The company which is responsible for assigning the issuers of particular kind of debt obligations and debt instruments the credit ratings is known as a credit rating agency (CRA). There are a few cases in which the ratings are given to the underlying debt servicers. It is the special purpose entities, non-profit organizations, companies, national governments and the state and local governments who, in majority of the cases get the securities issued. The credit worthiness (i.e., the ability to pay the loan back) as well as the rate of interest which is applied to a specific security being issued is taken into consideration while assigning a credit rating to an issuer. After the financial crisis which took place in 2007/2009 the value of this kind of ratings was questioned to a great extent. A report was submitted by the Securities and Exchange Commission to the congress in 2003 which contained details of the plans to have an investigation conducted into the credit rating agencies' anti-competitive practices as well as the issues regarding the conflicts of interest (Partnoy, 2006).
Investors, broker-dealers, issuers, governments and investment banks make use of the credit ratings. The range of investment alternatives is increased by the credit rating agencies for the investors and they are provided with easy-to-use measurements of relative credit risk as well as more independence. All this usually lowers the costs for the lenders and borrowers and increases the efficiency of the market and in turn the overall supply of the risk capital present in the economy gets increased which results in stronger growth. The capital markets also get opened to various types of borrower who otherwise might get shut out completely; these can be startup companies, universities, small governments and hospitals (Partnoy, 2006).
Credit rating is relied upon by the issuers as something that can verify the worth of their credit in an independent manner as well as the resultant value of the instruments which is issued by them. In majority of the cases there should at least be one rating for an important bond issuance and this rating should preferably be from a respected CRA in order for the issuance to be successful. It has been shown by the studies done by Bond Market Association that a debt issuance with at least 3 ratings is now being preferred by a lot of the institutional investors (Partnoy, 2006).
The credit ratings are also used by the issuers in particular structured finance transactions. For example, if a company which has quite high credit ratings and it wants to obtain a research project which is very risky then it could create an entity which is separate in the legal terms and has particular assets owned by it and doing the research work. All of the research risks will then be assumed by this "special purpose entity" and in order to finance the research it will issue own debt securities. The credit rating of the SPE will probably be quite low and a high rate of return will have to be paid by the issuer on the issued bonds. Although, the overall credit rating of the parent company will not be lowered by this risk as, the SPE is going to be an individual entity. Another way through which borrowing can be done on better terms by a company that has low credit rating by forming an SPE and transferring its important assets to this newly formed subsidiary and issue debt securities which are secure. In this way in case that the venture doesn't work the lenders will have the option of the assets that will be owned by the SPE. This will also help in lowering the interest rate which the SPE, as a part of the debt offering has to pay (Partnoy, 2006).
It is possible for the same issuer to have various credit ratings for various bonds. It is the structure of the bond that is responsible for this difference such as; the way that the bond was secured, the extent of its subordination to other debt etc. The "credit rating advisory services" are offered by a lot of large CRAs. The basic function of these services is that they give instructions to the issuers on how they can structure the SPEs and bond offerings so that they can achieve specified credit rating for a particular debt tranche. A probable conflict of interest is created by this since it might be felt by the CRA that it has to give the specified rating to the issuer as the advice regarding the structuring of offering was followed by the issuer. This conflict is avoided by some of the CRAs in such a way that they decline to rate the debt offerings that their advisory services had been sought for (Partnoy, 2006).
History of the Rating Market
Taking into consideration the recent events it is beneficial to take into account the credit rating agencies' history as well as the role that was played by them in the financial markets. Credit ratings have been made use of in order to differentiate between debt creditworthiness grades since the beginning of the last century. However, it was in the beginning of 1975 that explicit references were started being made by SEC to the credit ratings in its rules. Originally the term "NRSRO" was adopted by the Commission in 1975. The sole purpose of using this term at that time was to determine the capital charges on various grades of the debt securities under the Commission's net capital rule for broker-dealers. However, this concept of NRSRO was incorporated into various SEC rules and regulations which also included the rules that were issued under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. This concept of NRSRO was started to be used by Congress in its legislation along with many other regulatory bodies such as banking regulators both abroad and at home (Frost, 2006).
Even though the concept of NRSRO was used by SEC for the regulatory purposes before the Rating Agency Act was enacted but still no legislation has given statutory regulatory authority to the Commission over the credit rating agencies. Prior to the enactment of Rating Agency Act the credit rating agencies were identified as NRSROs by the Commission staff, this was done through the no-action letter process. According to this process the documents and information which was submitted by the credit rating agency was reviewed by the staff in order to determine if the broad market acceptance has been achieved by the agency for its ratings. If the staff decides that the agency has been able to achieve the acceptance then, a letter is issued by the staff which states that enforcement actions aren't recommended against the broker-dealers who made use of the agency's credit ratings for the sake of complying with the net capital rule of the Commission (Frost, 2006).
With this process 11 firms were previously identified by the SEC staff as NRSRO. However, a consolidation of many NRSROs took place with the help of which 5 of the credit rating agencies which had been acknowledged under the no-action letter process were able to stay in business at the time of enactment of Rating Agency Act. These agencies were: A.M. Best Company, Inc.; Fitch, Inc.; DBRS Limited; Moody's Investors Service, Inc.; the Standard & Poor's Division of the McGraw Hill Companies, Inc. between the passage of the Rating Agency Act and its enactment there were two more NRSROs identified. These were; Rating and Investment Information, Inc.; and Japan Credit Rating Agency, Ltd. (Frost, 2006).
The Credit Rating Agency Reform Act of 2006
The no-action letter was replaced by the rating Agency Act with a program of the Commission for the credit rating agencies which elect to get registered as NRSROs. According to the Rating Agency Act an agency which is seeking to be registered as an NRSRO has to apply in the Commission for the registration, make some of its information in the application public so that its credibility could be evaluated easily and procedures could be implemented in order to manage the handling of conflict of interest and nonpublic information. According to the statutory mandate the implementing rules of the Commission require that an NRSRO's conflicts of interest should be disclosed and particular conflict of interest should be proscribed. The important Rating Agency Act's provisions as well as the new Commission rules have been mentioned below briefly (Flandreau, 2009).
Disclosure Requirements and Performance Measurement Statistics
An NRSRO is required by the Rating Agency Act as well as itsimplementing rules to generally describe its methodologies andprocedures that are used for the determination of credit ratings inthe public filings with the SEC. Also, it is important for the NRSROto make public certain performance measurement statistics whichincludes default rates as well as the historical downgrade in each oneof its credit rating categories in the short, medium and long terms.The purpose of these statistics is to…