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A Brief History Of Credit Rating Agencies

Credit ratings provide individual and institutional investors with information that assists them in determining whether issuers of debt obligations and fixed-income securities will be able to meet their obligations with respect to those securities. Credit rating agencies provide investors with objective analyses and independent assessments of companies and countries that issue such securities. Globalization in the investment market, coupled with diversification in the types and quantities of securities issued, presents a challenge to institutional and individual investors who must analyze risks associated with both foreign and domestic investments. Historical information and discussion of three companies will facilitate a greater understanding of the function and evolution of credit rating agencies. Fitch Ratings John Knowles Fitch founded the Fitch Publishing Company in 1913. Fitch published financial statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In 1924, Fitch introduced the AAA through D rating system that has become the basis for ratings throughout the industry. With plans to become a full-service global rating agency, in the late 1990s Fitch merged with IBCA of London, subsidiary of Fimalac, S.A., a French holding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Ratings Co. Beginning in 2004, Fitch began to develop operating subsidiaries specializing in enterprise risk management, data services and finance industry training with the acquisition of Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Training. (For information bond ratings systems see Bond Ratings Agencies: Can You Trust Them.) Moody's Investors Service John Moody and Company first published "Moody's Manual" in 1900. The manual published basic statistics and general information about stocks and bonds of various industries. From 1903 until the stock market crash of 1907, "Moody's Manual" was a national publication. In 1909 Moody began publishing "Moody's Analyses of Railroad Investments", which added analytical information about the value of securities. Expanding this idea led to the 1914 creation of Moody's Investors Service, which, in the following 10 years, would provide ratings for nearly all of the government bond markets at the time. By the 1970s Moody's began rating commercial paper and bank deposits, becoming the full-scale rating agency that it is today. Standard & Poor's Henry Varnum Poor first published the "History of Railroads and Canals in the United States" in 1860, the forerunner of securities analysis and reporting to be developed over the next century. Standard Statistics formed in 1906, which published corporate bond, sovereign debt and municipal bond ratings. Standard Statistics merged with Poor's Publishing in 1941 to form Standard and Poor's Corporation, which was acquired by The McGraw-Hill Companies, Inc. in 1966. Standard and Poor's has become best known by indexes such as the S&P 500, a stock market index that is both a tool for investor analysis and decision making, and a U.S. economic indicator. (See A Trip through Index History to learn more about Standard & Poor's Indexes.) Nationally Recognized Statistical Rating Organizations (NRSRO) Beginning in 1970, the credit ratings industry began to adopt some important changes and innovations.

Previously, investors subscribed to publications from each of the ratings agencies and issuers paid no fees for performance of research and analyses that were a normal part of development of published credit ratings. As an industry, credit ratings agencies began to recognize that objective credit ratings significantly increased in value to issuers in terms of facilitating market and capital access by increasing a securities issuer's value in the market place, and decreasing the costs of obtaining capital. Expansion and complexity in the capital markets coupled with an increasing demand for statistical and analytical services led to the industry wide decision to charge issuers of securities fees for ratings services. In 1975, financial institutions, such as commercial banks and securities broker-dealers, sought to soften the capital and liquidity requirements passed down by the Securities and Exchange Commission (SEC). As a result, nationally-recognized statistical ratings organizations (NRSRO) were created. Financial institutions could satisfy their capital requirements by investing in securities that received favorable ratings by one or more of the NRSROs. This allowance is the result of registration requirements coupled with greater regulation and oversight of the credit ratings industry by the SEC. The increased demand for ratings services by investors and securities issuers combined with increased regulatory oversight has led to growth and expansion in the credit ratings industry. An Overview of Credit Ratings Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take into account the overall economic conditions of a country including the volume of foreign, public and private investment, capital market transparency and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country. The sovereign rating is often the prerequisite information institutional investors use to determine if they will further consider specific companies, industries and classes of securities issued in a specific country. Credit ratings, debt ratings or bond ratings are issued to individual companies and to specific classes of individual securities such as preferred stock, corporate bonds and various classes of government bonds. Ratings can be assigned separately to short-term and long-term obligations. Long-term ratings analyze and assess a company's ability to meet it's responsibilities with respect to all of its securities issued. Short-term ratings focus on the specific securities' ability to perform given the company's current financial condition and general industry performance conditions. (For more information see What Is A Corporate Credit Rating?) Conclusion Investors may utilize information from a single agency or from multiple rating agencies. Investors expect credit rating agencies to provide objective information based on sound analytical methods and accurate statistical measurements. Investors also expect issuers of securities to comply with rules and regulations set forth by governing bodies, in the same respect that credit rating agencies comply with reporting procedures developed by securities industry governing agencies. Understanding the history and evolution of ratings agencies gives investors insight on the methodology that agencies use, as well as the quality of ratings from each agency. The analyses and assessments provided by various credit rating agencies provide investors with information and insight that facilitates their ability to examine and understand the risks and opportunities associated with various investment environments. With this insight, investors can make informed decisions as to the countries, industries and classes of securities in

which they choose to invest.

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Why Bad Bonds Get Good Ratings

Credit ratings were developed to provide a way to assess a company's financial strength and its likely ability to repay investors in a timely manner. Ratings can be an important indicator of an issuer's financial stability, as well as a helpful tool in determining the relative safety of buying a company's debt. However, ratings alone tell only part of the story. Learn why you, as a bond investor, should not limit your bond investing criteria to credit ratings, and which additional criteria you should examine before making a bond investment. (For further reading on corporate ratings, check out the article What Is A Corporate Credit Rating?) Potential Weaknesses of Credit Ratings While credit ratings are helpful tools in making an investment decision, they're not perfect. Below, we'll go over some of the weaknesses associated with credit ratings.

Based on Potentially Biased Information Credit rating agencies are not independent auditors. They assign ratings primarily on the basis of financial statements that the issuing company or government provides to them. Agency analysts do not undertake independent research, they analyze information and use statistical models to determine the likelihood of default based on the information the issuer provides. If the issuer provides faulty or incomplete information, the agency's rating will be based on that incorrect information. Cannot Account for or Predict Fraud Because credit rating agencies work with information that the issuer provides, they cannot predict potential defaults due to fraudulent activity on the issuer's part. (Be sure to read our Investment Scams Tutorial to learn more about fraudulent activity within companies.) Not Fully Objective Rating agencies have come under some scrutiny regarding their ability to remain objective when the majority of their income comes from fees paid by the bond-issuing organizations that they are rating. In addition, bond issuers can hire agencies for consulting advice on how to best structure securities in order to get a positive rating. Also, because rating agencies work so closely with their customer firms, the possibility that analysts could assign a slightly more or less favorable rating based on personal relationships with executives in companies or governments issuing debt always exists. (Check out The Debt Rating Debate to see how lack of competition and potential conflict have called the value of these ratings into question.)

Lagging Indicators Because agencies assign ratings based on past corporate and market performance, they are considered "lagging indicators". This means that the agency's ratings changes typically come after it would be beneficial for an investor to make the change to either buy, if the rating improves, or sell, if the rating drops.

Are Bond Ratings Still a Helpful Investment Criterion? Given all their potential weaknesses, investors may wonder whether ratings are still worth assessing. The answer is yes. While not infallible, ratings provide an important determinant of a company's demonstrated historical ability, and therefore inferred future ability, to perform on its debt commitments. In addition, ratings analysts, while human, still provide a critical expert assessment of a company's financial health. Investors should consider credit ratings as one important piece of their bond investment decision-making process. (Learn more about bond-investing basics in Get Active In Your Bond Portfolio.) Other Factors to Evaluate for Potential Bond Investment Seasoned bond investors know that ratings alone should not guide their investment choices. So what other factors should you carefully consider?

Call and Put Provisions Call and put provisions are redemption features that can change how long you maintain your bond investment. If you want the protection that comes from knowing you can oblige the bond issuer to repurchase your debt investment before it matures and repay your principal, you'll want a bond that has put provisions. Put provisions are especially important if the interest rate environment changes significantly and you want to move out of your bond investment and reinvest your money into a security that offers a more attractive rate. Likewise, make sure you know if the bond has a "call provision" that allows the issuer to repay you for your investment before the bond's stated maturity date. (To learn more about provisions, read The ABCs Of The Bond Market.) Issuer's History of Credit Downgrades A bond will be downgraded - assigned a lower rating than it was initially given - when something changes either with the bond itself or the underlying economic fundamentals of the company, government or organization that issued the bond. Offsetting Compensations for Investors in Event of Downgrade Some issuers will take proactive measures in order to assure potential investors of their commitment to performing on their debt securities by offering some form of compensation if the security is downgraded. Investment Goals and Objectives and the Bond's Features While it may seem obvious, in addition to examining the financial health and ability of a bond's issuer, it's important to know the bond's features (i.e. duration, yield, maturity, etc.) and how those features match up with your investment goals. For example, consider an 'AAA'-rated bond with a 20-year maturity. While the bond has a very attractive and competitive 'AAA' rating, if your primary bond investment objective is to realize high yields, you may want to also consider bonds with lower ratings.

Bonds with lower ratings have correspondingly higher yields, as they are going to have to pay higher yields to attract investors. However, if your primary bond investment objective is to minimize your interest rate risk, a highly rated bond will put you at greater risk for interest rate changes compared to a bond with a lower credit rating and shorter maturity. This is because of its long maturity period. (Be sure to check out our Advanced Bond Concepts Tutorial to learn more about the features of bonds.)

Expenses and Fees Bonds are typically priced with a built-in markup that includes the broker or dealer's profit. If your broker or dealer does not have a bond in his or her inventory that you are considering for investment, you may need to pay an extra commission fee. Most dealers keep a fairly substantial portfolio of previously-issued bonds for their clients. If you are investing in a bond fund, you may have to pay an annual management fee. Also, if you invest in a bond fund or bond unit investment trust, you may have to pay a small sales fee. (Read Don't Let Brokerage Fees Undermine Your Returns to learn how smart investors don't give away more money than necessary in commissions and fees.)

The Bottom Line Know why you're investing in bonds and carefully read the prospectus for the bond issue you're considering before you make a choice based solely on its rating. Although a credit rating can be quite useful, it does not provide a complete picture of the bond, and there are other factors that need to be taken into consideration.

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The Debt Ratings Debate

The effectiveness of the debt rating system is a hotly debated subject. This issue was never more clear than during the subprime crisis of 2007, which revealed the system's flaws when highly-rated structured securities were suddenly revealed to be of very questionable value. The loans supporting these structured securities were made to marginally qualified borrowers and were often backed by very inadequate collateral, yet did not result in significant downgrades from ratings agencies. Some questions have been raised as to whether this could have been a result of a potential conflict of interest and/or a lack of competition in the industry. Here we'll take a look at ratings agencies and at why critics contend ratings may be suspect, particularly for structured securities. (To learn more about the subprime crisis, see our special Subprime Mortgages feature.)

Ratings and Structured Securities When an individual invests in a fixed-income security, he or she is essentially loaning money for a promise of scheduled, fixed-interest payments and the eventual return of principal when the loan matures. An investment in this type of security involves a risk that the company might not do well enough to pay the agreed-upon interest on the scheduled dates. There is an even greater risk that the company will not be able to return the principal borrowed when the security matures. To help investors assess these risks, ratings agencies such as Standard & Poor's and Moody's analyze and rate companies and the fixed-income securities they issue, to determine the likelihood that they will default on their loans. (For more insight, read What Is A Corporate Credit Rating?) When house prices dropped during the subprime meltdown, the value of much of the subprime homemortgaged property dropped below the principal values of the home mortgages. As a result, the collateral for the home mortgages provided no collateral for the structured securities. Critics suggest that the rating agencies should have accounted for this risk in their ratings, particularly when it had been known that many subprime mortgagors were marginally qualified for the home loans they received. Lack of Competition According to a report published by the Basel Committee on Banking Supervision in 2000, there are about 150 credit rating agencies worldwide. However, only a handful of these companies are nationally recognized as major players called Nationally Recognized Statistical Rating Organizations (NRSRO). NRSRO ratings are what the Securities and Exchange Commission (SEC) relies on when determining whether a particular security must be registered. In light of this relative lack of widespread competition, the issuers may appear to be under pressure to cooperate with the big rating agencies. (To learn more securities, read Policing The Securities Market: An Overview Of The SEC.) A poor rating can result in a substantial financial detriment to the issuer of the security. Because of the impact of a given rating, the companies issuing the securities are under severe pressure to treat rating agencies favorably. With so few players and so much riding on the rating bestowed on the security, it may be possible for rating agencies to become involved in or threatened by conflicts of interest. Another concern is that the debt rating industry is dominated by three companies: Standard & Poor's (S&P), Moody's and Fitch; S&P and Moody's together held over 75% of the market in 2007. This market dominance may give these large agencies more influence. Credit Rating Basics Ratings agencies are a vital part of the securities market. Their ratings greatly influence the fixed-income markets; markets react, often dramatically, to the increased or decreased likelihood of default when a rating changes. Additionally, for the debt-issuing company, a high rating may translate into hundreds or thousands of dollars in savings in interest payments and registration fees. A company with a high rating given by an NRSRO can issue certain commercial paper that is exempt from registration with the SEC, but also relieved of registration under the Uniform Securities Act. (To learn more about debt ratings, read Why Bad Bonds Get Good Ratings.) Ratings range from the highest credit quality (insured securities) to the lowest credit quality (securities in default). Long-term bonds and structured debt are rated using an "ABC" system. Triple A ('AAA' for Standard & Poor's, 'Aaa' for Moody's) reflects the highest credit quality, and 'C' (Moody's) or 'D' (Standard & Poor's) reflects the lowest quality. Within this range, there are varying degrees to each

rating. Moody's adds numerical modifiers 1, 2 and 3 to each generic rating classification from 'Aa' through 'Caa'. 1 indicates that the obligation ranks in the higher end of its generic rating category, 2 indicates a midrange ranking and 3 indicates a ranking in the lower end of that generic rating category. Standard & Poor's ratings may be modified by the addition of a "+" or "-" (plus or minus). Figure 1, below, provides an overview of the different ratings symbols that Moody's and Standard and Poor's currently issue and have been issuing for many years:

Moody's Aaa Aa A Baa Ba B Caa Ca C

S&P AAA AA A BBB BB B CCC CC D

Definition Highest Rating Available Very High Quality High Quality Medium Risk Low Quality/High Risk Very Speculative Substantial Risk

Notes Investment Grade Investment Grade Investment Grade Minimum Investment Below Investment Grade Below Investment Grade Below Investment Grade

Poor Below Investment Quality/Highest Risk Grade In Default Below Investment Grade

Figure 1: Moody's and Standard & Poor's debt rating systems

A Real or Potential Conflict of Interest The rating companies receive their compensation from the companies whose structured securities they rate. As a result, ratings company critics suggest that the fact that the ratings companies obtain fees from the companies that issue structured securities may make the ratings agencies susceptible to issuing artificially high ratings. In addition, the rating agencies may become reluctant to downgrade the securities of firms they were involved with for fear of losing future business. This sense of loyalty is thought to have played a large part in the meltdown of the subprime mortgage industry. Some critics have said that not only did ratings agencies give speculative investments higher initial ratings than would seem warranted, they were also slow to downgrade them. (For related reading, see Who Is To Blame For The Subprime Crisis?) Some ratings agencies also advise issuers on structured debt securities and then rate the securities they helped structure, which many believe to be a questionable business practice leading to inflated ratings.

On the other hand, charging the issuers a rating fee may be more beneficial to the public because under this system, the public has open access to the rating information, whereas if the system put the burden of payment on individuals, they would have to pay for the right to see the ratings, reducing public access to this information. Federal Intervention The issue of conflict of interest, or the appearance thereof, has led to so much criticism that in 2008, the SEC began an investigation to determine whether the ratings agencies were "unduly influenced'' by issuers and the investment banks selling structured securities. In response to the criticism, and perhaps spurred by the SEC investigation, debt rating agencies proposed changes in the way structured securities are rated in order to help distinguish them from less complex investments such as corporate or Treasury bonds and to make it more clear that structured securities do not have the same risk characteristics as similarly rated corporate securities. The International Organization of Securities Commissions (IOSCO), which is regarded as a forum for securities regulators, also proposed the creation of a code of conduct prohibiting debt rating agencies from providing advice on debt instruments for which they provide ratings. This potential conflict of interest created by a rating organization being paid by the companies whose securities they rate may be parallel to the potential conflict of interest situation that existed when stock analysts employed by brokerage firms were issuing favorable reports on securities that were underwritten by the investment banking side of those same brokerage firms. Because of this, rules were promulgated that required a separation of functions. For example, FINRA rule 2711 and NYSE Rule 472 require that those performing research do not supervise and are not to be supervised by anyone in the same firm's investment banking department and, perhaps more importantly, that no member may pay any bonus, salary or other form of compensation to a research analyst that is based on a specific investment banking services transaction. (To learn more, read The Chinese Wall Protects Against Conflicts Of Interest.) Conclusion Credit rating agencies are under scrutiny and the subject of substantial criticism. Until the conflict of interest issues are squarely addressed, it is likely that the criticism will continue and the matter will remain in turmoil.

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