Rating agencies

Since the downgrade of the American sovereign rating and the mistaken announcement stipulating that France would be rid of its triple A, rating agencies have come under the limelight.

rating agenciesrating agencieAt the centre of controversy, these institutions which are powerful in the financial markets have, for several years, accumulated blunders, failures along with judgment errors. A focus on these markets’ policemen with well-kept-secrets.

The role of rating agencies

Rating agencies are independent economic entities specialized in the evaluation and rating of a borrower’s capacity, be it state, local community (commune, department, region, …), financial corporate or not. Their job is to assess the capacity of these economic players to honor their financial obligations and to measure debt default risks.

This evaluation is carried out by means of rating awarding to the companies or states which need to borrow money from financial markets.

The rating

A four-letter and twenty-four-scale alphabet ranging from AAA, the most solid to D, default, which characterizes the solvency of companies and states keen on borrowing from the markets.

Rating agencies: Introducing the leaders

Although 150 financial rating agencies are censed worldwide in 2010, three of them are monopolizing the financial landscape: Standard & Poor’s, Moody’s and Fitch. Baptized “the big three”, these agencies, which share almost 90% of the rating market, are endowed with the power of life and death over the governments of 126 countries throughout the world, hence the oligopolistic position of these century-old enterprises on the rating market.

Their influence on global finance is such that some specialists jokingly refer to them as the new masters of the world or the new oracles.

Rating agency: Standard & Poor’s

Standard & Poor’sStandard & Poor’s whose origin dates back to the 19th century has developed with the expansion of railways in the United States. Only in 1941 did the agency take its current name following the merger of Standard’s Statistics Bureau, established in 1906, and Poor’s Publishing Company, launched in 1868 and which used to publish an annual manual on railway companies, compiling financial data.

In 1966, S&P was purchased by American media group McGraw-Hill.

  • American firm
  • 2010 turnover: 2.9 billion USD
  • Total staff: 6 700 staff members worldwide
  • Rating teams’ staff: 1 345 employees
  • Presence in 23 countries
  • Market share: 40%

Rating agency: Moody's

Moody-sIt was John Moody who established in 1900 Moody’s Investors Service, a company specialized in the sale of statistic studies on the operations of railway companies. In 1906, the company started the attribution of letters for the evaluation of railway companies’ indebtedness. For now, the agency is a subsidiary of Moody’s Corp, whose main shareholder is Berkshire Hathaway, Warren Buffet’s investment fund.

  • American firm
  • 2010 turnover: 2 billion USD
  • Total staff: 4 700 staff members worldwide
  • Rating teams’ staff: 1 200 employees
  • Presence in 26 countries
  • Market share: 32%

Rating agency: Fitch Ratings

Fitch RatingsSet up in New York in 1913 by the American John Knowles Fitch, this agency became in 1977 under the reign of Fimalac, the holding of French businessman Marc Ladreit de Lacharrière. Fitch Ratings is controlled up to 60% by Fimalac.

  • French firm
  • 2010 turnover: 820 million USD
  • Total staff: 2 000 staff members worldwide
  • Rating teams’ staff: 1 050 employees
  • Presence in 50 countries
  • Market share: 14%

Rating agency: AM Best

Even though AM Best is not among "the big three", it has specialized in the rating of insurance and reinsurance companies.

Established in 1899 by Alfred M. Best, it is dotted with premises in the United Kingdom, the United States and in Hong Kong. A.M. Best provides comprehensive credit rating services dedicated to insurance and reinsurance business.

Rating agencies: the rating process

Despite their weight over global finance, rating agencies are not endowed with staff that could be characterized as stock market genius nor holders of PhD degrees. Their analysts are often bi-nationals mastering several languages, generally business schools graduates having an economist training with experience in the public sector. Their salaries are rather closer to those adopted in audit institutions than to those in use by front offices for traders or fund managers. Junior analysts earn approximately 45 000 EUR (59 638 USD) a year while senior ones’ salaries range between 75 000 and 100 000 EUR (99 397 and 132 530 USD).

Analysts operate within reduced units. A team is generally made up of two analysts: a senior analyst, assisted by a back-up analyst, entrusted with the task of collecting data required for rating: annual reports, sector-based studies, economic surveys and field investigations. The survey stage could require several weeks of work and analysis.

Each agency applies its own methodology. It is upon the request of senior analyst that the rating committee, comprising about fifteen analysts, meets in order to decide on the final rating to be granted in full confidentiality and in limited time.

ratingOnce the rating is determined (modification, increase, downgrade, under supervision adjustment or outlooks change), it is sent to the issuer of the debt who has about 12 hours to proceed to the correction of possible errors. Afterwards, once the possible rectifications have been made, the rating goes public.

Ratings are revised at least once a year or anytime deemed necessary by the agency, in the event of a major political, social or economic happening or during any acquisition.

Rating agencies: Different kinds of rating

There are two kinds of rating: sovereign and corporate ratings.

  • Sovereign rating refers to the evaluation of the country’s risk. This rating is designed for companies that are intent on signing contracts abroad in order to help them better address the risks to which they are exposed when investing in the country.
  • Corporate rating is designed to help company leaders take decisions. It is designed to evaluate the corporate capacity to meet financial commitments. It particularly indicates to what extent the company’s financial obligations are affected by the economic, financial and political perspectives of the country of origin or the host country.

Methodology of the rating agencies

ratingThe methodology of rating agencies has been the subject of numerous studies, especially when it comes to sovereign rating.

In fact, methodology differs from one agency to another, often with significant gaps. Nevertheless, all agencies tend to analyze the financial situation of the issuer, whether it is solvent or not.

The sovereign rating appraisal is essentially based on five major criteria:

  • public debt in relation to budgetary revenues (public debt/GDP),
  • GDP per capita,
  • the country’s payment defaults record,
  • the country’s economic and political governance,
  • the inflation rate reported.

Corporate rating analysis pertains to the following points:

  • the analysis of the macro-economic and regulatory environment in which the company evolves,
  • the analysis of the commercial risk which takes into account the company’s competitive environment along with its position on its market,
  • the analysis of the financial risk which is wrapped around five major axes: financial policy, profitability, financial structure, auto-financing and financial flexibility,
  • the fundamental analysis of the issuer which is based, among other factors, on the study of its shareholder’s equity level, its reserves and on the evaluation of the quality of its assets.

Remuneration of the rating agencies

Rating agencies receive no retribution for the ratings attributed to the states. The study of the sovereign rating stands as advertisement for the agencies.

However, companies, banks, insurance companies and other institutions pay to get rated. For debt-issuing companies, remuneration is calculated according to the volume of the debt issued. The rating of public sector companies (local authorities, town halls, departments, …) accounts, in average, for only 15% of the agencies’ income. The most of their turnover comes from private companies.

According to S&P’s 2009 scale, an American company disburses at least 70 000 USD to get rated, in addition to a surveillance subscription which is worth more than half of the initial sum.

Rating is a lucrative business model as is shown by the enormous profitability rate of these companies. The “big three”: Standard & Poor’s, Moody’s and Fitch are reporting substantial profits accounting for approximately 50% of their turnover.

Rating agencies: Growing influence on global finance

worldOriginally, the three big rating agencies were simple financial data offices with no influence. Later they managed to acquire the status of a provider of sophisticated and complex data. Then came the ratings which range from AAA (the most solid) to D (payment default).

The role of rating agencies was definitively confirmed in the 1970s with the growing number of legislations recommending or requiring from companies a rating attributed by an acknowledged agency. It was national and international regulators who have indeed gave rating agencies the status of oracle.

The legislation of some countries, for instance, requires that institutional investors purchase only stocks that are well-rated by one of the three agencies.

In other words, good results exhibited by a stock no longer suffice for its value to be appreciated. Its solvency has to be also well-evaluated by an agency.

It is also worth noting that since 2004, the Basel II protocol regarding prudential rules pertaining to shareholders’ equity has granted the agencies the status of a very powerful evaluator. According to these standards, the European banks and the European Central Bank are required to rely on the analysis of both American rating agencies: Moody’s and S&P for the evaluation of the credit risk.

Moreover, these agencies have acquired the power to decide the fate of countries in difficulty such as Greece, Italy or even Ireland.

Rating agencies: A controversial business model

Although ratin g remains a useful and essential notion in the decision making for both the issuer and the investor, rating agencies have come under criticism because of:

  • their dependence, bias and lack of objectivity. They are representative of the "issuer-payer" principle: the issuer of financial assets pays the rating agency to get rated
  • the opacity of their rating methods
  • the lack of anticipation and credibility. For 15 years, they have failed to predict any crises: the bankruptcy of South American States in the 1980s, the sub-prime crisis in 2008, the bad state of the Greek public finance in 2010
  • being more conciliatory toward Anglo-Saxon countries than toward other European countries
  • being pro-cyclical, sowing panic, often exacerbating economic crises and triggering serious recessions
  • the inappropriate interference in the domestic economic policy of some countries, markets or companies
  • the considerable decisional power they have over the fate of countries in difficulty
  • judgment errors made before and during recent economic crises and the lack of accuracy of their ratings

The oligopolistic character of the rating sector has also given rise to some criticism with three agencies monopolizing almost the entire market.

Rating agencies failures

  • The 1997-1998 Asian crisis. Blinded by the Asian miracle, the three agencies failed to spot some defaulting countries which were faced with serious liquidity and solvency issues such as Thailand, Malaysia, South Korea and Indonesia.
  • Enron’s bankruptcy in December 2001. Enron, the world’s number one in energy brokerage and seventh American company went bankrupt as a result to some fraudulent operations while enjoying a triple A rating until its disappearance.
  • Ireland and Spain obtained a triple A rating in 2006. Both countries have maintained their rating until 2009 despite their worrying indebtedness rate.
  • Moody’s discovered in early 2007 a computer error in its model of evaluation of some financial products which were consequently overrated.
  • The 2008 sub-prime crisis. Standard & Poor’s, Moody’s and Fitch failed to foresee the disaster, granting best ratings for products which turned out to be ultra toxic. These three agencies later admitted their mistake and Washington blamed them for the great recession. The rating of structured products then accounted for 50% of the agencies’ revenues.
  • Iceland was granted an Aaa rating by Moody’s in May 2008. A few months later the country collapsed following the implosion of its banking system.
  • On the eve of its bankruptcy, on September 15, 2008, the multi-national bank Lehman Brothers was rated triple A The inquiry of the American Congress in June 2010 proved Standard & Poor’s biased.
  • The United States lost their triple A rating in August 2011. The American administration accused S&P of underestimating the 2 000 billion USD budget deficit reduction, that is, 15% of the American GDP. Following this judgment error that the agency attributed to divergence of interpretation, S&P boss along with his executive in charge of the American rating were forced to resign, and an inquiry by the justice department ensued.

    Following this failure and the downgrade of the American sovereign rating, the major American banks along with five insurance companies (Knight of Columbus, New York Life, Northern Mutual, the California Teachers Association and Automobile Association Insurance Services) have lost their ‘triple A’ rating. The outlooks for the rating of Berkshire Hathaway and for those of its subsidiaries went from “stable” down to "negative".

    Other collateral damage, the American and European stock market index which displayed negative results and considerable losses for several sessions.

  • In November 2011, S&P has sown panic throughout the markets for two hours when the agency mistakenly announced that France had lost its triple A rating. As a consequence to this clumsiness:
    • an increase at 3.49% of French interest rate while 10 billion EUR (13.2 billion USD) in debts are being exchanged every day on the markets
    • the euro losing ground to the dollar
    • the financial markets from Paris to New York and from Frankfurt to London were affected

Measures to reduce the influence of rating agencies

In spite of their accumulated errors, failures and clumsiness, the agencies have not yet lost their status of the almighty evaluator.

S&P has recently put fifteen European countries under negative watch. This decision, which sent euro zone markets into chaos, has revived the debate over the role and the exorbitant powers of rating agencies.

A bill designed to reform these institutions is already being examined. Introduced by the European Securities and Markets Authority (ESMA), this bill is calling for:

  • the suspension of rating of a country under financial assistance,
  • the penalization of agencies in the event of errors,
  • the license requirement for agencies operating on the European continent,
  • prior notification of states about any change affecting their ratings twenty-four hours and no longer twelve hours before publication,
  • changing agency every three years to promote competition,
  • prior approval By ESMA of any change in the agencies’ methodologies.

Other measures have been proposed such as:

  • recourse to internal analysts for the evaluation of country and corporate risks,
  • the establishment of an independent European public rating agency, free from any conflict of interest, especially with the banking sector,
  • different regulation works around Basel III also designed to reduce the power of rating agencies.

The club of triple A-rated countries

The countries with a triple A-rating form a very restricted club. Today, 13 countries are part of this circle. Following the downgrade of its rating by S&P in August 2011, the United States has lost the privilege which they enjoyed since 1975.

At November 31, 2011, the 13 countries with AAA ratings are:

& Poor’s
Moody’sFitchDebt to GDP ratio in %Ten-year borrowing rate in %
United Kingdom
Source: Rating agencies, IMF

The various long-term debt ratings, granted by the three main rating agencies

& Poor’s
AaaAAAAAAIt is the highest rating granted for an insurer who has an extremely strong financial security characteristics.
AaAAAAIt is slightly lower than the highest rating. The insurer has very strong financial security characteristics.
AAAThe insurer has strong financial security characteristics with an economic , financial and institutional strength.
BaaBBBBBBThe insurer has good financial security characteristics.
BaBBBBThe insurer has marginal financial security characteristics. From this rating and lower, inability to meet financial commitments is more important on the long term. Yet, not obvious.
BBBThe insurer has weak financial security characteristics. The probability to meet financial commitments is uncertain.
CaaCCCCCCThe insurer has very weak financial security characteristics. He is not able to meet financial commitments on the long term.
CaCCCCThe insurer has extremely weak financial security characteristics and is near to bankruptcy.
C-DState of default or bankruptcy.
Source: Abcbourse
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