PRIMER Credit Rating Agencies by wuyunqing


									         A PRIMER on CRAs:
         Credit Rating Agencies

     What Is the Role of Rating Agencies?
       How Did Rating Agencies Start?
How Did They Get Government-Sanctioned Roles?
         Why Are There Only Three?
  Do the Agencies Have Insider Information?
     How Do the Agencies Make Ratings?
What Is the Role of Rating Agencies?
 • Assess and grade creditworthiness
   – Of entities that issue debt
   – Of specific debt securities
 • Their assessment
   –   helps determine interest rates in the market
   –   gets written into loan covenants as a trigger point
   –   is a key measure of corporate financial health
   –   affects loan restructuring and access to alternative
       financing sources in the market
   How Did Rating Agencies Start?
• Moody, John. Manual of Railroad
  Securities, 1909. Provided operating
  statistics for 200 railroads and their
• 1916—Standard Co. began grading bonds.
• 1920s—Poor and Fitch began bond rating.
• 1941—Poor’s and Standard merged.
• Customers were investors who wanted
  unbiased, arms-length financial analysis
           Changes Occurred!

• 1970s—Began charging issuers
  for ratings, because of ease of
• 1990s—Began lucrative side
  business in ―rating impact studies‖ to predict
  effect of M/A activity on credit ratings
• 2000s—Began moving into Euro market
  ratings in a big way
        How Did They Acquire
     Government-Sanctioned Roles?
• 1936—Comptroller of the Currency:
  ―Banks can hold only investment
  grade securities!‖
• 2002—Basle Accord changes are
  likely to require use of ratings for
  capital adequacy measures (if adopted, will
  go into effect 2006)
    Why Are There Only Three?
•1975—SEC designated the companies whose
 ratings were acceptable—NRSROs

―The SEC has enveloped the
 agencies in a very protective
                                   S&P Moody’s Fitch
 webbing that keeps anyone
 else from challenging them.
 There they are, a 2 ½ firm
 industry, sitting pretty.‖
(Lawrence White, Economics, NYU)
      Do the Agencies Have Insider
• Usually! ―Selective disclosure‖
  – SEC allows sensitive financial information to be
    released to bond raters, without requiring it to be
    revealed to the public. No on-going disclosure
• Lack of competition keeps it               ―insider‖
• ―Market mover‖ status keeps                        it as
  insider information
   How Do the Agencies Make
     Ratings of Countries?

• Trends within a country: economic
  condition, reforms, % of government debt
  held by domestic investors
• Consistency among countries:
  stability, inflation
   How Do the Agencies Make
     Ratings of Companies
• 80/20 rule—for debt, 80% based on the
  past, 20% based on projections. Reversed
  for equity
• Issuer’s market position and size
   How Do the Agencies Make
  Ratings of Specific Securities?
• Rating agency picks a sample of loans to inspect
  and underwrite
   – 50-70% of the package, including largest 10
   – Loan-to-value ratios, debt service coverage, individual
     cash flow component analysis
• Results are extrapolated to the non-sampled
  portion of the portfolio of underlying assets
• Often more than one agency rates a deal
• ―In the financial services business, there would be
  no commerce without credibility‖ (Bergsman)
    Scope of the Business Today
• Lucrative—Moody’s as the example
  – $4.2 billion assets
  – $158 million (2000) revenues—85% paid by security
  – $770 million (2001) revenues  $382 million
    operating income
  – 36% of revenues come from ―relationship pricing‖;
    64% from ―transactional pricing‖
  – 1/3 of revenues from structured financing
  – Rates $30 trillion, from 100 countries, 4,200
    corporations, and 68,000 public finance obligations
     Scope of the Business Today
• Accurate predictions
  – Less than 1% of A- or better rated bonds default over
    5 years
  – 85% of A rated securities retain the rating for more
    than 1 year
• Growth outside the US
  – Europe: 1500 unrated companies with revenues
    greater than €1 billion
• Baccardax, Martin. ―Who’s Watching the Watchdogs?‖,
  Corporate Finance, August, 2001, p. 33-35.
• Bergsman, Steve. ―Rating Agencies Waging War over
  Market Pie‖, National Real Estate Investor, October 1,
  1999, p. 46-60.
• Borrus, Amy. ―The Credit-Raters: How They Work and
  How They Might Work Better‖, Business Week, April 8,
  2002, p. 38-40.
• ―Finance and Economics: A1 for Risk, D for Effort;
  Japan’s Credit Rating‖, The Economist, May 18, 2002, p.
• McLean, Bethany. ―The Geeks Who Rule the World‖,
  Fortune, December 24, 2001, p. 93-96.
    What else does CRA stand for in the
    financial regulation world?
   Community Reinvestment Act

    What technology reversed the roles of
    investor and issuer?
   The indispensable COPY MACHINE!

    Who is the largest shareholder of Moody’s?
   Berkshire Hathaway owns 15% (12/2001)

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