Credit ratings: old risks and new challenges for financial markets

Office of the Moody’s Corporation ratings agency. Daniel J. Macy

In 2019, Moody’s Corporation, the holding company of Moody’s Investors Service, is celebrating its 110th birthday. Being the first rating agency and creator of a completely new industry, Moody´s is still successful today – in 2017, it generated $1 billion net income. However, since its foundation, the financial system has dramatically changed, and important issues have been raised about credit-rating agencies (CRAs) and their business model.

Even though Moody’s, Standard & Poor’s (S&P) and other CRAs have a successful past, today they face critics and the future of credit ratings has to be considered. Following the financial crisis in 2008 and the European debt crisis, criticism on CRAs rose. According to the Financial Crisis Inquiry Commission, CRAs were “key enablers of the financial meltdown” in 2008. The sovereign downgrade of major Eurozone economies additionally “accelerated the Eurozone’s sovereign debt crisis”.

A long history

The concept of the credit rating scale was already introduced in 1909 and has not been changed over the last decades, even though the financial market has. The simplicity of the scale, which combines letters and numbers in a range from Aaa (the best) to C (default), is easily usable by the market. The rating scales differ slightly between the agencies, but generally more letters followed by lower numbers express a better rating. Moody’s ratings between AAA and Baa3 are considered as investment grade and have a low probability of default while ratings from Ba1 have a “junk” status and higher probabilities of default. The classification can be understood even without a deep knowledge of finance, one reason why it remained so successful over decades.

The importance of credit ratings has increased due to changes in the regulation. In 1975 the Security and Exchange Commission (SEC) issued new rating-based rules which established bank and broker-dealer capital requirements. The SEC additionally required that these ratings must have been issued by Nationally Recognized Statistical Ratings Organizations (NRSRO). Seven rating agencies were originally approved as NRSRO and today their number includes only three more.

The market is dominated by Moody’s and S&P. Their combined US market share is approximately 83% (Moody’s 34.2%, Standard & Poor’s even 48.9%), with similar figures for Europe. Thanks to their long experience, they have a unique expertise in evaluating firm risk and new agencies struggle to compete with this knowledge. In addition, both companies have a solid reputation in the financial markets and the usage of smaller agencies could be interpreted as suspicious. Fitch Ratings was able to establish itself as the third biggest party, with a market share of around 13%. Fitch’s credit rating is especially important when the ratings of Moody’s and S&P differ from each other because it serves as a tiebreaker.

New payment models… thanks to the photocopier

Another significant change for the rating industry occurred in the beginning of the 1970s. In the original business idea, the investors needed to know the default probability and therefore they were charged for the service. However, when the prices for photocopy machines dropped, the issued rating reports could be copied easily and be accessible to all investors free of charge. Rating agencies had to change the payment model: bond issuers became the ones that had to pay, as they were required by law to have issuer ratings.

Referring to the new “issuer pays” model, Lynn Stout, Professor of Corporate and Securities Law at the University of California states: “When the people being watched get to choose their watchdog, they’re not going to choose the toughest animal around”. Regulators tried to change this payment model, whose problems become even more prominent in times of stress, such as financial crises. In addition, research found that the difference in ratings between “issuer pays” and “investor pays” is more pronounced when the conflict of interest is particularly severe.

Should issuers or investors pay?

The “issuer pays” model might lead to “rating shopping”, a situation in which the issuer contacts different agencies and chooses the one with the most favourable rating. Especially when the asset is complex to evaluate and ratings differ, the issuer has an incentive to choose only the best rating. This happened, for example, with CDOs (Collateralized Debt Obligations) tranches and triggered the financial crisis in 2008. Agencies rated risky bonds with good ratings in an attempt to gain more business. The “issuer pays” model is still the predominant type of payment and Moody’s, S&P and Fitch use this model, while only three of the 10 recognized agencies apply the “investor pays” model. For example, the rating agency Egan-Jones, founded in 1995, entered the market and is increasing its market share continuously thanks to this concept.

Another concern on CRAs consists of the rating analysts. The exact methodology of how CRAs evaluate the creditworthiness of issuers is a firm’s secret to avoid copies. The credit risk is evaluated through the application of quantitative and qualitative factors. Therefore, ratings express the CRA’s opinion and are dependent on the analysts themselves. Research recently found subjectivity in ratings issued by the same firm. Analysts can be optimistic or pessimistic and this can be reflected in their decision. This consequently leads to a rating bias that can have serious consequences. As an example, during the financial crisis analysts were often too optimistic while analysing default risk and the market followed their advices.

The last and probably the main challenge for CRAs lies in the changes of regulations which are due to the arising scepticism on their regards. In the last decade, several regulatory changes affected the rating industry. The most important one was the Dodd-Frank Act, signed into US law in 2010 in response to the financial crisis. The Dodd-Frank Act increased the liability for issuing inaccurate ratings and made it easier to sanction CRAs in case of material misstatements or fraud.

Market data is the key in future

Currently, CRAs are backed by the need of the financial markets because companies need to have at least one credit rating issued by a NRSRO in the case they want to issue a bond. CRAs indicate the opinion of the creditworthiness of firms, in particular of bond issuers. What happens if this would no longer be the case? In the past 20 years, alternative market instruments have provided similar information. Several researchers show that credit default swaps (CDS) spreads can be used to extract implied credit ratings.

CDS data help to get more information about the issuer from a market perspective. Implied credit ratings have the advantage to be independent of analysts and are based on the opinion on the bond market participants themselves. The question is whether these market implied ratings – or other new instruments – will replace the CRA’s traditional ratings. The Big Three – Moody’s, S&P and Fitch Ratings – have already established market-based ratings, using data from the CDS market. A better integration between market data and the judgement of analysts could in the future lead to more balanced ratings.