Credit rating agency

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain type of debt obligations as well as the debt instruments themselves. The rating represents the CRAs evaluation of fundamental and technical health of the company. A poor rating indicates a CRAs view that the company or govt. has a high risk of defaulting, based on the agencys analysis of long term economic prospects.

The Big Three

Credit Rating Agencies have been accused by many observers of being oligopolistic. The three dominant CRAs are:
Standard &Poors (40% market share) Moodys Investors Services (40% market share) The 3rd ranked CRA is Fitch Ratings (controlling about 14% market share) sometimes is used as an alternative to one of the other majors.

Criticism

Do not downgrade companies promptly enough

Enron's rating remained at investment grade four days before the company went bankrupt Moody's gave Freddie Mac preferred stock the top rating until Warren Buffett talked about Freddie on CNBC. He said game is over for Freddie and Fannie and that they do not have any net worth And on the next day Moody's downgraded Freddie to one tick above junk bond.

Familiar relationships with the companys management

These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. CRAs are accused of being too cozy with the companies they rate, and are accused of being too focused on a company's "bottom line and unwilling to listen to a company's explanations for its actions.

Heavy-handed blackmail tactics

Moody's published an "unsolicited" rating of Hannover Re, with a subsequent letter to the insurance firm stating that "it looked forward to the day Hannover would be willing to pay In 2004, Moodys cut Hannover's debt to junk status, and even though the insurer's other rating agencies gave it strong marks

Credit Rating Agencies have made errors of judgment in rating structured products

Assign AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. Many of the structured financial products that they were responsible for rating, consisted of lower quality 'BBB rated loans, but were, when pooled together into CDOs, assigned an AAA rating

Narrow-minded view of government default

Countries who can print their own currency are given stronger ratings As it is a perception of the CRAs that countries with the ability of printing their own currency are more financially stable. While this should not happen coz even if a country prints its own currency, theyd have to do away with some other asset (gold reserves most probably).

Industry Structure: "Issuer Pays" vs. "Subscriber Pays"

Most criticism of credit raters centers on the "issuer-pays" model--the system employed by S&P, Moody's, and Fitch--whereby a bond's issuer pays the rating agencies for the initial rating and ongoing ratings of a security. The public (and investors) then have access to these ratings free of charge. Many rating agencies shifted to this model in the 1970s, after years of following a "subscriber-pays" model, which required large institutions investing in bonds and other securities to pay for their ratings instead. According to the Congressional Research Service, this shift may have occurred in part because raters found issuers more willing to pay for these services than investors, since the issuers needed certain ratings in order to sell their bonds to regulated financial institutions. Aside from the Big Three, some smaller raters are still paid by investors. Under that system, the raters use publicly available financial data to evaluate the riskiness of securities. In contrast to the dominant issuer-pays agencies, they do not have the advantage of interviewing the issuers (as clients) to inform their reviews. Subscriber-pays raters have used the recent controversy surrounding the issuer-pays firms to tout the virtues of their alternative model. Egan-Jones Ratings Company, a subscriber-pays firm, for instance, has criticized the Big Three for allegedly being monopolistic and enabling biased ratings.

Unprecedented Downgrade
On August 5, S&P downgraded U.S. debt for the first time in U.S. history, by one notch from AAA to AA+
Congressional leaders and the White House reached a deal to avert default in the nick of time, but, in the opinion of S&P, did not implement significant measures to reduce the U.S. deficit over the next ten years President Obama sought to diminish the importance of S&P's verdict, citing investor Warren Buffett, who said the United States should have a "quadrupleA rating." S&P forcefully defended its decision in the wake of criticism. Nonetheless, in the first days of trading after the downgrade, global markets from Asia to Wall Street responded with a steep sell-off, which triggered volatility in equity markets not seen since the financial crisis.

Regulating the Rating Agencies

Critics of the Big Three in the U.S. and Europe have long voiced concern that legislation and financial regulations have created institutional frameworks that rely too heavily on the raters, leaving investors few alternatives. In 1975, the U.S. Securities and Exchange Commission began choosing which raters could be used to determine the minimum capital levels required for financial firms to trade certain debt securities, depending on their riskiness. The three raters initially chosen--Moody's, S&P, and Fitch--were deemed "nationally recognized statistical rating organizations," or NRSROs. Though the SEC added more rating agencies to the list over the years, Moody's, S&P, and Fitch maintained their dominant positions. In addition to creating an Office of Credit Ratings at the SEC, the July 2010 Dodd-Frank Act invested the SEC with the authority to examine NRSROs on an annual basis, levy fines when necessary, and even deregister an agency for providing inaccurate ratings.

 Similarly, the EU's oversight mechanism, the ESMA, "contributes to the development of a single rulebook in Europe" by ensuring the "consistent treatment of investors across the Union and enabling an adequate level of protection of investors through effective regulation and supervision.
In the wake of the Portugal downgrade, Commissioner Barnier, in addition to calling for a European agency, said the EU would reveal further measures to regulate the Big Three in the fall of 2011, forcing them to be more transparent. But we argue that government regulation is unlikely to solve the conflicts inherent in credit rating agencies, particularly when it comes to sovereign debt. The best way to counter the monopolistic power of the Big Three, we argue, is to stop putting so much weight in their ratings.

Preferential Treatment?
European officials have publicly accused the Big Three of showing preferential treatment to the United States, which until August 5 maintained a AAA rating, despite carrying an unsustainable deficit and increasingly high levels of public debt. The EU has also criticized excessive speculation by the U.S. agencies over European debt, even as concrete budgetary policies are being implemented by Eurozone periphery states--most recently, Spain and Italy -at risk of contagion. Many European officials, including European Commissioner for Internal Market and Services Michel Barnier, have called for the creation of an independent, European rating agency to counter the influence of the Big Three. Barnier even echoed former French finance minister and current IMF chief Christine Lagarde, saying that credit rating agencies should be banned from rating countries that are receiving international aid plans. Could a new rating agency compete with the well-established Big Three? "If you are a rating agency, and if you want to be a rating agency that enjoys credibility on the markets, you need to be able to demonstrate that you have a big stock of clients who are buying your services because they believe in what you're doing," Can a European-created agency would be able to maintain independence, particularly when rating sovereign debt, since it would be "a politically created body."

THANK YOU

Parmeet K. Nagi 8122 Karan Raghav 8111