Credit Ratings 101
The worst ever slump has hit the US economy and its rock-bottom credit ratings by Standard and Poor’s have raised concerns
worldwide. Amitayu Sengupta, renowned Economist at the Economic Research Foundation, cuts the jargon and demystifies how the
system of credit ratings works
There has been a lot of talk of the recent US debt handling imbroglio and the resultant downgrade in US credit rating by international agencies. To understand the whole issue, it is important to understand what credit ratings are all about.
A credit rating is essentially a measure of the credit worthiness of any entity. Credit worthiness, in simple terms, is related to credit risk of any lender. In layman’s language, suppose you are approached by someone, asking you to lend some money. For any lender, one of the biggest worries is that he/she will not be repaid. Even though any borrower commits to repaying the borrowed amount (with interest or according to any terms of agreements mutually decided), there is always a risk that the borrower may fail to do so. Thus any lender takes a ‘risk’ while lending out money, and this is known as ‘credit risk’.
Lenders therefore would prefer to lend out money to only those borrowers about whom they are assured. This is interpreted in terms of ‘credit worthiness’ of the borrower. Someone who has a good track record of returning borrowed money in time, or who has a very good business proposition that is bound to be fruitful naturally, tend to offer better assurance to any lender. Thus, the ‘credit worthiness’ of such borrowers is high and therefore the associated ‘credit risk’ for lenders is low.
The mechanism of credit rating agencies
In the business world, stock or bond markets are mechanisms through which economic entities generate funds for their purposes from investors. Thus, a company issuing bond is essentially the borrower, and the investor is the lender. In such a scenario, the investor faces a credit risk when he/she buys a bond. Therefore any investor would like to check the credit worthiness of the issuer of the bond. In the big wide world, it is not possible for an investor to personally check out the credit worthiness of every company or economic entity out there in the market issuing stocks or bonds. Thus investors have to rely on some independent agency dedicated to the task of assessing credit worthiness of economic entities. Credit rating agencies that have evolved over the years serve this crucial purpose.
The success of any such credit rating institution depends on its credibility. In today’s world, even though many credit rating agencies do exist, some stand above the rest because of their credibility. Some of the globally recognised credit rating agencies are Standard and Poor, Moody’s, Fitch, Dun and Bradstreet etc. Such agencies issue long term and short term credit ratings for different economic entities.
While there is no fixed nomenclature for credit ratings, the most conventional norm followed is ranking ratings by denoting alphabets. For example, most credit rating agencies follow a scale of 4 major alphabets, A, B, C and D. D is the lowest ranking, and is synonymous with Default. As are the highest ranks, much like the grades we receive in school. Even amongst these alphabets, demarcations are made to differentiate. For example, both Standard and Poor and Fitch follow a ranking system where AAA is a higher rank than AA, with AA+ ranking between the two. Moody’s follow a different nomenclature like A3, A2, A1 ranking below AA3, AA2, AA1, which in turn ranks below AAA. Triple A is the best ranking, with AAA+ being used to denote standing above the best possible.
Rating the credit-worthiness of countries
Over time credit ratings have moved beyond ranking only firms and companies and moved to rating countries as well. In the globalised world today, Governments too borrow money from the world, domestically or from other sources as well. Thus credit ratings of governments become necessary as they too run the risk of defaulting like any other economic agent. More importantly, since Governments control the state currency, the government turning defaulter results in the crash of that currency’s value, which has very serious repercussions on the global economy. For instance, imagine an investor planning to invest in India in the form of FDI or FII. The investor holds money in one currency (say Dollar) and is investing in India where the investment is calculated in terms of Rupees. Obviously there is a conversion factor involved which is the exchange rate of our currency vis-à-vis the Dollar. In such an investment the investor runs two major risks. Firstly, the company he/she is investing in might default on its payment. Secondly, the country he/she is investing in might run into some trouble so that the exchange rate tomorrow may worsen to such and extend that the returns on the investments in terms of Rupees might not be enough in terms of Dollars. Thus the investor will first look into the credit rating of India as a country and then look into the credit rating of the company he/she seeks to invest in. Therefore, in today’s world of global finance, country ratings play as important a role as
the ratings of individual companies or industries.
High ratings and low ratings explained
The most obvious question that arises regarding credit ratings is what are the implications of a high or low ratings in real terms? To put it differently, how do investors react to high or low ratings? A low credit rating essentially means that the credit risk is higher. There are various risk mitigation policies that are followed, but the most common reaction to higher credit risk is asking for higher interest rates. Risk based pricing is one of the oldest practices in the world of credit financing. If lending to a borrower is deemed riskier, a lender will ask for higher interest rates to compensate for the higher risk he/she is taking. A borrower too has to offer a higher interest rate to woo lenders if the borrower’s credit worthiness is deemed to be low. Thus credit ratings play a big role in setting interest rates in the world of globalised finance. Any change in the credit rating of any company or a country translates into higher interest rates demanded by investors. If the sovereign credit rating falls, all foreign investments in the country seek higher interest rates. This generates pressure on the domestic interest rates as well, since stock markets will seek to balance the interest rates between domestic investors and global investors that can generate inflationary pressures. Furthermore, if the global community starts asking for higher interest rates, it essentially puts pressure on the value of the domestic currency in the world that means changes in the exchange rate of the currency itself.
Where do these ratings come from?
While so much depends on the credit ratings, it is interesting to note that the ratings themselves are often based on subjective factors. While mathematical calculations do play a role in evaluating credit ratings, the rating system itself is not based on any stringent mathematical formula or parameters. This is because credit ratings take into account both quantitative and qualitative factors. Rating agencies rely on their experience and judgments in denoting the ratings which they feel best. Despite being a rigorous exercise, credit ratings are not as foolproof as they are expected to be.
Credit Rating agencies often fail to respond to market signals or newer development in time, which make their ratings redundant at times. Credit rating agencies like Standard and Poor drew a lot of flak during the recent US financial crisis when all of them failed to predict such a breakdown. In fact, the rating agencies were held responsible for generating this crisis by giving misleading ratings to investments over a long period of time, thereby triggering accumulation of bad debts in the economy. The entire sub-prime crisis was a result of bundling mortgages and other loans taken by unworthy borrowers together as assets of the bank and being sold in the stock market to investment banks. The credit rating agencies gave very high credit rating to such bundles, which mislead investors who bought these bundles. When the mortgages failed, all such investments were reduced to junk. While the laxity of the banks in lending money to unworthy creditors has resulted in discussions about stringent financial regulations, the high credit ratings provided by the rating agencies has led to lot of discussions about the malpractices in the rating processes.
Where they fall short
One of the biggest criticisms against rating agencies is unscrupulous practices. Rating agencies are accused of giving higher ratings to favourable companies in exchange of payoffs. Large corporations and credit rating agencies have frequent interactions, where the latter often ‘advices’ the former on what all it can do to maintain higher ratings. This often results in rating agencies following arm twisting tactics on corporates who are dependent of the credit ratings for their fortunes. It is also alleged to work the other way round, with institutions bribing rating agencies to give better ratings, as the sub-prime crisis story alleges.
The sudden knee jerk reaction of credit rating agencies to crises too is problematic as they tend to generate snowballing effect. For instance, Moody’s rating for Freddie Mac was high till it changed the rating over night following news reports that created panic the very next day leading to an avalanche selling. Indeed, the power that credit rating agencies have over the fortunes of companies is so high that such sudden changes in ratings create a flurry in the stock markets activities.
While a newer financial framework is being sought globally after the recent financial crisis, the role and scope of credit rating agencies too will need to change to adapt to the changing conditions. However, as long as the need for finance and investments remain, the need for credit ratings cannot be dispensed with.