What are rating agencies and what are used they for?

Louis DETALLE

In this article, Louis DETALLE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2023) explains what are the different rating agencies and what are they used for?

What is a rating agency?

The purpose of a rating agency is to assess the credit risk of a company or a state. Since the 1980s, these agencies have become benchmarks for both issuers and investors when issuing bonds, for example. They therefore play a major role since the information they communicate (rating, positive or negative outlook) greatly influences the way in which the financial markets perceive the rated companies and states. However, the reputation, independence and existence of rating agencies are sometimes being questioned.

What are the main rating agencies?

There are mainly three rating agencies: Moody’s, Standard & Poors and Fitch Ratings. These three rating agencies are all American. Besides the three main agencies, the Chinese Dagong has gained in importance in recent years, especially in Asian countries.

Each rating agency choses its own rating ranking that you can see below:

Capture d’écran 2022-11-23 à 13.58.35

After a grade is given to a company by one of these three rating agencies, it will determine how the company is perceived on financial markets. For example, if a company with a “BB-“ S&P rating wants to issue a bond, it will have to pay a higher interest rate to the bond’s buyers that a company with a “A+” S&P rating for the same bond issuance. All this is due to the fact that the risk of default from the BB- company will be greater than the A+ company. For that matter, it will be more expensive for “poorly rated” companies to issue debt on financial markets.

Why are rating agencies debated so much?

Rating agencies are often questioned because of the influence they have. Indeed, the three major rating agencies, Moody’s, Standard & Poor’s and Fitch Ratings, together account for 94% of the government and company rating market as of June 2022. This raises a first concern, relating to the plurality of sources of information and the asymmetry of the financial markets, which are partly based on the information provided by only three rating agencies.

On the other hand, since lower-rated securities present risks and therefore higher interest rates, the rating process ends up acting in a pro-cyclical way. When a company and/or a state suffers a downgrade, this has the direct consequence of increasing the cost of its financing and aggravating the issuer’s difficulties. The opposite is true: when a company sees its rating get better, the cost of its debt will go down and it will improve its financial health…

Finally, since the rating agencies are paid by the companies that want to be rated by them, a potential conflict of interest seems possible. Some rating agencies have entire departments devoted to advising the potential client on how an operation – a merger for example- would impact the rating…

What role did credit rating agencies played during the subprimes crisis?

Rating agencies have played a crucial role in securitisation, a financial technique that transforms illiquid assets into easily tradable securities, such as bonds. The agencies then rate the securitised loan packages and the bonds issued as counterparts according to different risk bands. This is what the rating agencies did: they rated the baskets containing subprime loans. But the agencies were far too generous in giving AAA ratings (the highest rating) on the securitised packages. This contributed to the euphoria surrounding these financial products. Without this rating, the real risk would probably have been better understood.

Then, when the housing market turned, the agencies did not downgrade mortgage securities properly and in time. They reacted too late and with abrupt downgrades, which aggravated the crisis.

In the end, almost all of the mortgage securitisations marketed in 2006 with a AAA rating are now rated as “junk bonds”.

Resources

Article about how Rating Agencies played a significant role in the subprime crisis in 2008…

S&P

Moody’s

Fitch Rating

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About the author

The article was written in November 2022 by Louis DETALLE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2023).

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