Table of Contents
1.1 What are Credit Rating Agencies ?
2. Raison d'être
3.2 Conflict of Interest
3.3 Profit Maximization
3.4 Oligopoly market
3.5 Economic Relevance of a Downgrade
4. Role of credit Rating Agencies in politics and the financial market
4.1 Regulatory Power
4.2 Influence on political sciences
6. Works cited
"There are two superpowers in the world in my opinion. There‘s the United States and there‘s Moody‘s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody‘s can destroy you by downgrading your bonds. And believe me, it‘s not clear sometimes who‘s more powerful"1
Since the financial crisis in 2008, rating agencies are in the spotlight. Often they were blamed by politicians and economists for causing the crisis, because they rated some financial products with an excellent grade, without exactly knowing what was really behind these products. To understand why and how Credit Rating Agencies like Standard & Poors, Fitch and Moody's rate, we have to look closer at the CRA and their rating in order to understand how they work. In this research paper I will take a critical look at these institutions. I will talk about the independence of these global oriented enterprises and I will analyze their impact on the financial market and the politics in order to demonstrate why they are so powerful like quoted above. My research paper is based on two books which I read plus some interviews. The first books is written by Herwig M. Langohr and Patricia T. Langohr and called "The rating Agencies and their Credit Ratings", published by Wiley in 2008. The other book is a German book which is written by Jens Rosenbaum and called "Der politische Einfluss von Rating Agenturen, published by VS-Verlag in 2009. Additional I also used a very interesting essay from Dr. Deniz Coskun; Supervision of Credit Rating Agencies: the Role of Credit Agencies in Finance Decisions.
1.1 What are Credit Rating Agencies ?
To have an understanding about the Rating Agencies, we have to look at the past of these agencies and see where they come from. The first guy who was thinking about rating firms was Henry Varnum Poor. He evaluated American Railroad companies in a Newspaper in 1860. The Audience were British investors. Poor thought it would be a good idea to evaluate the chance of defaults, since the investors didn't know anything about the Railroad companies performances and how save their investment were. Today Rating Agencies rate not only firms, they almost rate everything from states over stocks to almost every investment product. This brings up the question what are ratings and who needs this ratings? First, let us look at the definition of Moody's.
"A Moody's credit rating is an independent opinion about credit risk. It is an assessment of the ability and willingness of an issuer of fixed-income securities to make full and timely payment of amounts due on the security over its life."2
This is just one definition of one rating agency; the others have one, too. And they are all different, but they also have something in common. It illustrates the divergence among the CRAs. What they all agree on, is that a rating is just an opinion about the creditworthiness and they try to tell in the rating something about the default risk, but each CRA has its own focus. Each CRA has an own developed grading scale which they use to rate, it's like a school grade. You can see the different grades below in the graphic. 3
Everything what is BBB- or higher is called investment grade. Everything what is below BBB- is called non-investment grade or junk grade. Later we will see why it is so important that firms have a least an investment grade. Each firm developed and uses its own matrices to position securities and index values, comparing them would after Langohr be like comparing apples and pears.4 There is an additional rating for the short term, these ratings are valid for up to 390 days, but on average they are used for 30 days and then they change. The difference between the long term and short term rating is that the long term has an outlook from three up to five years and they take a closer look at the overall performance. On the other hand short term ratings look closer at the upcoming business period and the focus is on the liquidity of the issuer5. Short term defaults are very rare. This displays the point of rating agencies, they benchmark default likelihoods, but that brings up difficulties, because it means CRAs are aiming on moving targets. We have to note that Credit Rating Agencies only benchmark the possibility of a default of a firm and not the chance that it will get bankrupt.
What we also have to consider when we look at Credit Rating Agencies, we need to know that they act in an oligopoly. There are only a few major CRAs, like S&P, Moody's and Fitch. Supporters say that they can be way more efficient in an oligopoly and that it's better to have only a few ratings, otherwise it would be too confusing if there would be 100 ratings on each firm. Critics say that the oligopoly is caused by the high entry barriers. The three big rating agencies mentioned above own together 92% of the market share.6 Moody's and S&P have together a market share of 77% Fitch has a share of only 17%.7
Another fact we have to know about Rating Agencies is that they get paid by the Bond Issuer, Issuing firm (corporate rating) or state (sovereign rating) which wants a rating. This means also that the rating agencies work close together with firms in order to evaluate the default risk. The agencies usually rely on the given information by the corporation, of course this brings up some conflicts of interest which we will discuss later (this is what also happened during the Enron scandal)8. In 1970 the Rating Agencies changed their payment system, before 1970 the Investors had to buy information about a certain firm, nowadays the issuers of bonds are responsible for the payment, because they have a big interest in an evaluation of their bonds, which is access to money.9 But the Rating Agencies do not only sell Ratings, they also produce the so called "unsolicited Ratings" those ratings are not ordered by someone, the rating agencies evaluates a some firms in order to complete their coverage in an industry. 10 Of course this ratings will be worse than a normal rating bought by the issuer, because the rating agencies want to attract the firms to buy ratings and they are doing this with setting incentives.11
2. Raison d'être
Even if rating agencies have in the public a bad reputation, they are still very important for the market. Rating Agencies help to resolve the information Asymmetry. They satisfy needs of different market actors, they provide investors acess to information, so they don't need to spend a lot of time in evaluating the risk and the Agencies provide better information, because they have access to insider information. Insiders always outsmart outsiders. Without rating agencies the Investors would only have only access to public information. So for them it is an advantage. The bond issuers gain also from Rating Agencies, because they get access to funds. Without the agencies the Issuers would have a harder time to raise money, because they would have to find other ways to convince investors. By resolving this Information asymmetry the Rating Agencies play an important role in the free market economy, they bring the economy closer to a perfect market, where everybody knows everything.12 This makes it easier to apply economic theories. Resolving the Information Asymmetry means that first the Credit Rating Agencies offer transparency. Second they provide means of comparison this means the agencies help that it is easier to compare different firms or states with each other, this goes hand in hand with the fact that they provide a common standard or language.13 All in all we can note that the Credit rating agencies are very useful for the market since the Issuer and the Investor profit from the provided information by the agencies. Another reason why they exist is the supervisory role, which I will explain later more in detail.
In the game of the economy the rating agencies bring not only advantages to the market, there also exist some serious conflicts between different parties and the interest of the rating agencies. In this section I am going to demonstrate the different conflicts which appear.
There are three great critics about the methodology of the agencies. The first one is that they evaluate and rate in a pro cyclical manner14. This means during economic boom times they tend to evaluate better and during a recession they downgrade firms. Of course the agencies know this problem and try to evaluate in long-term outlook. This pro cyclical behavior can lead to the fact that it accelerates recessions and causes herding behavior by the other market actors. That means if during recession Fitch for example lowers the rating of a firm, because they are not doing well, some investors may see this as an signal and jump out, that causes that capital is taken away from the market and the recession speeds up. Second the rating agencies are blamed that they rate after Anglo-Saxon based views.15 Anglo-Saxon views means that they prefer fiscal short-term orientation. The danger in this situation is that states and corporations try be liked by the credit rating agencies and change their behavior. In the long run this could lead to a convergence towards an Anglo-Saxon economic system. The third critic point about the methodology of credit ratings is that the rating criteria do not include the political risk in some states.16 That means that some political instable countries can still have an excellent rating, even if its predictable that the country will collapse in a few month. Do you think that investors can than rely on the rating published by the agencies? probably not, because it is too risky in some cases. But this also means that it is easy for unstable countries to finance themselves, because good rating equals low risk premium for treasury bonds. That means that sometimes dictatorship governments easy get access to money. To defense of the Rating Agencies we need to note, that there is an extra country rating, which rates a country's political and economic stability.
3.2 Conflict of Interest
There are two major conflicts of interest, the first one is the fact that credit rating agencies rate firms which don't pay for the rating or didn't assign the rating service to produce a rating. But the agencies do these so called „unsolicited“ ratings sometimes to complete their coverage.17 Now you will probably ask yourself why that is a conflict of interest? Since the Agencies are private organizations, they try to generate profit (I will talk about this specific topic more detailed further on). So the effect will be,that unsolicited ratings will be worse than just normal purchased ratings, because the agencies want to set an incentive to buy the rating or just don't put a lot of effort into the rating. This has a bad overall effect for the whole economy, because this distorts the competition.18 To make it more understandable, let’s assume we have two identical firms which are not rated. Firm A assigns a rating and gets the Grade AAA, firm B which has not ordered a rating gets rated too, but just because the Agency wants to complete its coverage. It puts less effort into to rating process and firm B gets the grade AA+. Even it was not on purpose the two identical firms has different grades. This means firm A has easier access to capital since the interest rate is lower. This example explains why rating agencies can cause a distortion of competition. The second major conflict of interest is the fact that the competition of rating agencies will cause the agencies try to get as many customers as possible. After Smith and Walter this will lead to an underestimation of the credit-worthiness. It is possible for firms to go so called "rating shopping" that means they ask each firm to make a rating of their firm and at the end, the firm takes the best evaluation. Since only 10% of the revenue of the rating agencies is from the initial rating, the credit rating agencies are able to tolerate this behavior. The other 90% of the revenue is generated from the ongoing re-evaluations.19 In the competition each agency tries to have the best rating and this will lead to an underestimation of the creditworthiness on purpose.20
1 "The News Hour with Jim Lehrer: Interview with New York Times" Thomas L. Friedman (PBS television Broadcast, February 13, 1996) (Coskun, 2009)
2 Moody's Investors Service, 2004, Guide to Moody's ratings, rating process, June, Report
3 (Graphic) http://forex.fxdd.com/wp-content/uploads/2012/01/FXDD-Blog-0096.jpg (copyright 2012)
4 (Langohr, 2008) S.50
5 (Langohr, 2008) S. 50
6 (Rosenberg, 2009) S.18
7 The Credit Rating Industry: Competition and Regulation, Dissertation, Universität Köln, S.17-18
8 (Eisen, 2007) S.255
9 (Coskun, 2009)
10 (Langohr, 2008)
11 (Rosenberg, 2009) S.20
12 (Langohr, 2008)
13 (Langohr, 2008) S.90
14 (Ferri/Liu/Stiglitz, 1999)
15 Strulik (2000) Willke (2001) Nölke(2005)
16 Haque/Mark/Mathieson (1998)
17 (Eisen, 2007) s.56
18 (Poon 2003)
19 (Bauer, 2009)