Who is behind rating agencies

The first guy who was thinking about rating firms was Henry Varnum Poor. He evaluated American Railroad companies in a Newspaper in The Audience were British investors. Poor thought it would be a good idea to evaluate the chance of defaults, since the investors didn't know anything about the Railroad companies performances and how save their investment were.

Today Rating Agencies rate not only firms, they almost rate everything from states over stocks to almost every investment product. This brings up the question what are ratings and who needs this ratings? First, let us look at the definition of Moody's. It is an assessment of the ability and willingness of an issuer of fixed-income securities to make full and timely payment of amounts due on the security over its life.

This is just one definition of one rating agency; the others have one, too. And they are all different, but they also have something in common. It illustrates the divergence among the CRAs. What they all agree on, is that a rating is just an opinion about the creditworthiness and they try to tell in the rating something about the default risk, but each CRA has its own focus.

Each CRA has an own developed grading scale which they use to rate, it's like a school grade. You can see the different grades below in the graphic. Everything what is BBB- or higher is called investment grade. Everything what is below BBB- is called non-investment grade or junk grade. Later we will see why it is so important that firms have a least an investment grade. Each firm developed and uses its own matrices to position securities and index values, comparing them would after Langohr be like comparing apples and pears.

The difference between the long term and short term rating is that the long term has an outlook from three up to five years and they take a closer look at the overall performance. On the other hand short term ratings look closer at the upcoming business period and the focus is on the liquidity of the issuer 5. Short term defaults are very rare. This displays the point of rating agencies, they benchmark default likelihoods, but that brings up difficulties, because it means CRAs are aiming on moving targets.

We have to note that Credit Rating Agencies only benchmark the possibility of a default of a firm and not the chance that it will get bankrupt. What we also have to consider when we look at Credit Rating Agencies, we need to know that they act in an oligopoly. Supporters say that they can be way more efficient in an oligopoly and that it's better to have only a few ratings, otherwise it would be too confusing if there would be ratings on each firm. Critics say that the oligopoly is caused by the high entry barriers.

Another fact we have to know about Rating Agencies is that they get paid by the Bond Issuer, Issuing firm corporate rating or state sovereign rating which wants a rating.

This means also that the rating agencies work close together with firms in order to evaluate the default risk. The agencies usually rely on the given information by the corporation, of course this brings up some conflicts of interest which we will discuss later this is what also happened during the Enron scandal 8.

In the Rating Agencies changed their payment system, before the Investors had to buy information about a certain firm, nowadays the issuers of bonds are responsible for the payment, because they have a big interest in an evaluation of their bonds, which is access to money.

Even if rating agencies have in the public a bad reputation, they are still very important for the market. Rating Agencies help to resolve the information Asymmetry. They satisfy needs of different market actors, they provide investors acess to information, so they don't need to spend a lot of time in evaluating the risk and the Agencies provide better information, because they have access to insider information.

Insiders always outsmart outsiders. Without rating agencies the Investors would only have only access to public information. So for them it is an advantage. Credit ratings, debt ratings, or bond ratings are issued to individual companies and to specific classes of individual securities such as preferred stock , corporate bonds, and various classes of government bonds.

Ratings can be assigned separately to both short-term and long-term obligations. Long-term ratings analyze and assess a company's ability to meet its responsibilities with respect to all of its securities issued. Short-term ratings focus on the specific securities' ability to perform given the company's current financial condition and general industry performance conditions. They intend to give the market information that is both reliable and accurate about the risks associated with certain kinds of debt.

Fitch is one of the world's top three credit rating agencies. It operates in New York and London, basing ratings on company debt and its sensitivity to changes like interest rates.

When it comes to sovereign debt, countries request Fitch—and other agencies—to provide an evaluation of their financial situation along with the political and economic climates.

These letter grades indicate no to low potential for default on debt. Non-investment grade ratings go from BB to D, the latter meaning the debtor has defaulted. Moody's assigns countries and company debt letter grades, but in a slightly different way. Investment grade debt goes from Aaa—the highest grade that can be assigned—to Baa3, which indicates that the debtor is able to pay back short-term debt.

Below investment grade is speculative grade debt, which are often referred to as high-yield or junk. These grades range from Ba1 to C, with the likelihood of repayment dropping as the letter grade goes down. John Moody and Company first published " Moody's Manual" in The manual published basic statistics and general information about stocks and bonds of various industries. From until the stock market crash of , "Moody's Manual" was a national publication. In , Moody began publishing "Moody's Analyses of Railroad Investments," which added analytical information about the value of securities.

Expanding this idea led to the creation of Moody's Investors Service, which, in the following 10 years, would provide ratings for nearly all of the government bond markets at the time.

By the s Moody's began rating commercial paper and bank deposits , becoming the full-scale rating agency it is today. The lower the rating, the more potential it has to default, with a D-rating being the worst. Henry Varnum Poor first published the "History of Railroads and Canals in the United States" in , the forerunner of securities analysis and reporting that would be developed over the next century.

Standard Statistics formed in , which published corporate bond, sovereign debt, and municipal bond ratings. The credit ratings industry began to adopt some important changes and innovations in Investors subscribed to publications from each of the ratings agencies and issuers paid no fees for performance of research and analyses that were a normal part of the development of published credit ratings. As an industry, credit ratings agencies began to recognize that objective credit ratings significantly helped issuers: They facilitated access to capital by increasing a securities issuer's value in the marketplace and decreasing the costs of obtaining capital.

Expansion and complexity in the capital markets coupled with an increasing demand for statistical and analytical services led to the industry-wide decision to charge issuers of securities fees for ratings services. In , financial institutions such as commercial banks and securities broker-dealers sought to soften the capital and liquidity requirements passed down by the Securities and Exchange Commission SEC.

Financial institutions could satisfy their capital requirements by investing in securities that received favorable ratings by one or more of the NRSROs.

This allowance is the result of registration requirements coupled with greater regulation and oversight of the credit ratings industry by the SEC. The increased demand for ratings services by investors and securities issuers, combined with increased regulatory oversight, has led to growth and expansion in the credit ratings industry. Since large CRAs operate on an international scale, regulation occurs at several different levels.

The European Union EU has never produced a specific or systematic legislation or created a singular agency responsible for the regulation of CRAs. There are several EU directives, such as the Capital Requirements Directive of , that affect rating agencies, their business practices and their disclosure requirements. Credit rating agencies came under heavy scrutiny and regulatory pressure following the financial crisis and Great Recession of to It was believed that CRAs provided ratings that were too positive, leading to bad investments.

Part of the problem was that despite the risk, the agencies continued to give mortgage-backed securities MBSs AAA-ratings. These ratings led many investors to believe that these investments were very safe with little to no risk.

The investment grade bonds are those with a BBB or above, and speculative or junk bonds are those with a BB or below. However, it has a fairly high percentage of every category, with Founded in by John Moody, this agency was created in the wake of the stock market crash.

Having lost his business in the crash, Moody decided to begin offering investors an analysis of security values.

This difference in primary motivation is one of the reasons why the same securities may have differing ratings among the agencies. The majority of its ratings are for government securities, occupying It also handles Bond ratings are assigned to both the organizations that issue bonds and the bond issues themselves. Ratings can also provide an incentive to organizations to stay current with their debts and not take on more debt than they can comfortably afford. On the investor side, bond ratings provide important information about the riskiness of various investments.

Whether you are only comfortable purchasing investment-grade bonds or you are willing to take a calculated risk by purchasing junk bonds, having the ratings assigned by the agencies provides another important metric you can use to decide which investments are right for you. Though having access to these bond ratings can be very helpful to investors, they are not without flaws. To start, bond rating agencies are privately owned companies, and bond issuers pay the agencies to rate them.

This presents a potential conflict of interest, and investors should always keep this fact in mind when using information from rating agencies. Many experts advise investors to use ratings as just one piece of information for deciding where to invest, rather than the only piece of information.

Additionally, since the methodology for rating securities and their issuers is proprietary, it is not always clear why and how the agencies assign their ratings.

The evaluation methodology used by rating agencies may also fail to foresee coming problems, as happened in Each of the three major rating agencies gave high ratings to the kinds of mortgage-backed securities that proved to be far riskier than their ratings indicated. Investors who trusted in these ratings were often then overexposed to securities that contributed to the housing bubble correction that year. Emily Guy Birken is a former educator, lifelong money nerd, and a Plutus Award-winning freelance writer who specializes in the scientific research behind irrational money behaviors.

Her background in education allows her to make complex financial topics relatable and easily understood by the layperson. With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree.