Performance of Credit Rating Agencies

Credit Ratings

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 tell us about the NRSRO'sperformance with regards to its ability of assessing thecreditworthiness of the obligors and issuers. Lastly, as it has beenexplained regarding the rules of NRSRO in the June 2007's adoptingrelease of the Commission, it is being studied by the Commission if itwill be suitable to require the disclosing of additional kind ofperformance statistics as an alternative or as an addition to thedowngrade rates and historical default like a credit rating downgradewhich takes place a long time after an important drop in the worth ofthe securities which are being rated. It is our believe that thedisclosure requirements according to the Rating Agency Act that willhelp the users of the credit ratings inevaluating an NRSRO's ratingreliability over a period of time and it will also help in increasingthe transparency with regards to an NRSROs' ratings accuracy (Dittrich, 2007).

Moody's, Standard & Poor's (S&P) and Fitch Group

When an individual is relying on someone's 'promise to pay', then thecredit worthiness of the person who is making the promise has the mostsignificance to the person who expects a payment. An independentmanner in which the credit worthiness of someone who has made apromise to make the payment can be judged is by making use of CreditRating. Today, a very important role is being played by the CreditRating in the finance decision making as, it helps in judging the riskof default as well as the credit quality (MIS, 2007; Fitch, 2007; S&P,

2005).

It was in 1841 when credit rating was done for the first time by amercantile credit rating agency which was set up in New York. In thisagency the merchants' ability to pay their obligations regardingfinances was rated. Afterwards, Robert Dun took over the agency. Itwas in 1859 that the very first rating guide was published by theagency. In 1849 John Bradstreet established the second agency andlater on this agency was merged with the first one and in 1933 Dun & Bradstreet came into being. In 1962 this firm became the owner ofMoody's Investor's Service. The stone of Moody's Investor's Servicewas laid down byJohn Moody in 1900 as he rated the Railroad Companiesand published 'Manual of Railroad Securities' (MIS, 2007; Fitch, 2007;S&P, 2005).

An expansion of the Credit Rating Industry took place in the early1920s when the first rating guide was published by Poor's PublishingCompany in 1916, soon after that Standard Statistics Company was setup in 1922 and Fitch Publishing Company in 1924. In 1941 Poor andStandard merged to form Standard & Poor. But no significant new CreditRating Agencies were set upfrom the years 1924 to 1970 (MIS, 2007;Fitch, 2007; S&P, 2005).

Since 1970 a lot of Credit Rating Agencies have been set up throughoutthe world. Some of the countries in which these agencies have been setup are Australia, Malaysia, Korea and Thailand etc. (MIS, 2007; Fitch,2007; S&P, 2005).

In the list of the developing countries India was probably the 1st oneto set up a Credit Rating Agency. This agency was set up in the middleof 1980s. CRISIL was the first Credit Rating Agency that was set up inIndia in the year 1988. Following this was the establishment of ICRAin 1991 and later on in 1994, CARE. Presently, there are 4 large ratingagencies that are present in India and these are CRISIL, ICRA, CARE andFITCH (MIS, 2007; Fitch, 2007; S&P, 2005).

The Credit Rating Agencies' functions were institutionalized when itwas made mandatory by RBI that commercial papers be issued and lateron by SEBI when credit rating was made compulsory by it for particularkinds of debt instruments. It was in June 1994 that rating the debtinstruments of Non-Banking Financial Companies was made compulsory byRBI (MIS, 2007; Fitch, 2007; S&P, 2005).

Even in these recent times when the economy all over the world facedthis slowdown, domestic agencies like ICRA or the international CreditRating Agencies like Standard & Poor's, Moody's Investors Services etc.have not been able to predict this slowdown. In fact, a lot of the financialinstitutions were given higher ratings by these agencies (MIS, 2007;Fitch, 2007; S&P, 2005).Around 50 to 100 companies were downgraded by other Credit RatingAgencies as a result of the public criticism that they faced.Following are some of the main reason for these downgrades:

There was a steep falling in the Service Company's earnings because ofthe recession being faced by the economy. The very overrated financialflexibility of companies by the rating agencies. Most of the financialflexibility was undoubtedly dependent on accumulating money for thenew issues in the capital market; this has been next to impossible todo because of the latest crash that took place in the stock markets (MIS, 2007; Fitch, 2007; S&P, 2005).

It was next to impossible for the financial institutions to raise anysort of money. The finance companies of this sort have the habit ofmaking investments in the long-term fixed assets by taking fixeddeposits of short-term nature. Liquidity problem was faced by themwhen the credit flow stopped (MIS, 2007; Fitch, 2007; S&P, 2005).

Overall rating gives a very good idea about the actual creditworthiness that a company has but it can't predict extreme scenarioslike the ones stated above which probably can't be predicted by many ofthe investors as well. Therefore, there is always a possibility ofsurprises (MIS, 2007; Fitch, 2007; S&P, 2005).

Role in Capital Markets

Accuracy and Responsiveness

Rating has proved to be very useful in various constituents of capital market. There are different benefits that can be achieved by makinguse of rated instruments for various classes of people.

1) Investors: By recognizing the risk safeguards are rated againstbankruptcy. It tells us about the risk which is present in aninvestment. The credibility of the issuing company can be evaluated.Information regarding the instrument quality is given by the ratingsymbols in a rather simpler manner which can be apprehended by a layinvestor and it can further help him in reaching a decision regarding theinvestment without getting help from a broker. The institutions aswell as individuals can draw up their own policies regarding creditrisk and evaluate the risk premium which is offered by market oncredit ratings' basis (Dittrich, 2007).

2) Issuers of Debt Instruments: A company which has highly ratedinstruments has higher chances of getting wider access to capital andthat too at a cost of borrowing which is relatively low. Best timingand pricing of issues is facilitated by rating and it also givesfinancing flexibility. Rating can be used as a marketing tool by thecompanies that have rated instruments in order to make a better imageof the company in customers', creditors' and lenders' eyes. Companies areencouraged by ratings to give more disclosures regarding theirmanagement patterns, accounting systems and financial reporting. Theinvestors who need mandated rating from renowned rating agencies tomake investments can also do so with the help of these ratings (Dittrich, 2007).

3) Financial Intermediaries: When it comes to decisions concerninginvestment and lending the financial intermediaries such as investmentadvisors, merchant bankers and banks find rating to be quite useful (Bolton et al., 2008).

4) Business Counter-parties: The business Counter parties find creditratings to be very helpful in the establishment of businessrelationships especially when it comes to opening letters of credit, getting into the collaborating agreements and awarding contracts etc.(Bolton et al., 2008).

5) Regulators: With some help from credit ratings, the entry barriersand eligibility criteria for new securities, promoting the efficiencydebt securities market, monitoring the financial soundness of firmscan be determined by the regulators. The transparency of financialsystem is increased by this which leads to a sound development of themarket (Bolton et al., 2008).

Rating and Default Risk

The use of credit ratings is preferred by many of the investors inorder to evaluate the default risk. Rating services are being offeredby the internationally renowned credit rating agencies such asStandard and Poor's, Moody's and Duff and Phelps. The rating agencies get paid by the bond issuers in order judge the worth of the issued bond so that the flow of information to the investors could be increased which would probably bring an increase in the demand for their bonds.Bond rating is determined by the rating agencies by taking many factors into consideration such as, the values of corporate bonds is evaluated by studying the bond indenture, future earning power, management and financial resources by Standard and Poor's. To be more precise the cash flow is mainly focused upon by Standard and Poor's in order to evaluate the financial viability of a firm. There are letter grades that are assigned to the categories of the bond. The highest grade bonds: these are the bonds that have negligible risk of default are rated as A (Aaa or AAA). Pluses or minuses (e.g.Aa+ A-)are assigned by the rating agencies whenever it's appropriate in order to show where the significant rating categories stand (Tasche, 2006).

Explanation of flaws and Excessive Power

When it comes to credit rating there are a lot of limitations. Firstly, there occurs a change in the credit ratings when it is felt by the agencies that a lot of change has taken place. It is physically not possible for the rating agencies to monitor all the firms that are present in the market on a constant basis. In case of events that may impact the asset quality of an issuer in a bad way, it might have an impact on the opinions that the rating agencies have regarding that issuer. Secondly, discrete categories are imposed on the default risk with the use of credit ratings whereas, in real the default risk is actually a uninterrupted phenomenon. It was recognized by Moody in 1982 that with the addition of numbers in the letter system the number rating category can be increased from 9-10-19. However, there still is this limitation that exists. Thirdly, due to the constraints of cost and time it is not possible for the credit ratings to seize all of the issue and issuers' characteristics (Tasche, 2006).

The cost of borrowing can be reduced by the borrowing company if it is able to get higher rating for its anticipated issue. Therefore, the pressure to get good ratings is very high and if a company finds out that it will be getting a low quality rating from the hired agency it an approach another one and use the best rating from amongst the two as it is not necessary for the firms to disclose all of their ratings. According to the rating practice in India it is not necessary for a corporate entity to agree to the first rating that is given to the debt issue and it also has the option of not using that agency again to get rated. In this sort of scenario, the rating agency is not allowed to reveal the assessments in front of anyone and the corporate entity has the freedom to go to some other agency as well. However, if ones the corporate entity has agreed with its first rating then, it can't get out of it (Tasche, 2006).

It is important for the rating agencies to ensure that the rating decisions being made by them are not determined by the profitability and volume and in the hopes of ensuring a promising impact on the share price. It should also be mentioned here that the rating agencies should be judged on their performance overall and not just by one or two defaults (Tasche, 2006).

The financial meltdown: Cause and effect

After the corporation agrees with the initial rating, the rating agency has to evaluate the debt issue subsequent to its maturity and release the rating as a component of the surveillance system. It has been seen that rating agencies haven't been able to asses a disaster in making and keep giving investment grade rating to various companies, which default after a certain amount of time. It is often stated that CRB scam wouldn't have occurred, had it been a competitive credit rating agency, warning would have been issued to the company. When disaster struck then, these rating agencies became careful and started downgrading ratings for some companies (Tasche, 2006).

For example, ICRA, CARE and CRISIL downgraded at least 35, 50 and 140 companies in 1997. The rating was changed by CRISIL, CARE and ICRA by 36%, 64% and 40% by at least three or four notches (Tasche, 2006).

Performance assessment

Conflict of interest

The Rating Agency Act allows NRSRO to reveal its conflicts of interest which are probable in its case of shaping its credit ratings and for maintaining, establish and enforce policies and procedures designed moderately, while considering the nature of business deeply for tackling and managing conflicts of interests. The Rating Agency Act gave the commission the authority to forbid or reveal fully the conflicts of interests aligned with respect to credit ratings by NRSRO. The commission has highlighted rules which bar the NRSRO from harboring some conflicts of interests in case, it hasn't worked in conjunction with requirements of Rating Agency Act for managing and disclosing them.

The conflicts seen in this category are receiving of compensation from the underwriter / issuer to grade securities issued or backed by the company. The commission's rule forbids NRSRO from harboring many other conflicts in various situations. Some of the most conflicts are taking compensation for assessing credit rating, where a customer paid for the credit rating given by NRSRO with maximum total revenue at the end of the financial year which exceeded or equaled 10% of NRSRO's gross revenue (Blochwitz et al., 2003). .

The SEC has certain rules, one of them involves handling the nonpublic information by NRSRO and forbid malpractices, unfair, coercive and abusive for that matter by NRSRO- this includes threatening to modify or modifying the credit ratings or not following the systematic procedures / methods outlined for determining the credit ratings, encompassing the obligor as well as the affiliate of an obligor, buys the credit rating and other services / products of NRSRO and personnel related to NRSRO (Blochwitz et al., 2003).

Records, book keeping and financial reports

Apart from that disclosure requirements and provisions for conflict of interest, the commission and Rating Agency Act has implemented rules, which enables NRSRO to keep records and books as well as documents of the procedures and methodologies in question employed by NRSRO to work out credit ratings. These records and books will permit commission examiners to assess if their procedures are being followed as outlined and in conjunction with Rating Agency Act. NRSRO's are bound to keep both outgoing and ingoing communications sent / received by the NRSRO and its employees which comprises of maintaining, determining, changing and withdrawing credit rating (Hull et al., 2004).

The Rating Agency Act as well as implementing rules allows NRSRO's to answer in front of a commission in confidentiality, some monetary reports, every year which includes audited financial statements. Apart from the audited financial statements, rules also need NRSRO's to provide unaudited financial reports which helps the commission in executing its responsibilities under the act of Rating Agency Act (Hull et al., 2004).

The Rating Agency Act states that all records given in NRSRO are liable to special, periodic and cross examination by commission's representatives, when the commission thinks it necessary to do so. The interests of the investors have to be protected. This is also done to carry out the Securities Exchange Act of 1934 (Hull et al., 2004).

Forbidding the regulating rating procedures

The commission is also wary of congress's intent in this case implementing this statue. The commission's judgment must be taken heed rather than that of rating agencies (Hull et al., 2004). The Securities and Exchange Commission on September 17, 2009 voted in favor of instituting a rule for examining the credit ratings agencies.

Revealing the rating activity history: The Commission made an amendment allowing the NRSRO's to reveal their history on ratings action. These actions consist of downgrades, upgrades, affirmations and withdrawals. This makes NRSRO responsible for all the ratings done as earlier as June 26, 2007. The disclosure must be made under two years' time after the action has taken place for paid ratings and under one year for issuer paid ratings. They should be available online and easy to search manner (Flandreau, 2009).

Making sure that NRSRO's must have same information: Demands that an NRSRO- which is paid by the arranger to grade a structure finance product-to reveal other NRSRO's which are in grading such credit rating during the process. This amendment thus requires NRSRO to gain a representation from arranger that the required arranger will reveal the information to various NRSRO's looking to grade the product (Flandreau, 2009).

Recording the compliance reviews: This permits the NRSRO to deliver SEC a report explaining the compliance reviews for the financial year (Flandreau, 2009).

Furnishing information on conflict of interest: This permits the NRSRO to show NRSRO's net revenue percentage interrelated to 20 biggest consumers of credit rating services of NRSRO (Flandreau, 2009).

Additional information is given about magnitude of conflicts: This compels NRSRO to be available as public information for personnel, who paid for credit ratings. Under the devised rule, the NRSRO will publish a report on their website for every year, which shows the net revenue percent generated by NRSRO for that financial year for delivering services and products apart from credit rating services and current position of a person (top 10%, top 25%, top 50%, bottom 50% and bottom 25%) translating the net revenue generated by the NRSRO related to the person (Flandreau, 2009).