, and 24.0% for Commercial Paper. The factors that ICRA takes into consideration for rating depend on the nature of borrowing entity. The inherent protective factors, marketing strategies, competitive edge, competence and effectiveness of management, human resource development policies and practices, hedging of risks, trends in cash flows and potential liquidity, financial flexibility, asset quality and past record of servicing of debt as well as government policies affecting the industry are examined. Besides determining the credit risk associated with a debt instrument, ICRA has also formed a group under Earnings Prospects and Risk Analysis (EPRA). Its goal is to provide authentic information on the relative quality of the equity. This requires examination of almost all parameters pertaining to the fundamentals of the company including relevant sectoral perspectives. This qualitative analysis is reinforced and completed by way of the unbiased opinion and informed perspective of one analyst and wealth of judgement of committee members. ICRA opinions help the issuing company to broaden the market for their equity. As the name recognition is replaced by objective opinion, the lesser know companies are also able to access the equity market.
- CARE: CARE is a credit rating and information services company promoted by IDBI jointly with investment institutions, banks and finance companies. The company commenced its operations in October 1993. 'In January 1994, CARE commenced publication of CAREVIEW, a quarterly journal of CARE ratings. In addition to the rationale of all accepted ratings, CAREVIEW often carries special features of interest to issuers of debt instruments, investors and other market players.
Usage 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, start-up companies, hospitals, and universities.
Ratings use by bond issuers:
Issuers rely on credit ratings as an independent verification of their own credit-worthiness and the resultant value of the instruments they issue. In most cases, a significant bond issuance must have at least one rating from a respected CRA for the issuance to be successful (without such a rating, the issuance may be undersubscribed or the price offered by investors too low for the issuer's purposes). Studies by the Bond Market Association note that many institutional investors now prefer that a debt issuance have at least three ratings.
Issuers also use credit ratings in certain structured finance transactions. For example, a company with a very high credit rating wishing to undertake a particularly risky research project could create a legally separate entity with certain assets that would own and conduct the research work. This "special purpose entity" would then assume all of the research risk and issue its own debt securities to finance the research. The SPE's credit rating likely would be very low, and the issuer would have to pay a high rate of return on the bonds issued. However, this risk would not lower the parent company's overall credit rating because the SPE would be a legally separate entity. Conversely, a company with a low credit rating might be able to borrow on better terms if it were to form an SPE and transfer significant assets to that subsidiary and issue secured debt securities. That way, if the venture were to fail, the lenders would have recourse to the assets owned by the SPE. This would lower the interest rate the SPE would need to pay as part of the debt offering.
The same issuer also may have different credit ratings for different bonds. This difference results from the bond's structure, how it is secured, and the degree to which the bond is subordinated to other debt. Many larger CRAs offer "credit rating advisory services" that essentially advise an issuer on how to structure its bond offerings and SPEs so as to achieve a given credit rating for a certain debt tranche. This creates a potential conflict of interest, of course, as the CRA may feel obligated to provide the issuer with that given rating if the issuer followed its advice on structuring the offering. Some CRAs avoid this conflict by refusing to rate debt offerings for which its advisory services were sought.
Ratings use by investment banks and broker-dealers:
Investment banks and broker-dealers also use credit ratings in calculating their own risk portfolios (i.e., the collective risk of all of their investments). Larger banks and broker-dealers conduct their own risk calculations, but rely on CRA ratings as a "check" (and double-check or triple-check) against their own analyses.
Ratings use by government regulators:
Regulators use credit ratings as well, or permit ratings to be used for regulatory purposes. For example, under the Basel II agreement of the Basel Committee on Banking Supervision, banking regulators can allow banks to use credit ratings from certain approved CRAs (called "ECAIs], or "External Credit Assessment Institutions") when calculating their net capital reserve requirements. In the United States, the Securities and Exchange Commission (SEC) permits investment banks and broker-dealers to use credit ratings from "Nationally Recognized Statistical Rating Organizations" (or "NRSROs") for similar purposes. The idea is that banks and other financial institutions should not need to keep in reserve the same amount of capital to protect the institution against (for example) a run on the bank, if the financial institution is heavily invested in highly liquid and very "safe" securities (such as U.S. government bonds or short-term commercial paper from very stable companies).
CRA ratings are also used for other regulatory purposes as well. The US SEC, for example, permits certain bond issuers to use a shortened prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimic the safety and liquidity of a bank savings deposit, but without FDIC insurance) comprise only securities with a very high NRSRO rating. Likewise, insurance regulators use credit ratings to ascertain the strength of the reserves held by insurance companies.
Under both Basel II and SEC regulations, not just any CRA's ratings can be used for regulatory purposes. (If this were the case, it would present an obvious moral hazard, since an issuer, insurance company, or investment bank would have a strong incentive to seek out a CRA with the most lax standards, with potentially dire consequences for overall financial stability.) Rather, there is a vetting process of varying sorts. The Basel II guidelines (paragraph 91, et al.), for example, describe certain criteria that bank regulators should look to when permitting the ratings from a particular CRA to be used. These include "objectivity," "independence," "transparency," and others. Banking regulators from a number of jurisdictions have since issued their own discussion papers on this subject, to further define how these terms will be used in practice. (See The Committee of European Banking Supervisors Discussion Paper, or the State Bank of Pakistan ECAI Criteria.)
In the United States, since 1975, NRSRO recognition has been granted through a "No Action Letter" sent by the SEC staff. Following this approach, if a CRA (or investment bank or broker-dealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determines that this is the case, it sends a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff will not recommend enforcement action against that entity. These "No Action" letters are made public and can be relied upon by other regulated entities, not just the entity making the original request. The SEC has since sought to further define the criteria it uses when making this assessment, and in March 2005 published a proposed regulation to this effect.
On September 29, 2006, US President George W. Bush signed into law the "Credit Rating Reform Act of 2006". This law requires the US Securities and Exchange Commission to clarify how NRSRO recognition is granted, eliminates the "No Action Letter" approach and makes NRSRO recognition a Commission (rather than SEC staff) decision, and requires NRSROs to register with, and be regulated by, the SEC. S & P protested the Act on the grounds that it is an unconstitutional violation of freedom of speech. In the Summer of 2007 the SEC issued regulations implementing the act, requiring rating agencies to have policies to prevent misuse of non-public information, disclosure of conflicts of interest and prohibitions against "unfair practices".
Recognizing CRAs' role in capital formation, some governments have attempted to jump-start their domestic rating-agency businesses with various kinds of regulatory relief or encouragement. This may, however, be counterproductive, if it dulls the market mechanism by which agencies compete, subsidizing less-capable agencies and penalizing agencies that devote resources to higher-quality opinions.
Ratings 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, 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.
There has been criticism in the wake of large losses in the collateralized debt obligation (CDO) market that occurred despite being assigned top ratings by the CRAs. For instance, losses on $340.7 million worth of collateralized debt obligations (CDO) issued by Credit Suisse Group added up to about $125 million, despite being rated AAA or Aaa by Standard & Poor's, Moody's Investors Service and Fitch Group.
The rating agencies respond that their advice constitutes only a "point in time" analysis, that they make clear that they never promise or guarantee a certain rating to a tranche, and that they also make clear that any change in circumstance regarding the risk factors of a particular tranche will invalidate their analysis and result in a different credit rating. In addition, some CRAs do not rate bond issuances upon which they have offered such advice.
Complicating matters, particularly where structured finance transactions are concerned, the rating agencies state that their ratings are opinions (and as such, are protected free speech, granted to them by the "personhood" of corporations) regarding the likelihood that a given debt security will fail to be serviced over a given period of time, and not an opinion on the volatility of that security and certainly not the wisdom of investing in that security. In the past, most highly rated (AAA or Aaa) debt securities were characterized by low volatility and high liquidity—in other words, the price of a highly rated bond did not fluctuate greatly day-to-day, and sellers of such securities could easily find buyers. However, structured transactions that involve the bundling of hundreds or thousands of similar (and similarly rated) securities tend to concentrate similar risk in such a way that even a slight change on a chance of default can have an enormous effect on the price of the bundled security. This means that even though a rating agency could be correct in its opinion that the chance of default of a structured product is very low, even a slight change in the market's perception of the risk of that product can have a disproportionate effect on the product's market price, with the result that an ostensibly AAA or Aaa-rated security can collapse in price even without there being any default (or significant chance of default). This possibility raises significant regulatory issues because the use of ratings in securities and banking regulation (as noted above) assumes that high ratings correspond with low volatility and high liquidity.
BENEFITS OF CREDIT RATING:
Rating serves as a useful tool for different constituents of the capital market. For different classes of persons, different benefits accrue from the use of rated instruments.
- Investors: Rating safeguards against bankruptcy through recognition of risk. It gives an idea of the risk involved in the investment. It gives a clue to the credibility of the issuer company. Rating symbols give information on the quality of instrument in a simpler way that can be understood by lay investor and help him in taking decision on investment without the help from broker. Both individuals and institutions can draw up their credit risk policies and assess the adequacy or otherwise of the risk premium offered by the market on the basis of credit ratings.
- Issuers of Debt Instruments: A company whose instruments are highly rated has the opportunity to have a wider access to capital, at lower cost of borrowing. Rating also facilitates the best pricing and timing of issues and provides financing flexibility. Companies with rated instruments can use the rating as a marketing tool to create a better image in dealing with its customers, lenders and creditors. Ratings encourage the companies to come out with more disclosures about their accounting systems, financial reporting and management pattern. It also makes it possible for some Category of investors who require mandated rating from reputed rating agencies to make investments.
- Financial Intermediaries: Financial intermediaries like banks, merchant bankers, and investment advisers find rating as a very useful input in the decisions relating to lending and investments. For instance, kith high credit rating, the brokers can convince their clients to select a particular investment proposal Ignore easily thereby saving on time, cost and manpower ill convincing their clients.
- Business Counter-parties: The credit rating helps business counter-parties in establishing business relationships particularly for opening letters of credit, awarding contracts, entering into collaboration agreements, etc.
- Regulators: Regulators with the help of credit ratings, determine eligibility criteria and entry barriers for new securities, monitor financial soundness of organizations and promote efficiency in debt securities market. This increases transparency of the financial system leading to a healthy development of the market.
There are several limitations of credit ratings. First, credit ratings are changed when the agencies feel that sufficient changes have occurred. The rating agencies are physically unable to constantly monitor all the firms in the market. The opinions of rating agencies may turn wrong in the context of subsequent events that may have an adverse impact on asset quality of the issuer.
Second, the use of credit ratings imposes discrete categories on default risk, while, in reality default risk is a continuous phenomenon. Moody's recognised this way back in 1982 by adding numbers to the letter system, thereby increasing its number of rating categories from 9 to 19. Nevertheless, this limitation still pertains. The letter grades assigned by rating agencies serve only as a general, somewhat coarse form of discrimination.
Third, owing to time and cost constraints, credit ratings are unable to capture all characteristics for an issuer and issue.
A borrowing company can reduce the cost of borrowing, if it obtains a higher rating for its contemplated issue. The stakes and pressures, consequently, to get a good quality rating are high. If the company comes to know that its issue is going to get a low quality rating, it may approach another agency and then use the best rating among them since it is not under obligation to disclose all ratings. According to the practice in the rating industry in India, a
corporate entity has the option of not agreeing to the first rating given to its debt issue and can choose not to get rated by that agency at all. In such a situation, the rating agency cannot divulge its assessment to anybody, and the corporate entity is free to go to any other agency. But once the corporate entry agrees with the first rating, it has no option to getting out of ,the-rating discipline imposed by the rating agency. T.hii may tempt rating agencies to woo clients with the help of an initial favourable rating, but the freedom may eventually be misused by the rating agency because corporate client doesn't have the option to differ with the agency, once it initially agrees to get rated by it. To ensure that corporate clients are not dependent on one rating agency, the system of compulsory dual ratings of all instruments could be considered. Sometimes, the rating agency may reduce the rigor of their criteria on their own to enlarge the business and improve profits especially if they are a listed company. Investors should, therefore, not follow blindly the ratings of different agencies in regard to the safety of fixed income instruments. The investors should explore other alternative evaluation sources so that they become aware of the true risks involved. The rating agencies have to be alert to ensure that their rating decisions are not driven by volume and profitability with a view to ensure favourable impact on the price of its share. It may be asserted that the rating agencies should be judged by overall performance and not by one or two defaults. There are instances of default in the instruments rated as investment grade of high safety by top agencies of the world.
Once the corporate agrees with the first rating, the rating agency is obliged to assess the debt issue till its maturity and publish the rating as part of its surveillance system. It has been observed that rating agencies have miserably failed in predicting the brewing crisis and have continued to give investment grade rating to companies, which have eventually defaulted. It has been argued that CRB scam would not have taken place if we had a better credit rating agency that would have cautioned in time on the status of the company. After the crisis, rating agencies became overcautious and resorted to drastic downgrades of ratings in respect of specific companies.
For instance, CRISIL, ICRA, and CARE downgraded respectively 140, 35 and 50 companies in 1997. Of the rating changes effected by CRISIL, ICRA, and CARE-36%, 40% and 64% respectively were by three or more notches.
The high proportion of companies whose investment grade rating was overnight changed to non-investment grade is not conducive for enhancing the faith of investors in ratings. In India, as in the developed countries, rating changes often lag the variations in stock prices. Of the 157 rating downgrades made by the three rating agencies in 1997, in 130 companies, the change in ratings lagged the decline in share prices. Despite evidence that stock price movements do eventually lead to a change in ratings, there is reason to believe that further changes are urgently needed when the ratings of companies and their stock prices are compared. This need is more prominent in the case of the investment grade ratings granted to NBFCs by CRISIL and ICRA than to the companies which are trading below par, yet command investment grade rating.
Criticism on working and performance of credit rating Agencies
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 the fact that credit rating agencies had been aware of the company's problems for months. Some empirical studies have documented that yield spreads of corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that the market often leads a downgrade and questioning the informational value of credit ratings. This has led to suggestions that, rather than rely on CRA ratings in financial regulation, financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spreads when calculating the risk in their portfolio.
- 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 agents of globalization and/or "Anglo-American" market forces, that drive companies to consider how a proposed activity might affect their credit rating, possibly at the expense of employees, the environment, or long-term research and development. These accusations are not entirely consistent: on one hand, the larger CRAs are accused of being too cozy with the companies they rate, and on the other hand they are accused of being too focused on a company's "bottom line" and unwilling to listen to a company's explanations for its actions.
- 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' 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. The high profit on Moody's revenues (>50% gross margin), which are consistent with the high barriers to entry, do nothing to allay market fears of monopoly pricing.
- 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. 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. 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.)
- Ratings agencies, in particular Fitch, Moody's and Standard and Poors have been implicitly allowed by the government to fill a quasi-regulatory role, but because they are 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.
As part of the Sarbanes-Oxley Act of 2002, Congress ordered the U.S. SEC to develop a report, titled Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets detailing how credit ratings are used in U.S. regulation and the policy issues this use raises. Partly as a result of this report, in June 2003, the SEC published a "concept release" called Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws that sought public comment on many of the issues raised in its report. Public comments on this concept release have also been published on the SEC's website.
In December 2004, the International Organization of Securities Commissions (IOSCO) published a Code of Conduct for CRAs that, among other things, is designed to address the types of conflicts of interest that CRAs face. All of the major CRAs have agreed to sign on to this Code of Conduct and it has been praised by regulators ranging from the European Commission to the U.S. Securities and Exchange Commission.
Apr. 26--MUMBAI, India -- Indian rating agency Crisil is now a subsidiary of the world's largest credit rating agency Standard & Poor's (S&P). S&P on Monday managed to acquire over 51 percent in Crisil with the completion of the conditional open offer for the company. Currently, S&P holds 9.48 percent stake in the local rating agency.
There was no statement from S&P till the time of going to the press. However, sources close to the deal said that S&P holding has crossed 51 percent with the open offer.
While ICICI Bank sold its entire 10.75 percent holding, state-owned financial institutions like Life Insurance Corporation (3.16 percent), United India Insurance (1.10 percent), Unit Trust of India (7.56 percent) and State Bank of India .
Conn. may sue credit-rating firms
Bloomberg News / November 26, 2009
NEW YORK - Connecticut plans to join Ohio in suing credit-rating companies for “negligent, reckless, and incompetent work'' in grading debt purchased by state pension funds, Attorney General Richard Blumenthal said yesterday.
Connecticut and “a number of other states'' are preparing legal action against Standard & Poor's, Moody's Corp., and Fitch Ratings, Blumenthal said. Ohio Attorney General Richard Cordray sued the debt raters this month on behalf of five Ohio public employee retirement and pension funds, saying improper ratings cost the funds more than $457 million.
The state actions come amid criticism of the ratings services by investors and lawmakers. Senate Banking Committee chairman Christopher Dodd, Democrat of Connecticut, has said they wrongly assigned top rankings to subprime-mortgage bonds just before that market collapsed in 2007. Defaults on the debt ignited a credit crisis that has led to more than $1.7 trillion in write-downs.
“We want money back for our taxpayers as a consequence of these misratings,'' Blumenthal said.
Spokesmen for two of the companies did not immediately return calls seeking comment.
“Moody's continues to be confident in the integrity of its ratings, its people and its processes and believes there is no basis for such a lawsuit,'' spokesman Anthony Mirenda said in an e-mail.
Fitch Cuts Credit Rating on $2.94 Billion in Los Angeles Debt
By Michael B. Marois
Nov. 24 (Bloomberg) -- Los Angeles, the largest city in California by population, had its credit rating lowered on $2.94 billion of debt by Fitch Ratings, which said the city's deficit next year will exceed 9 percent of revenue.
Fitch said in a statement it lowered ratings to AA- from AA on $1.5 billon of general obligation bonds and to A+ from AA- on $1 billon of the city's certificates of participation, or municipal bonds backed by the general fund, $25 million of judgment obligation bonds and $419.7 million of debt sold for the Los Angeles Convention and Exhibition Center Authority.
The city of 3.8 million people will face a budget gap of $408 million for its 2011 fiscal year that begins July 1, Fitch said, a record high of 9 percent of general fund spending amid rising unemployment brought on by the recession. That shortfall would grow to $1 billion by 2014. Those deficits will persist even after Los Angeles closed a $529 million gap in the current year's budget.
“The downgraded ratings reflect the city's reduced general fund reserves and the limited ability to replenish them given the city's weakened economy and future years' projected sizable general fund structural imbalance,” Fitch said in the statement. “The ratings acknowledge the city's meaningful response to this year's projected budget gap, although solutions enacted provide ongoing savings that address only about one-half of the projected fiscal 2011 operating deficit.”
The number of jobs declined for the first time since 2003. The unemployment rate rose to 14 percent in September from 9 percent the year before, Fitch said.
MICROCAPITAL.ORG STORY: India-based Credit Rating Agency Crisil Observes That Percentage Of Bad Loans In Indian Microfinance Institutions May Triple As Microborrowers Feel The Impact Of The Global Economic Crisis
In an article entitled ‘MFI's bad loans may triple: Crisil' on India's Business Standard online news portal , it was stated that the percentage of bad assets of MFIS' is expected to triple to 1.5 percentfrom 0.5 percent by March 2010, as compared to the levels of bad assets in March 2009.This was the conclusion of India-based credit rating agency, Crisil. The agency attributed the increased levels of deteriorating assets to the global economic crisis which has had an adverse impact on microborrowers' ability to repay their loans. Nonetheless, Crisil's managing director and CEO, Ms Roopa Kudva stated that the deterioration in asset quality was still not at the levels seen in 2007 and that MFIs' asset quality was generally healthier than those of other participants in India's financial sector.
Ms Kudva added that the deterioration in asset quality largely coincided wi