Introduction

A Credit Rating estimates the credit worthiness of an individual, corporation, or even a country.
It is an evaluation made by credit bureaus of a borrowers overall credit history. A credit rating is
also known as an evaluation of a potential borrower's ability to repay debt, prepared by a credit
bureau at the request of the lender Black's Law Dictionary. Credit ratings are calculated from
financial history and current assets and liabilities. Typically, a credit rating tells a lender or
investor the probability of the subject being able to pay back a loan. However, in recent years,
credit ratings have also been used to adjust insurance premiums, determine employment
eligibility, and establish the amount of a utility or leasing deposit.
A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest
rates, or the refusal of a loan by the creditor.

A Credit Rating Agency (CRA) is a company that assigns credit ratings for issuers of certain
types of debt obligations as well as the debt instruments themselves. In some cases, the servicers
of the underlying debt are also given ratings. In most cases, the issuers of securities are
companies, special purpose entities, state and local governments, non-profit organizations, or
national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary
market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e.,
its ability to pay back a loan), and affects the interest rate applied to the particular security being
issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness
is generally called a credit bureau or consumer credit reporting agency.)

Page | 1

Functions of Credit Rating Agencies

The primary function of the credit rating agencies is to provide credit ratings to the service
providers of various forms of debt products and services. They are also meant to provide ratings
to the debt instruments being provided by these service providers. The clients of the credit rating
agencies are those entities that deal in the provision of debt products and services. At times, it
has been observed that the companies that provide debt products and services are rating the debt
instruments by themselves.
The providers of securities like the companies, the governmental organizations at the state and
central level and special purpose entities are the major clients of the credit rating agencies. The
non-profit seeking organizations and the national governments also avail the services of the
credit rating agencies.

Page | 2

Credit rating Agencies in USA

Moodys Corp.
Moodys Corporation, through its subsidiaries, provides credit ratings and related research, data,
and analytical tools; quantitative credit risk measures, risk scoring software, and credit portfolio
management solutions; and securities pricing software and valuation models principally in the
United States and Europe. The company operates through two segments, MIS and MA. The MIS
segment publishes credit ratings on a range of debt obligations, including various corporate and
governmental obligations, structured finance securities, and commercial paper programs, as well
as the entities that issue such obligations in markets worldwide. This segment provides ratings in
approximately 110 countries. Its ratings are disseminated via press releases to the public through
a range of print and electronic media, including the Internet and real-time information systems,
which is used by securities traders and investors. As of December 31, 2008, MIS had ratings
relationships with approximately 13,000 corporate issuers and approximately 26,000 public
finance issuers. Additionally, the company rated and monitored ratings on approximately
109,000 structured finance obligations. The MA segment develops a range of products and
services that support the credit risk management activities of institutional participants in financial
markets. These offerings include quantitative credit risk scores, credit processing software,
economic research, analytical models, financial data, securities pricing software, and valuation
models, and specialized consulting services. It also distributes investor-oriented research and
data, including in-depth research on debt issuers, industry studies, and commentary on topical
events developed by MIS as part of its rating process. The company was founded in 1900 and is
headquartered in New York, New York.

Standard & Poors

Standard & Poor's (S&P) is one of the world's preeminent providers of credit ratings, indices,
risk evaluation, investment research and data. It also provides a wide range of other products and
Page | 3

services designed to help individuals and institutions make better-informed financial decisions.
Range of services provided by Standard & Poor's include advice on asset allocation, portfolio
strategies,

fund

recommendations

and

research.

Standard and Poors was formed in 1941 with the merger of Standard Statistics and Poor's
Publishing Company. Standard and Poor's has an unrivalled depth and breadth in coverage and
analysis. Standard & Poor's has the world's largest network of credit ratings analysts. Over $1
trillion in investors' assets is directly tied to S&P indexes - more than all other index providers
combined. Standard & Poor's indices include the premier U.S. portfolio index, the S&P 500.
Standard & Poor's has a long history of creating standards for the financial industry. S&P has
several firsts to its credit. Standard & Poor's was the first to rate Securitized financings, Bond
insured transactions, Letters of credit, The financial strength of non-U.S. insurance companies,
Bank

holding

companies,

Financial

guaranty

companies.

Standard & Poor's issues credit ratings for the debt of corporations, be they public or private. It
has been designated a Nationally Recognized Statistical Rating Organization by the U.S.
Securities and Exchange Commission. S&P issues both short-term and long-term credit ratings.

Fitch and Co.

Fitch Ratings, one of the top three credit rating agencies in the world (alongside Moody's and
Standard & Poor's), issues ratings for thousands of banks, financial institutions, insurance
companies, corporations, and governments. With dual headquarters in New York and London
and about 50 offices worldwide, Fitch Ratings engages in the politically charged business of
rating the debt of nations; it covers companies and governments in more than 90 nations. The
company is part of the Fitch Group, which is a majority-owned subsidiary of France-based
Fimalac.

Page | 4

Ratings Tables

Moodys
Long-term obligation ratings
Moody's long-term obligation ratings are opinions of the relative credit risk of fixed-income obligations
with an original maturity of one year or more. They address the possibility that a financial obligation will
not be honored as promised. Such ratings reflect both the likelihood of default and the probability of a
financial loss suffered in the event of default.
Investment grade
Aaa

highest quality, smallest degree of risk

Aa1, Aa2, Aa3

high quality, subject to very low credit risk, "their susceptibility

to long-term risks appears somewhat greater"

A1, A2, A3

low credit risk, susceptible to impairment over the long term"

Baa1, Baa2, Baa3

moderate credit risk, medium-grade, characteristically unreliable

Speculative grade (Also known as High Yield or 'Junk')

Ba1, Ba2, Ba3

questionable credit quality

B1, B2, B3

speculative, high credit risk, generally poor credit quality

Caa1, Caa2, Caa3

poor standing, very high credit risk, extremely poor credit

quality, may be in default

Ca

highly speculative, usually in default on their deposit obligations

lowest rated class of bonds, typically in default, potential

recovery values are low

Page | 5

Special
WR

Withdrawn Rating

NR

Not Rated

Provisional

Short-term taxable ratings

Moody's short-term ratings for taxable securities are opinions of the ability of issuers to honor short-term
financial obligations. Ratings may be assigned to issuers, short-term programs or to individual short-term
debt instruments. Such obligations generally have an original maturity not exceeding thirteen months,
unless explicitly noted.
Moody's employs the following designations to indicate the relative repayment ability of rated issuers:
P-1

Issuers (or supporting institutions) rated Prime-1 have a superior ability to repay short-term debt
for the obligations.

P-2

Issuers (or supporting institutions) rated Prime-2 have a strong ability to repay short-term debt
obligations.

P-3

Issuers (or supporting institutions) rated Prime-3 have an acceptable ability to repay short-term
obligations.

NP

Issuers (or supporting institutions) rated Not Prime do not fall within any of the Prime rating
categories.

Note: Canadian issuers rated P-1 or P-2 have their short-term ratings enhanced by the senior-most
long-term rating of the issuer, its guarantor or support-provider.

Short-term tax-exempt ratings

Unlike S&P, Moody's has separate categories for short term municipal bonds. The ratings categories
largely overlap, though, and have the same implications for the ability to repay short-term obligations.

Page | 6

Individual bank ratings

Moody's also rates each bank's financial strength. These ratings differ from deposit ratings in that they
measure how likely the bank is to need assistance from third parties.
A

"superior intrinsic financial strength"

"strong intrinsic financial strength"

"adequate intrinsic financial strength"

"modest intrinsic financial strength, potentially requiring some outside support at times"

very modest intrinsic financial strength, with a higher likelihood of periodic outside support"

S&P
Credit ratings
Standard & Poor's, as a credit rating agency (CRA), issues credit ratings for the debt of public and private
corporations. It is one of several CRAs that have been designated a Nationally Recognized Statistical
Rating Organization by the U.S. Securities and Exchange Commission.
It issues both short-term and long-term credit ratings.
Long-term credit ratings
S&P rates borrowers on a scale from AAA to D. Intermediate ratings are offered at each level between
AA and CCC (i.e., BBB+, BBB and BBB-). For some borrowers, S&P may also offer guidance (termed a
"credit watch") as to whether it is likely to be upgraded (positive), downgraded (negative) or uncertain
(neutral).

Page | 7

Investment Grade

AAA : the best quality borrowers, reliable and stable (many of them governments)

AA : quality borrowers, a bit higher risk than AAA

A : economic situation can affect finance

BBB : medium class borrowers, which are satisfactory at the moment

Non-Investment Grade (also known as junk bonds)

BB : more prone to changes in the economy

B : financial situation varies noticeably

CCC : currently vulnerable and dependent on favorable economic conditions to meet its
commitments

CC : highly vulnerable, very speculative bonds

C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on
obligations

CI : past due on interest

R : under regulatory supervision due to its financial situation

SD : has selectively defaulted on some obligations

D : has defaulted on obligations and S&P believes that it will generally default on most or all
obligations

NR : not rated

Short-term issue credit ratings

S&P rates specific issues on a scale from A-1 to D. Within the A-1 category it can be designated with a
plus sign (+). This indicates that the issuer's commitment to meet its obligation is very strong. Country
risk and currency of repayment of the obligor to meet the issue obligation are factored into the credit
analysis and reflected in the issue rating.

Page | 8

A-1 : obligor's capacity to meet its financial commitment on the obligation is strong

A-2 : is susceptible to adverse economic conditions however the obligor's capacity to meet its
financial commitment on the obligation is satisfactory

A-3 : adverse economic conditions are likely to weaken the obligor's capacity to meet its
financial commitment on the obligation

B : has significant speculative characteristics. The obligor currently has the capacity to meet its
financial obligation but faces major ongoing uncertainties that could impact its financial
commitment on the obligation

C : currently vulnerable to nonpayment and is dependent upon favorable business, financial and
economic conditions for the obligor to meet its financial commitment on the obligation

D : is in payment default. Obligation not made on due date and grace period may not have
expired. The rating is also used upon the filing of a bankruptcy petition.

Stock market indices

Standard & Poor's publishes a large number of stock market indices, covering every region of the world,
market capitalization level, and type of investment (e.g. indices for REITs and preferred stocks)
These indices include:

S&P 500 -- value weighted index of the prices of 500 large-cap common stocks actively traded in
the United States.

S&P 400 MidCap Index

S&P 600 SmallCap Index

Fitch Co.
Long-term credit ratings
Fitch Rating' long-term credit ratings are set up along a scale from 'AAA' to 'D', first introduced in 1924
and later adopted and licensed by S&P. Moody's also uses a similar scale, but names the categories
Page | 9

differently. Like S&P, Fitch also uses intermediate modifiers for each category between AA and CCC
(i.e., AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB- etc.).
Investment grade

AAA : the best quality companies, reliable and stable

AA : quality companies, a bit higher risk than AAA

A : economic situation can affect finance

BBB : medium class companies, which are satisfactory at the moment

Non-investment grade (also known as junk bonds)

BB : more prone to changes in the economy

B : financial situation varies noticeably

CCC : currently vulnerable and dependent on favorable economic conditions to meet its
commitments

CC : highly vulnerable, very speculative bonds

C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on
obligations

D : has defaulted on obligations and Fitch believes that it will generally default on most or all
obligations

NR : not publicly rated

Short-term credit ratings

Fitch's short-term ratings indicate the potential level of default within a 12-month period.

F1+ : best quality grade, indicating exceptionally strong capacity of obligor to meet its financial
commitment

F1 : best quality grade, indicating strong capacity of obligor to meet its financial commitment
Page | 10

F2 : good quality grade with satisfactory capacity of obligor to meet its financial commitment

F3 : fair quality grade with adequate capacity of obligor to meet its financial commitment but
near term adverse conditions could impact the obligor's commitments

B : of speculative nature and obligor has minimal capacity to meet its commitment and
vulnerability to short term adverse changes in financial and economic conditions

C : possibility of default is high and the financial commitment of the obligor are dependent upon
sustained, favourable business and economic conditions

D : the obligor is in default as it has failed on its financial commitments.

What was the US Subprime crisis all

about?
How and when did the sub-prime mortgage crisis begin?
Charity begins at home, it is said. Here, crisis began at home, or more exactly, home loans.
Housing prices began spiralling upwards in the US in the early years of this decade and
continued through mid-2006, with the borrowing and lending rates extremely low which helped
boost the demand for and supply of new and existing houses.
Many institutions offered home loans to borrowers with poor or no credit histories by requiring
higher than normal repayment levels creating what is now referred to as sub-prime
mortgages attracting investment banks and hedge fund owners to bet big on this emerging
aspect of the US economy.
When did the slide begin?

Page | 11

A retrospect does help when the market is in a crisis. The countdown began on June 30, 2004,
when the Federal Reserve (the central bank in the US) began a cycle of interest rate hikes that
raised the cost of borrowing from the lowest levels registered since the 1950s.
It increased the interest rates seventeen times and paused only in June 2006 when the borrowing
cost touched 5.25 per cent.
The US housing market began sliding in August 2005 and that continued through 2006. Building
rates and housing prices tumbled.
Did this cause business failure?
Yes. Several sub-prime mortgage holders defaulted on their loans and the first sign of a crisis
emerged in March 2007 when shares in New Century Financial, one of the largest sub-prime
lenders in the US, were suspended amid fears that the firm could be heading for bankruptcy.
Another US-based sub-prime firm Accredited Home Lenders Holding said it would pass on $2.7
billions of its loans at a heavy discount. On April 2, 2007, New Century Financial filed for
bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of
bad loans.
What do you think was the spillover effect of the slide?
The sub-prime mortgage crisis went on to affect major global investment banks as well. Shares
in Bear Stearns came under pressure in May 2007 because of the banks exposure to the US subprime market. In June, Merrill Lynch seized and sold $800 millions of bonds used as collateral
for loans made to Bear Stearns hedge funds that were used to bet on the sub-prime mortgage
market.
In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business it
bought in 2004. Goldman Sachs also announced financial support for one of its struggling hedge
funds hit by the defaulting sub-prime mortgages.
Can you give us a timeline of the recent events?
Page | 12

Given the dominance of US financial markets in other developed and developing economies, the
sub-prime mortgage market crisis affected markets and institutions all over the globe.

Who is to Blame?
Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the
instance of subprime mortgage woes, there is no single entity or individual to point the finger at.
Instead, this mess is a collective creation of the world's central banks, homeowners, lenders,
credit rating agencies and underwriters, and investors. Let's investigate.
The Book
The economy was at risk of a deep recession after the dotcom bubble burst in early 2000; this
situation was compounded by the September 11 terrorist attacks that followed in 2001. In
response, central banks around the world tried to stimulate the economy. They created
capitalliquidity through a reduction in interest rates. In turn, investors sought higher returns
through riskier investments. Lenders took on greater risks too, and approved subprime mortgage
loans to borrowers with poor credit. Consumer demand drove the housing bubble to all-time
Page | 13

highs in the summer of 2005, which ultimately collapsed in August of 2006. (For an in-depth
discussion

of

these

events,

see The

Fuel

That

Fed

The

Subprime

Meltdown.)

The end result of these key events was increased foreclosure activity, large lenders and hedge
funds declaring bankruptcy, and fears regarding further decreases in economic growth and
consumer spending. So who's to blame? Let's take a look at the key players.
Biggest Culprit : The Lenders
Most of the blame should be pointed at the mortgage originators (lenders) for creating these
problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk
of default. (To learn more about subprime lending, see Subprime Is Often Subpar.)
When the central banks flooded the markets with capital liquidity, it not only lowered interest
rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster
their investment returns. At the same time, lenders found themselves with ample capital to lend
and, like investors, an increased willingness to undertake additional risk to increase their
investment

returns.

In defense of the lenders, there was an increased demand for mortgages, and housing prices were
increasing because interest rates had dropped substantially. At the time, lenders probably saw
subprime mortgages as less of a risk than they really were: rates were low, the economy was
healthy

and

people

were

making

their

payments.

As you can see in Figure 1, subprime mortgage originations grew from $173 billion in 2001 to a
record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a
clear relationship between the liquidity following September 11, 2001, and subprime loan
originations; lenders were clearly willing and able to provide borrowers with the necessary funds
to

purchase

home.

Page | 14

Figure 1

Partners in Crime : Home Buyers

While we're on the topic of lenders, we should also mention the home buyers. Many were
playing an extremely risky game by buying houses they could barely afford. They were able to
make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages)
that offered low introductory rates and minimal initial costs such as "no down payment". Their
hope lay in price appreciation, which would have allowed them to refinanceat lower rates and
take the equity out of the home for use in other spending. However, instead of continued
appreciation, the housing bubble burst, and prices dropped rapidly. (To learn more, read Why
Housing

Market

Bubbles

Pop.)

As a result, when their mortgages reset, many homeowners were unable to refinance their
mortgages to lower rates, as there was no equity being created as housing prices fell. They were,
therefore, forced to reset their mortgage at higher rates, which many could not afford. Many
homeowners were simply forced to default on their mortgages. Foreclosures continued to
increase

through

2006

and

2007.

In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may
Page | 15

have given the impression that there was no risk to these mortgages and that the costs weren't
that high; however, at the end of the day, many borrowers simply assumed mortgages they
couldn't reasonably afford. Had they not made such an aggressive purchase and assumed a less
risky mortgage, the overall effects might have been manageable. (To learn about moral debate
surrounding all things subprime, read Subprime Lending: Helping Hand Or Underhanded?)
Exacerbating the situation, lenders and investors of securities backed by these defaulting
mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left
with property that was worth less than the amount originally loaned. In many cases, the losses
were

large

enough

to

result

in

bankruptcy.

Investment Bankers Worsen The Situation

The increased use of the secondary mortgage market by lenders added to the number of subprime
loans lenders could originate. Instead of holding the originated mortgages on their books, lenders
were able to simply sell off the mortgages in the secondary market and collect the originating
fees. This freed up more capital for even more lending, which increased liquidity even more. The
snowball began to build momentum. (For a crash course on the secondary mortgage market,
check

out Behind

The

Scenes

Of

Your

Mortgage.)

A lot of the demand for these mortgages came from the creation of assets that pooled mortgages
together into a security, such as a collateralized debt obligation (CDO). In this process,
investment banks would buy the mortgages from lenders and securitize these mortgages into
bonds,

which

were

sold

to

investors

through

CDOs.

The chart below demonstrates the incredible increase in global CDOs issues in 2006.

Page | 16

Rating Agencies : Possible Conflict of Interest

A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and
other mortgage-backed securities that included subprime loans in their mortgage pools. Some
argue that the rating agencies should have foreseen the high default rates for subprime
borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating
given to the higher quality tranches. If the ratings had been more accurate, fewer investors would
have bought into these securities, and the losses may not have been as bad. (To learn more on the
ratings

system,

see What

Is

Corporate

Credit

Rating?)

Moreover, some have pointed to the conflict of interest between rating agencies, which receive
fees from a security's creator, and their ability to give an unbiased assessment of risk. The
argument is that rating agencies were enticed to give better ratings in order to continue receiving
service fees, or they run the risk of the underwriter going to a different rating agency (or the
security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not
rated.
Regardless of the criticism surrounding the relationship between underwriters and rating
agencies, the fact of the matter is that they were simply bringing bonds to market based on
market

demand.

Final Culprit: Hedge Funds

Page | 17

Another party that added to the mess was the hedge fund industry. It aggravated the problem not
only by pushing rates lower, but also by fueling the market volatility that caused investor losses.
The failures of a few investment managers also contributed to the problem. (To learn more.
check

out Taking

Look

Behind

Hedge

Funds.)

To illustrate, there is a type of hedge fund strategy that can be best described as "creditarbitrage".
It involves purchasing subprime bonds on credit and hedging these positions withcredit default
swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more
CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower
and further fueling the problem. Moreover, because leverage was involved, this set the stage for
a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser
quality

of

subprime

CDOs.

Because hedge funds use a significant amount of leverage, losses were amplified and many
hedge funds shut down operations as they ran out of money in the face of margin calls. (For
more on this, see Massive Hedge Fund Failures and Losing The Amaranth Gamble.)
Plenty of Blame To Go Around
Overall, it was a mix of factors and participants that precipitated the current subprime mess.
Ultimately, though, human behavior and greed drove the demand, supply and the investor
appetite for these types of loans. Hindsight is always 20/20, and it is now obvious that there was
a lack of wisdom on the part of many. However, there are countless examples of markets lacking
wisdom, most recently the dotcom bubble and ensuing "irrational exuberance" on the part of
investors.
It seems to be a fact of life that investors will always extrapolate current conditions too far into
the

future

good,

bad

or

ugly.

Page | 18

Role of CRAs
Credit rating agencies played an important role at various stages in the subprime crisis. They
have been highly criticized for understating the risk involved with new, complex securities that
fueled the United States housing bubble, such as mortgage-backed securities (MBS) and
collateralized debt obligations (CDO).
Impact on the crisis
Credit rating agencies are now under scrutiny for giving investment-grade, "money safe" ratings
to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. These high
ratings encouraged a flow of global investor funds into these securities, funding the housing
bubble in the U.S.[1] An estimated $3.2 trillion in loans were made to homeowners with bad
credit and undocumented incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007.
Page | 19

These mortgages could be bundled into MBS and CDO securities that received high ratings and
therefore could be sold to global investors. Higher ratings were believed justified by various
credit enhancements including over-collateralization (i.e., pledging collateral in excess of debt
issued), credit default insurance, and equity investors willing to bear the first losses. Economist
Joseph Stiglitz stated: "I view the rating agencies as one of the key culprits...They were the party
that performed the alchemy that converted the securities from F-rated to A-rated. The banks
could not have done what they did without the complicity of the rating agencies." Without the
AAA ratings , demand for these securities would have been considerably less. Bank writedowns
and losses on these investments totaled $523 billion as of September 2008.[2][3]
Competitive pressure to lower rating standards
The ratings of these securities was a lucrative business for the rating agencies, accounting for just
under half of Moody's total ratings revenue in 2007. Through 2007, ratings companies enjoyed
record revenue, profits and share prices. The rating companies earned as much as three times
more for grading these complex products than corporate bonds, their traditional business. Rating
agencies also competed with each other to rate particular MBS and CDO securities issued by
investment banks, which critics argued contributed to lower rating standards. Interviews with
rating agency senior managers indicate the competitive pressure to rate the CDO's favorably was
strong within the firms. This rating business was their "golden goose" (which laid the proverbial
golden egg or wealth) in the words of one manager.[4]
Author Upton Sinclair (1878-1968) famously stated: "It is difficult to get a man to understand
something when his job depends on not understanding it." [5] This competitive pressure and the
resulting profits gave a personal financial incentive to management to lower standards.
Internal rating agency emails from before the time the credit markets deteriorated, discovered
and released publicly by U.S. congressional investigators, suggest that some rating agency
employees suspected at the time that lax standards for rating structured credit products would
produce negative results.[6] For example, one email between colleagues at Standard & Poor's
states "Rating agencies continue to create and [sic] even bigger monster--the CDO market. Let's
hope we are all wealthy and retired by the time this house of cards falters."[7]

Page | 20

Conflicts of interest
Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that
organize and sell the debt to investors, such as investment banks. [8] John C. Bogle wrote in 2005
that there is an inherent conflict of interest when a professional firm is also publicly-traded, as
the pressure to grow and increase profits is relatively stronger, which may detract from the
quality of work performed.[9] Moody's became a public firm in 2001, while Standard & Poor's is
part of the publicly-traded McGraw-Hill Companies.
SEC Investigation
On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules
designed to address perceived conflicts of interest between rating agencies and issuers of
structured securities. The proposal would, among other things, prohibit a credit rating agency
from issuing a rating on a structured product unless information on assets underlying the product
was available, prohibit credit rating agencies from structuring the same products that they rate,
and require the public disclosure of the information a credit rating agency uses to determine a
rating on a structured product, including information on the underlying assets. The last proposed
requirement is designed to facilitate "unsolicited" ratings of structured securities by rating
agencies not compensated by issuers.[10
Rating actions during the crisis
Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3
2007 to Q2 2008, another indicator that their initial ratings were not accurate. This places
additional pressure on financial institutions to lower the value of their MBS. In turn, this may
require these institutions to acquire additional capital, to maintain capital ratios. If this involves
the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings
downgrades pressure MBS and stock prices lower.[11]
As of July 2008, Standard & Poor's (S&P) had downgraded 902 tranches of U.S. residential
mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been
originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A;" 466 of those
Page | 21

downgrades of "triple-A" securities were to speculative grade ratings. S&P had downgraded a
total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of
31,935 tranches originally rated, over half of all RMBS and CDOs of ABS originally rated by
S&P.[12] Since certain types of institutional investors are allowed to only carry investment-grade
(e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause
further devaluation.[13]
Actions taken to improve rating approach
Credit rating agencies help evaluate and report on the risk involved with various investment
alternatives. The rating processes can be re-examined and improved to encourage greater
transparency to the risks involved with complex mortgage-backed securities and the entities that
provide them. Rating agencies have recently begun to aggressively downgrade large amounts of
mortgage-backed debt.[14] In addition, rating agencies have begun taking action to address
perceived or actual conflicts of interest, including additional internal monitoring programs, third
party reviews of rating processes, and board updates.

Case Studies

California probes credit rating agencies

California Attorney General Jerry Brown issued subpoenas on Thursday to Standard & Poor's,
Moody's Investors Service, and Fitch Ratings as he launched an investigation of whether they
broke state law with the ratings they provided mortgage-backed securities.

Page | 22

"These agencies gave their seal of approval, their highest ratings, to underlying securities that
were highly dangerous and in fact wreaked havoc on the lives of millions of people," Brown said
at a news conference.
The investigation focuses on whether the agencies broke consumer protection and unfair
business practice laws, in the most populous U.S. state, which give the state broad authority to
bring suit in cases of false advertising and unfair competition.
"The agencies have been coddled and protected," Brown said. "It's time we smoked 'em out."
Agencies claim first amendment freedom-of-speech protection for their ratings, but courts have
given mixed support. A federal court in early September allowed a lawsuit against agencies
claiming such protection to go forward.
Supervising Deputy Attorney General Kathrin Sears, who heads the probe, said the agencies had
hidden behind the First Amendment, in her view. The investigation was just beginning, and the
state needed to review the agencies responses, she added.
The agencies must respond to subpoena questions and requests for documents by Oct. 19, but
could seek an extension, she said.
S&P, owned by McGraw-Hill Companies Inc. (MHP.N), said it had not received a subpoena and
could not comment.
Fitch, owned by Fimalac SA (LBCP.PA), said it expected to provide information once it
received a request, and Moody's Corp (MCO.N) said it had received inquiries from state and
regulatory authorities about its ratings and would cooperate as appropriate after reviewing them.

SUBPRIME CRISIS PROBE

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At the peak of the housing boom, the agencies gave their highest ratings to complicated financial
instruments, including securities backed by subprime mortgages, making them appear as safe as
government-issued Treasury bonds, Brown's office said.
But California's economy slumped as house prices fell sharply in the past couple of years. Its
unemployment rate has hit record highs and government faced a major crisis as tax revenue
plummeted.
The purchases of the securities helped fuel the housing bubble by providing funds for lenders to
"issue ever-riskier subprime and other toxic mortgages," Brown's statement said.
"When the bubble burst, however, those risky mortgages defaulted in record numbers and
investors were left holding worthless securities, unable to sell them," the statement said.
"Subsequently, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage
backed securities, a tacit acknowledgment of their failure to adequately assess the risks of the
debt they rated."
Brown said it was unclear how long the probe would take and what remedies and remuneration it
would seek if California sued the agencies.
"This is real stuff here, and yet for the last year and a half, action has not been taken," he said.
Federal Securities and Exchange Commission Chair Mary Schapiro on Thursday in prepared
remarks said the agency was considering a series of proposals to bolster regulation of the
agencies, including ones to shed light on 'rating shopping' and conflicts of interest by the
companies, which are paid by the issuers they rate. [ID:nN17202110]
Brown's probe was applauded in California State Treasurer Bill Lockyer's office, which has been
a harsh critic of credit rating agencies and has been pressing them to grade corporate debt and
less risky municipal debt by the same standards.

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"The state of California along with other municipal issuers are all too familiar with wildly
inaccurate ratings from the agencies," Lockyer spokesman Tom Dresslar said. "The ratings do
not come close to reflecting the risk of default, which in our case is nil."
"It's clear that the rating agencies played a significant role in the downfall of the U.S. economy,"
Dresslar said.

SEC REPORT ON RATING AGENCIES ROLE IN

SUBPRIME CRISIS
The Securities & Exchange Commission (SEC) publishedits Summary Report of Issues
Identified in the Commission Staffs Examination of Select Credit Rating Agencies [NRSROs].
The SEC concluded (in a year-long study released on July 8th), that rating agencies improperly
managed conflicts of interest and violated internal procedures in granting topratings tostructured
securities. The SEC report lists eight major areas of deficiencies in processes, procedures and
conflict of interest, including:
Page | 25

The massive volume and complexity of deals overwhelmed NRSROs resources, leading
to errors and shortcuts in procedures and documentation.

Aspects of the rating process were not always disclosed. There was a lack of consistency
in documentation on rating processes, models and rating committee meetings.

As to the quality of information underlying the ratings, there was no obligation for
rating agencies to verify the information provided by arrangers.

Significant aspects of the rating process, including rationale for rating committee actions
and decisions, were not always documented.

No due diligence on information was provided to NRSROs.

The surveillance process used appears to have been less robust than it should have been.

There were issues in the management of conflicts, for instance, with analysts taking part
in pricing.

Internal audit process varied significantly between rating agencies and were ineffective in
part due to lack of documentation.

Implications: Tighter regulations are now inevitable, but rating agencies are pushing back stating
that some of the recommendations are too costly and beyond the current mandate of the SEC.
However it is important to note that the NRSROs are proceeding with the implementation of
many of the recommendations made by the SEC. There are many proponents for a tighter
regulatory regime, here in the USA and on the other side of the Atlantic at the European
Commission. But there are others who caution that the NRSROs are not the only participants in
the value chain of bringing financial securities to the market. There is along route from
origination to investors all of which have to be part of a credit system overhaul. In regard to
entrusting NRSROs to European regulators the Financial Times wrote recently:If the worlds
best-paid financiers did not spot subprime, is it fair to entrust this tasks to Europes supervisors?
BIIA suspected all along that there was a disconnect with regard to the use of consumer
information. The USA has the highest penetration of credit due to the availability of reliable
information, and based on this fact the subprime debacle should not have happened. It is now
evident that there was wholesale misrepresentation, misuse of information and outright fraud in
Page | 26

the origination process of subprime mortgages. FICO scores appeared to have been imprecise
because the absence of underlying credit performance of subprime candidates (no loan history).
Experts are now questioning the reliability of credit scores. Others counter by proposing a
greater use of nonfinancial data (forexampleutilitypaymentsetc.) to compensate for the absence
of previous credit performance data from the financial sector) to improve the performance of
subprime credit scores.

Subprime crisis claims S&P scalp

STANDARD & POOR'S has named Deven Sharma to replace Kathleen Corbet as president
after lawmakers and investors criticised the credit rating company for failing to judge the risks
of securities backed by subprime mortgages.
McGraw-Hill, the parent of Standard & Poor's, said in a statement yesterday that Ms Corbet
had resigned to spend more time with her family. Her exit was not related to the current turmoil

Page | 27

in credit markets, said Steven Weiss, a spokesman for the company. Mr Sharma is executive
vice-president of investment services and global sales.
S&P and Moody's Investors Service failed to downgrade bonds backed by loans to borrowers
with poor credit until July, when some had already lost more than 50c in the dollar. McGrawHill shares have dropped 26 per cent this year amid concerns that the rout in the credit markets
may curtail new debt sales. The chairman of the US Senate Banking Committee, Christopher
Dodd, said yesterday credit rating companies had to explain why they assigned "AAA ratings
to securities that never deserved them".
"The business is at a critical juncture, a turning point," said Joshua Rosner, a managing director
at the investment research firm Graham Fisher & Co in New York, and co-author of a study
that found rating companies understated the risks of subprime mortgage bonds. "Perhaps this is
a sign of further personnel and business changes to come."
McGraw-Hill shares rose 48c to $US50.27 in New York Stock Exchange composite trading.
Moody's, the parent of the rating company Moody's Investors Service, fell 95c to $US45.09,
and is down 35 per cent this year.
The French President, Nicolas Sarkozy, called last month for an investigation into rating
companies and the European Union's financial services commissioner, Charlie McCreevy,
plans to review the management and resources of the companies, and any conflicts of interests.
The firms did "great damage" said Senator Dodd, who is seeking the Democratic Party's
presidential nomination. He wants to examine the "special status" that allows credit rating
companies more access than investors to information about public companies.
Mr Sharma's background is in strategy and consulting rather than the financial markets. He
joined McGraw-Hill in 2002 from Booz Allen & Hamilton, a management consulting firm,
where he served as a partner and advised companies on strategy, branding and sales
management for 14 years, according to a biography on S&P's website. He also worked for
Dresser Industries and Anderson Strathclyde.

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He is a graduate of Birla Institute of Technology in India and received a master's degree from
the University of Wisconsin and a doctoral degree in business management from Ohio State
University.
Credit-rating companies may be successfully sued by investors who lost money on subprimemortgage securities and similar bonds, according to a study published in May by Mr Rosner
and Joseph Mason, an associate finance professor at Drexel University in Philadelphia.
Short-selling of Moody's and McGraw-Hill shares has soared this year, a sign investors are
betting their earnings will suffer. Short interest in McGraw-Hill has tripled since February to
about 6.1 million shares. The short interest on Moody's has increased about ninefold in the
same period to 31 million shares, data compiled by Bloomberg show.
McGraw-Hill and Moody's have declined partly because of concerns that subprime mortgage
defaults will slow demand for ratings of collateralised debt obligations.
Growth at S&P, McGraw-Hill's most profitable unit, would slow in the second half from the
"very, very hot" first half, its chief executive, Terry McGraw, said on July 24.
"Deven Sharma is a very skilled executive with global experience and knowledge," Mr Weiss
said. "We remain very positive about the long-term trends that drive demand for S&P's credit
ratings, index services, equity research and other data products."

News Corp. hit by credit re-rating

NEWS Corporation shares hit a year low on the Sydney stock exchange yesterday, as credit
rating agency Standard & Poor's revised its outlook on Rupert Murdoch's media company from
"stable" to "negative".
The agency said a decision by Haim Saban, chairman of cable business Fox Family
Worldwide, to exercise an option to sell his 49.5pc stake in the cable business to News Corp was
"a source of potential concern".

Page | 29

In Sydney, the shares fell 45 cents to A$13.65 (511p), less than half their A$28 record high hit
last March. Under the terms of Mr Saban's put option, Mr Murdoch would have to pay between
$700m (473m) and $2 billion in cash to Saban Entertainment, News Corp's Fox Family joint
venture partner.
S&P warned that this cash payment, combined with the consolidation of Fox Family's $1.4
billion to $1.5 billion debt on News Corporation's balance sheet, "could put pressure on News
Corp's ratings". The media company remains on a BBB (stable) S&P's rating, based on its
underlying profitability in relation to both interest cover and debt.
Mr Saban's decision could also put pressure on Mr Murdoch's hopes to buy American satellite
broadcaster DirecTV and float News Corp's satellite business, Sky Global Networks, which
includes BSkyB and British set-top box manufacturer NDS, in the new year.
However, Mr Murdoch is expected to take action to alleviate News Corporation's credit profile.
This could include selling Mr Saban's stake in Fox Family to a third party, or selling the cable
company's main asset, the Fox Family Channel. News Corp may also try to negotiate with Mr
Saban to inject some shares into the final sale.
A News Corp spokesman said the S&P downgrade was "not a concern for the company" because
it would "not do anything to risk its debt rating". News Corp's bankers, Bear Stearns, have until
January 31 to negotiate an agreed valuation with Saban Entertainment for the stake in Fox.

Bibliography

Reuters.com

Standardandpoors.com

Fitch.com
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Moodys.com

Wikipedia.org

Google.com

BIIA.com

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