Checklist Description
This checklist provides advice on how to use credit rating agencies.
Definition
A credit rating agency is a company that assigns credit ratings to issuers of debt instruments and to the debt instruments themselves. A wide variety of organizations may issue debt in the primary market and thus come under the scrutiny of the credit rating agencies. These include companies, national, and local governments, and government and semi-government entities. Their debt instruments are then traded on a secondary market. Credit rating agencies assign ratings that seek to determine how creditworthy the issuer is, i.e. to gauge the level of risk that they will be unable to repay the loan.
An entity with very strong finances will be given the highest rating, often described as AAA, while the least creditworthy will receive the lowest rating, normally D, which applies to debt that is already in arrears. An entity with low credit ratings will have to pay a premium in terms of the interest on loans in order to compensate the lender for the higher risk that the loan may not be repaid. The rating agencies constantly monitor all the instruments they rate and will issue upgrades or downgrades if an issuer’s creditworthiness has changed.
Ratings are an invaluable tool for investors, providing a convenient way to identify the creditworthiness of a potential investment. Issuers use credit ratings to provide an independent analysis of their own creditworthiness, thus helping to determine the value of the instruments they issue. Government regulators and other agencies also use credit ratings to gauge the health of their financial system. Thus, regulators allow banks to use credit ratings from certain approved ratings agencies when calculating their net capital reserve requirements. Regulators could, for example, allow banks to include highly rated, liquid bonds when calculating their net capital reserve requirements.
The three largest credit rating agencies are Standard & Poor’s, Moody’s, and Fitch. All have come under fire as a result of the global credit crunch that developed in 2007. In July 2008, a damning report from the US Securities and Exchange Commission identified “serious shortcomings” in the rating of securities related to subprime mortgages, the products that triggered the crisis. Credit rating agencies have also come under fire for problems in structured finance products that they have rated, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. There is thus increasing pressure to introduce greater regulation of the credit rating agencies.
Advantages
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The ratings assigned by credit rating agencies allow investors to quickly, cheaply, and conveniently identify the risk involved in buying a particular debt instrument or in developing a business relationship with a particular organization.
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The use of ratings opens capital markets to entities such as new companies.
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Credit ratings give you an insight into an entity from an independent expert analyst.
Disadvantages
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The rating agencies have come under criticism as a result of the credit crunch. Many AAA-rated companies were downgraded to very low levels within a very short space of time.
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Credit rating agencies have come under fire for failing to downgrade companies quickly enough, with some companies faltering despite being assigned relatively good ratings.
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Credit rating agencies have been criticized for developing too close a relationship with the management of the companies that they rate.
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Credit rating agencies have been criticized for their role in rating structured finance products, and in particular for large losses in the collateralized debt obligation (CDO) market that occurred despite being assigned top ratings by the agencies.
Action Checklist
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Look at the ratings from as many credit rating agencies as possible.
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Gather as much other information as you can on a potential investment or business partner.
Dos and Don’ts
Do
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Be aware that issuers pay the rating agencies a fee. Critics say that this creates a potential conflict of interest.
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Conduct your own research as well as looking at the analysis supplied by the agencies.
Don’t
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Don’t forget that the ratings agencies are not infallible.
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Don’t forget that entities are subject to constant monitoring by the credit rating agencies. Ratings can and do change over time.
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