What is a rating agency?

11.01.2012 13:38

BBC: AAA, Ba3, Ca, CCC... they look like some kind of hyper-active school report.

They are, indeed, a marking system, and one that is designed to inform interested parties.

The letter formations are given to large-scale borrowers, whether companies or governments, and tell the buyers of this debt how likely they are to be able to get it back.

The score card also affects the amount that should be charged by way of return on that borrowing.

These letters have been all over the coverage of the financial impact of the crisis besetting the eurozone.

A change to the score means a change to the amount a borrower must pay its debt-holders, something that can make it more expensive to borrow as investors demand a higher rate of return for taking on more risky debt.

But while the borrowers in the news - the governments with the downgraded scorecards of Greece, Irish Republic, Portugal, and even the mighty US - are household names, the ones that have such an impact on their fortunes are nowhere near as familiar.
They are credit-rating agencies, which exist to assess the creditworthiness of bond issuers - companies or, as in this case, countries who borrow money by issuing IOUs known as bonds.

Their power is now so feared that the European Commission has a set of proposals designed to rein them in, including requiring them to be more transparent about their ratings and to be held accountable for their mistakes.

It also views them as hostile because the leading agencies are US-based. It would like to see a European agency of equal status.

But who are they? Do we need them and how do they work out whether to give the top-of-the-class AAA or a lower grade, such as CCC, which - sticking with the schools analogy - means the issuer is supected of planning the financial equivalent of bunking off?

Poor and Moody
Standard & Poor's (S&P), as the oldest, comes first. It was begun in 1860 by Henry Poor, who wrote a history of the finances of railroads and canals in the United States as a guide for investors.
The "Standard" part came into being in 1906, when the Standard Statistics Bureau was set up to examine finances of non-railroad companies.

The two businesses joined forces in the 1940s.

Moody's was started in 1909 by John Moody, who published an analysis of the tangled and uncertain world of railway finances, grading the value of its stocks and bonds.

These are now mighty concerns - Moody's operating income was $688m in 2010 and Standard & Poor's made $762m.

They each have 40% apiece of the business of rating major companies and countries.

Fitch, with another eponymous founder, John Fitch, was set up in 1913 and is a smaller version of the other two.

There are hosts of other ratings agencies, whose names rarely appear even within the darker corners of the financial pages - so why are these three businesses the ones everyone watches?

Track Record
Part of the answer lies with the Securities and Exchange Commission (SEC), the US financial watchdog.

In 1975, it acknowledged these three as Nationally Recognized Statistical Rating Organizations (NRSRO).
An endorsement from an NRSRO makes life quicker and easier for countries and financial institutions wishing to issue bonds. It basically tells investors a firm has a track record and indicates how likely it is to be able to pay back the money.

Further impetus for NRSROs comes from the fact that certain regulated investment funds are required by the SEC to hold only those bonds that have a very high rating from accredited agencies.

An insurance company's strength is also judged by the ratings applied to the investment reserves it holds.

A downgrade of an issuers' rating pushes down the value of a bond and raises its interest rate. It can mean regulated funds must now sell these bonds.

But this can cause a vicious circle.

A big sell-off adds in market forces - more sellers than buyers - reducing the price further. That means a yet higher interest rate must be paid - and that puts an even bigger strain on the borrower.

Although the SEC has 10 NRSROs on its approved list, including a Canadian agency and two Japanese ones, the big three - Standard & Poor's, Moody's and Fitch - remain the industry standard-bearers.

This is partly because they make their ratings available freely to investors - making their money from charging the organisations who want their bonds rated.

Heavy criticism
So much for their size. What of their actual methods?

Standard & Poor's says a committee of between five and eight people decides the actual rating.

They base their judgments on a range of financial and business attributes that might influence the repayment, some of which may depend on the issuer of the bond (ie the borrower).

In a statement, S&P gave a long list of indicators it might use, including "economic, regulatory and geopolitical influences, management and corporate governance attributes, and competitive position".

That seems to cover everything. But since the credit crisis that began in 2007, these agencies have come in for heavy criticism - and even hostility.
After all, stacks of mortgage-backed securities - the investments that were backed by mortgages that were either never going to be paid back or were even fraudulent - were given the very best grade by the three supposed experts in rating the likelihood of the money being paid back.

Similar dramatic swings have been taking place in the ratings applied to government-backed, rather than private property-supported debt. One day a country's bond is graded a safe top rating and the next given a mark that suggests investors' money is not safe.

Many observers believe that if the rating on the UK's government bonds - or gilts - was downgraded by just one notch from AAA to AA it would put up the cost of official borrowing by around half of one per cent.

That would mean a big rise in the annual interest bill which has to be met by taxpayers.

When asked why it changes ratings, S&P responded: "The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment - or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue."

It indeed appears a dark art - but one whose influence has a more measurable effect.

SCORE CARD

Rating agencies use different systems involving a long list of letters
A top mark is AAA or AAa
Down to BBB or Baa3 is also safe
BB or Ba1 down to C is speculative - or "junk"
Other less sequential numbers are applied to the worst kind of bond

CREDIT-RATING AGENCIES

Private-sector firms that assigns credit ratings for issuers of debt
A credit rating takes into account the debt issuer's ability to pay back its loan
That in turn affects the interest rate applied to the security (eg a bond) being issued
A credit downgrade can make it more expensive for a government to borrow money

Financial glossary

The current financial crisis has thrown terminology from the business pages onto the front pages of newspapers, with jargon now abounding everywhere from the coffee bar to the back of a taxi.

Here is a guide to many of the business terms currently cropping up regularly, as well as some of the more exotic words coined to describe some of the social effects of the financial crisis.

A

AAA-rating The best credit rating that can be given to a borrower's debts, indicating that the risk of a borrower defaulting is minuscule.

Administration A rescue mechanism for UK companies in severe trouble. It allows them to continue as a going concern, under supervision, giving them the opportunity to try to work their way out of difficulty. A firm in administration cannot be wound up without permission from a court.

AGM An annual general meeting, which companies hold each year for shareholders to vote on important issues such as dividend payments and appointments to the company's board of directors. If an emergency decision is needed - for example in the case of a takeover - a company may also call an exceptional general meeting of shareholders or EGM.

Assets Things that provide income or some other value to their owner.

Fixed assets (also known as long-term assets) are things that have a useful life of more than one year, for example buildings and machinery; there are also intangible fixed assets, like the good reputation of a company or brand.
Current assets are the things that can easily be turned into cash and are expected to be sold or used up in the near future.
Austerity Economic policy aimed at reducing a government's deficit (or borrowing). Austerity can be achieved through increases in government revenues - primarily via tax rises - and/or a reduction in government spending or future spending commitments.

B

Bailout The financial rescue of a struggling borrower. A bailout can be achieved in various ways:

providing loans to a borrower that markets will no longer lend to
guaranteeing a borrower's debts
guaranteeing the value of a borrower's risky assets
providing help to absorb potential losses, such as in a bank recapitalisation
Bankruptcy A legal process in which the assets of a borrower who cannot repay its debts - which can be an individual, a company or a bank - are valued, and possibly sold off (liquidated), in order to repay debts.

Where the borrower's assets are insufficient to repay its debts, the debts have to be written off. This means the lenders must accept that some of their loans will never be repaid, and the borrower is freed of its debts. Bankruptcy varies greatly from one country to another, some countries have laws that are very friendly to borrowers, while others are much more friendly to lenders.

Base rate The key interest rate set by the Bank of England. It is the overnight interest rate that it charges to banks for lending to them. The base rate - and expectations about how the base rate will change in the future - directly affect the interest rates at which banks are willing to lend money in sterling.

Basel accords The Basel Accords refer to a set of agreements by the Basel Committee on Bank Supervision (BCBS), which provide recommendations on banking regulations. The purpose of the accords is to ensure that financial institutions have enough capital to meet obligations and absorb unexpected losses.

Basis point One hundred basis points make up a percentage point, so an interest rate cut of 25 basis points might take the rate, for example, from 3% to 2.75%.

BBA The British Bankers' Association is an organisation representing the major banks in the UK - including foreign banks with a major presence in London. It is responsible for the daily Liborinterest rate which determines the rate at which banks lend to each other.

Bear market In a bear market, prices are falling and investors, fearing losses, tend to sell. This can create a self-sustaining downward spiral.

Bill A debt security- or more simply an IOU. It is very similar to a bond, but has a maturity of less than one year when first issued.

BIS The Bank for International Settlements is an international association of central banks based in Basel, Switzerland. Crucially, it agrees international standards for the capital adequacyof banks - that is, the minimum buffer banks must have to withstand any losses. In response to the financial crisis, the BIS has agreed a much stricter set of rules. As these are the third such set of regulations, they are known as "Basel III".

Bond A debt security, or more simply, an IOU. The bond states when a loan must be repaid and what interest the borrower (issuer) must pay to the holder. They can be issued by companies, banks or governments to raise money. Banks and investors buy and trade bonds.

BRIC An acronym used to describe the fast-growing economies of Brazil, Russia, India and China.

Bull market A bull market is one in which prices are generally rising and investor confidence is high.

C

Capital For investors, it refers to their stock of wealth, which can be put to work in order to earn income. For companies, it typically refers to sources of financing such as newly issued shares.

For banks, it refers to their ability to absorb losses in their accounts. Banks normally obtain capital either by issuing new shares, or by keeping hold of profits instead of paying them out as dividends. If a bank writes off a loss on one of its assets - for example, if it makes a loan that is not repaid - then the bank must also write off a corresponding amount of its capital. If a bank runs out of capital, then it is insolvent, meaning it does not have enough assets to repay its debts.

Capital adequacy ratio A measure of a bank's ability to absorb losses. It is defined as the value of its capital divided by the value of risk-weighted assets (ie taking into account how risky they are). A low capital adequacy ratio suggests that a bank has a limited ability to absorb losses, given the amount and the riskiness of the loans it has made.

A banking regulator - typically the central bank - sets a minimum capital adequacy ratio for the banks in each country, and an international minimum standard is set by the BIS. A bank that fails to meet this minimum standard must be recapitalised, for example by issuing new shares.

Capitulation (market). The point when a flurry of panic selling induces a final collapse - and ultimately a bottoming out - of prices.

Carry trade Typically, the borrowing of currency with a low interest rate, converting it into currency with a high interest rate and then lending it. The most common carry trade currency used to be the yen, with traders seeking to benefit from Japan's low interest rates. Now the dollar, euro and pound can also serve the same purpose. The element of risk is in the fluctuations in the currency market.

Chapter 11 The term for bankruptcy protection in the US. It postpones a company's obligations to its creditors, giving it time to reorganise its debts or sell parts of the business, for example.

Collateralised debt obligations (CDOs) A financial structure that groups individual loans, bonds or other assets in a portfolio, which can then be traded. In theory, CDOs attract a stronger credit rating than individual assets due to the risk being more diversified. But as the performance of many assets fell during the financial crisis, the value of many CDOs was also reduced.

Commercial paper Unsecured, short-term loans taken out by companies. The funds are typically used for working capital, rather than fixed assets such as a new building. The loans take the form of IOUs that can be bought and traded by banks and investors, similar to bonds.

Commodities Commodities are products that, in their basic form, are all the same so it makes little difference from whom you buy them. That means that they can have a common market price. You would be unlikely to pay more for iron ore just because it came from a particular mine, for example.

Contracts to buy and sell commodities usually specify minimum common standards, such as the form and purity of the product, and where and when it must be delivered.

The commodities markets range from soft commodities such as sugar, cotton and pork bellies to industrial metals such as iron and zinc.

Core inflation A measure of CPI inflation that strips out more volatile items (typically food and energy prices). The core inflation rate is watched closely by central bankers, as it tends to give a clearer indication of long-term inflation trends.

Correction (market) A short-term drop in stock market prices. The term comes from the notion that, when this happens, overpriced or underpriced stocks are returning to their "correct" values.

CPI The Consumer Prices Index is a measure of the price of a bundle of goods and services from across the economy. It is the most common measure used to identify inflation in a country. CPI is used as the target measure of inflation by the Bank of England and the ECB.

Credit crunch A situation where banks and other lenders all cut back their lending at the same time, because of widespread fears about the ability of borrowers to repay.

If heavily-indebted borrowers are cut off from new lending, they may find it impossible to repay existing debts. Reduced lending also slows down economic growth, which also makes it harder for all businesses to repay their debts.

Credit default swap (CDS) A financial contract that provides insurance-like protection against the risk of a third-party borrower defaulting on its debts. For example, a bank that has made a loan to Greece may choose to hedge the loan by buying CDS protection on Greece. The bank makes periodic payments to the CDS seller. If Greece defaultson its debts, the CDS seller must buy the loans from the bank at their full face value. CDSs are not just used for hedging - they are used by investors to speculate on whether a borrower such as Greece will default.

Credit rating The assessment given to debts and borrowers by a ratings agency according to their safety from an investment standpoint - based on their creditworthiness, or the ability of the company or government that is borrowing to repay. Ratings range from AAA, the safest, down to D, a company that has already defaulted. Ratings of BBB- or higher are considered "investment grade". Below that level, they are considered "speculative grade" or more colloquially as junk.

Currency peg A commitment by a government to maintain its currency at a fixed value in relation to another currency. Sometimes pegs are used to keep a currency strong, in order to help reduce inflation. In this case, a central bank may have to sell its reserves of foreign currency and buy up domestic currency in order to defend the peg. If the central bank runs out of foreign currency reserves, then the peg will collapse.

Pegs can also be used to help keep a currency weak in order to gain a competitive advantage in trade and boost exports. China has been accused of doing this. The People's Bank of China has accumulated trillions of dollars in US government bonds, because of its policy of selling yuan and buying dollars - a policy that has the effect of keeping the yuan weak.