1. Crisis - Spotlight on Credit Rating Agencies "Credit-rating agencies use their control of information to fool investors into believing that a pig is a cow and a rotten egg is a roasted chicken. Collusion and misrepresentation are not elements of a genuinely free market " - US Congressman Gary Ackerman The smooth functioning of global financial markets depends, in part, upon reliable assessments of investment risks, and Credit Rating Agencies play a significant role in boosting investor confidence in those markets. The above rhetoric, although harsh, beckons us to focus our lens on the functioning of credit rating agencies. Recent debacles, as enunciated below, make it all the more important to scrutinize the claim of Credit Rating Agencies as fair assessors. i) Sub-Prime Crisis: In the recent sub-prime crisis, Credit Rating Agencies have come under increasing fire for their covert collusion in favorably rating junk CDOs in the sub-prime mortgage business, a crisis which is currently having world-wide implications. To give some background, loan originators were guilty of packaging sub-prime mortgages as securitizations, and marketing them as collateralized debt obligations on the secondary mortgage market. The agencies failed in their duty to warn the financial world of this malpractice through a fair and transparent assessment. Shockingly, they gave favorable ratings to the CDOs for reasons that need to be examined. ii) Enron and WorldCom: These companies were rated investment grade by Moody's and Standard & Poor's three days before they went bankrupt. Credit Rating Agencies were alleged to have favorably rated risky products, and in some instances put these risky products together for a fat fee. There may be other over-rated Enron's and WorldCom's waiting to go bust. The agencies need to be reformed, to enable them pin-point such cancer well-in-advance, thereby increasing security in the financial markets. 2. Credit Ratings and Credit Rating Agencies i) Credit rating: is a structured methodology to rank the creditworthiness of, broadly speaking, an entity, or a credit commitment (e.g. a product), or a debt or debt-like security as also of an Issuer of an obligation. ii) Credit Rating Agency (CRA): is an institution, specialized in the job of rating the above. Ratings by Credit Rating Agencies are not recommendations to purchase or sell any security, but just an indicator. Ratings can further be divided into i) Solicited Rating: where the rating is based on a request, say of a bank or company, and which also participates in the rating process. ii) Unsolicited Rating: where rating agencies claim to rate an organisation in the public interest. Credit Rating Agencies help to achieve economies of scale, as they help avoid investments in internal tools and credit analysis. It thereby enables market intermediaries and end investors to focus on their core competencies, leaving the complex rating jobs to dependable specialized agencies. 3. Credit Rating Agencies of note Agencies that assign credit ratings for corporations include A. M. Best (U.S.) Baycorp Advantage (Australia) Dominion Bond Rating Service (Canada) Fitch Ratings (U.S.) Moody's (U.S.) Standard & Poor's (U.S.) Pacific Credit Rating (Peru) 4. Credit Rating Agencies - Power and Influence Various market participants that use and/or are affected by credit ratings are as follows a) Issuers: A good credit rating improves the marketability of issuers, as also pricing, which in turn satisfies investors, lenders or other interested counterparties. b) Buy-Side Firms : Buy side firms such as mutual funds, pension funds and insurance companies use credit ratings as one of several important inputs to their own internal credit assessments and investment analysis, which helps them identify pricing discrepancies, the riskiness of the security, regulatory compliance requiring them to park funds in investment grade assets etc. Many restrict their funds to higher ratings, which makes them more attractive to risk-averse investors.
c) Sell-Side Firms: Like buy-side firms many sell side firms, like broker-dealers, use ratings for risk management and trading purposes. d) Regulators: Regulators mandate usage of credit ratings in various forms for e.g. The Basel Committee on banking supervision allowed banks to use external credit ratings to determine capital allocation. Or, to quote another example, restrictions are placed on civil service or public employee pension funds by local or national governments. e) Tax Payers and Investors: Depending on the direction of the change in value, credit rating changes can benefit or harm investors in securities, through erosion of value, and it also affects taxpayers through the cost of government debt. f) Private Contracts: Ratings have known to significantly affect the balance of power between contracting parties, as the rating is inadvertently applied to t