Credit Rating

Background

• v  A credit rating agency (CRA) is a company that is in the business of rating the credit worthiness of debt. It does so by rating issuers of debt obligations and also by rating the debt instruments themselves. Credit ratings are meant to provide easy-to-use measurements of relative credit risk so that investors can make informed choices. The idea is to facilitate transactions and lower costs for both borrowers and lenders.

• v  Three CRAs dominate the market - Standard & Poor's (S&P), Moody's Investor Service, and Fitch Ratings. Each of the first two has 40% market share while Fitch has a 14% market share, bringing the combined market share of the big three to 94% and making them a powerful oligopoly.

• v  Credit ratings are used by debt issuers such as governments and corporations to send a signal to the market, and by subscribers such as pension funds or other investment funds to make investments. The premise is that CRAs provide an independent verification of the issuer’s credit-worthiness and the resultant value of the instruments it issues. This means that lenders who buy debt do not have to engage in due diligence of every debtor and every debt instrument, and can make faster and more reliable decisions. CRAs exist to make the debt market more efficient.

• v  CRAs are in trouble these days because of their role in the global financial crisis. They assigned high ratings to both issuers and debt instruments that turned out to be in massive trouble. Instead of giving the market accurate reference points to make informed judgments, they acted like a malfunctioning instrument dial that fueled a bubble that eventually burst.

• v  There are three main criticisms of CRAs. First, that they are part of an oligopoly with too much power and have anti-competitive practices. Second, and more important, that they lack competence. They often do not understand more complicated debt instruments such as the fancy derivatives that were used in the height of the crisis. Third, CRAs suffer from a fundamental conflict of interest. They rely on an "issuer-pays" business model in which most of the revenue of the CRAs comes from fees paid by the issuers themselves. This means that they are obligated to the very people that they are supposed to judge independently.