Over the past few years, headlines with the words “rating agencies” and ” credit ratings ” appear in news feeds and regular publications. These publications talk about raising or lowering credit ratings, both whole countries, and individual companies. The latest hype about the actions of rating agencies occurred in the midst of the 2008 crisis.
The rating agencies themselves are commercial organizations that study the quality of asset management, assess the solvency of issuers, analyze possible risks for potential investors and many others. At the moment there are more than 100 rating agencies in the world, the most famous of which are Moody’s, Fitch Ratings and Standard & Poor’s. In fact, all these agencies are publishing and information organizations that formulate and create credit ratings. It is generally accepted that they are completely independent since they do not participate in transactions in the markets.
Credit rating from rating agencies
The most known area of activity of rating agencies is solvency assessment or issuing a credit rating that reflects the risks of non-payment of debt obligations and has a direct impact on the yield and value of debt obligations, as well as on the interest rate. The lower the risk of non-payment, the higher the issuer’s credit rating. The exposed credit ratings can be short-term and long-term. Short-term ratings predict solvency of the estimated issuer during the year, and long-term ones for a longer period. When compiling a long-term rating, agencies give forecasts that can be stable, negative, positive or developing. These forecasts indicate a possible change in the credit rating in the next six months or a year.
Long-term ratings (by the example of Standard & Poor’s)
The long-term rating may take a value from D, which means default, to AAA, which speaks of exceptionally high opportunities for the issuer to repay loans. The following categories are located between the lowest and highest rating of the rating: C – serious difficulties, the beginning of the issuer’s bankruptcy procedure is more than likely SS – great difficulties with any payments CAS – serious difficulties with payments on debt obligations B – solvency is at a satisfactory level, but the unfavorable economic situation may adversely affect payments to BB – similar to rating B, but the probability of adverse economic conditions is slightly lower than BBB – satisfactory payment The ability A – high ability to pay credit obligations, but depending on the economic situation AA – the issuer’s high ability to repay loan obligations Interim estimates are displayed as a plus sign or a minus sign after the letter designation of the credit rating. In addition to the ratings listed, there are such values as: SD – refusal to pay on certain credit obligations NR – lack of a credit rating.
Short-term ratings are indicated much simpler than the long-term and include the following categories: D – for undertaking defaulted C – limited chances for the payment of debts, which are totally dependent on the economic situation B – speculative debt obligation with a chance of redemption to be strongly dependent on the market situation A -1, A-2, A-3 – are similar to the first three indicators of long-term ratings
Why are rating agencies used?
Ratings are used for investment restrictions, as well as for allowing investments in acceptable lists. For example, Central banks require ratings to be included in the Lombard list – the lower the rating, the higher the discount; Similar requirements are made by pension funds for investment. It is necessary to understand that the ratings only assess the ability of the issuer to pay debts. Therefore, countries or organizations that spend all their free funds for debt servicing will have a rating significantly higher than those engaged in refinancing and fast-growing issuers. The ratings are especially in demand during crises, when investors begin to look for safe opportunities for investing their funds.
How are credit ratings made by rating agencies?
During the determination of the issuer’s creditworthiness, a comprehensive check of its readiness and ability to fulfill its financial obligations in strict compliance with the terms of their fulfillment is carried out. This takes into account the competitiveness of the company, its corporate governance and management features, economic and geopolitical factors, performance indicators, business characteristics, specific risk factors and other financial and economic characteristics that may somehow affect the performance of debt obligations. When determining the credit rating of a sovereign issuer, which is the role of the national government, the main attention is paid to political risks, the general level of the debt burden and the stability of the national currency. bonds and the probability of default on them, the information provided by the issuer itself is most often used. When issuing ratings to municipal and corporate bonds, credit rating agencies are primarily rated by credit rating agencies of the issuer itself, and only after that the credit quality of the bond as a debt obligation. Such an evaluation mechanism acts as a kind of airbag that limits credit risks that may be associated with this obligation. Rating agencies can assess the level of probable debt recovery after a default, or the possibility that in the event of default of the borrower, investors will be able to repay the unpaid part of the principal amount. The probability of a return can act as a separate rating or be used as a factor in issuing a credit rating.
Who is funding the rating agencies?
The main source of funding for rating agencies is issuers themselves, who pay for the very fact of including them in the ratings. They pay an annual fee for the fact that they receive an assessment of their own opportunities for debt payments, as well as receive advice on improving existing credit ratings at the moment. It turns out that issuers and investors are interested in the activity of rating agencies. The first group seeks a higher position in the ratings, in order to obtain more favorable financing terms. The second group is interested in the integrity of agencies when issuing credit ratings. As the issuers pay, it is quite possible that there may be informal contracts between them and rating agencies. A similar business model actively criticized, but at the moment there is no real alternative. Therefore, rating agencies continue to play a significant role in the world economy due to the fact that it is practically impossible to prove their mistakes, and there is nobody to replace them at the moment.
Countries and credit ratings
Over the past five years, there have been quite a few disgruntled governments that have suffered the consequences of lowering credit ratings, leading to a significant increase in government spending on external debt servicing. Despite such criticism, investors continue to listen to rating agencies, as they need information about the financial affairs of a country. The reaction to this discontent was manifested in Europe by the adoption, last month, of a package of documents restricting the activity of rating agencies regarding sovereign ratings. From now on, they can be voiced only three times a year, which will somewhat reduce the interest of investors to them because of the lack of speed of data.
Are the forecasts of rating agencies adequate?
Against the backdrop of accusations of subjectivity, the adequacy of the forecasts of rating agencies is easy to verify. It is necessary to compare the number of defaults that occurred in fact on securities. The main factor of investors’ confidence in the “rating” is that the credit ratings have confirmed their predictive power. The statistics were very convincing even during crises: in the bond market, the number of defaults was directly dependent on the rating level. The higher the rating was, the fewer defaults on bonds. There is a fairly common misconception that with a high rating, the default is impossible, and if it happened, it is a mistake. The default can happen at any rating, even as high as possible. The main question is the number of such defaults. Any investor should understand that acquiring a portfolio of bonds with very high ratings, the entire portfolio will not be subject to serious risks, even if some paper “defaults.” After all, the credit rating is not at all a panacea for default.
Alternative to the “big three” rating agencies
European politicians are not happy with the fact that the whole world depends on three and in fact even two companies (Moody’s and Standard & Poor’s), which occupy about 80% of the world market in the sphere of rating services. In this situation, many are trying to find elements of a geopolitical plot, as the roots of the “rating three” from the United States. The first thing that comes to mind is to increase the number of rating agencies. Perhaps their estimates will differ from the forecasts of the “troika” and investors will form their opinion of the companies comparing the ratings. Europe is beginning to move along this path trying to increase the role of national rating agencies. Unfortunately, these agencies will be respected within certain countries, and nothing will mean when assigning ratings on a global scale. From the idea of creating a single European rating agency refused because of a conflict of interest. A worthy competitor to the “rating three” will appear in the form of the international rating agency Universal Credit Rating Group (UCRG), which is created by companies from Russia, the United States, and China, and the UCRA was invited to join the project. The idea of creating UCRG is based on the merger of companies with local expertise, well understanding the ininternal market who can qualitatively and unbiasedly assign ratings according to the national scale. These companies should not work for a global investor. The main objective of UCRG is the ability to combine local players to assign ratings on an international scale. The project has a good perspective, which confirms the existence of such initiatives. UCRG will be able to press the “rating three” only after 7-10 years, since it is impossible to instantly create trust.