Investors periodically receive information from news sources that a rating agency raises or downgrades a rating of an issuer, with the rating being revised up or down. The market reaction to this kind of news background can be quite stormy. Therefore, every trader should understand what the rating agencies are and what they do.
Rating agencies are commercial organizations that assess solvency, debt obligations, as well as other important financial indicators of various organizations: from business to governments.
They present their assessment in the form of credit ratings, which reflect the ability of a borrower to pay debts. The credit ratings are used by major institutional investors: banks, investment funds and pension funds.
The first credit ratings for bonds were given by John Moody in the USA only in 1909. Prior to that, for most of the history of modern capital markets, the issue of ratings as risk assessments was mostly theoretical. Most bonds were issued by countries and governments that were able and willing to meet their obligations, and investors already trusted them.
The real history of modern rating business, as we see it now, began in the 1970s with a number of decisions of the US Securities and Exchange Commission and accreditation of rating agencies. Some agencies were recognized at the level of a regulator, and they continued to benefit from it and became major market participants.
An American journalist said a wonderful phrase that if it was necessary to introduce tanks before, now it is enough to lower the rating of the state, and it will be almost the same blow to the country. This suggests that the ratings are now a very important political and economic factor, because they determine the cost of money for business and entire states. For the last 30 years the influence of ratings has been growing all the time and the peak of influence of rating agencies was at the beginning of the crisis. Now the reputation of agencies has slightly weakened and the influence of ratings has become a little lower.
For a rating agency to work successfully, investors must trust it. This requires a certain reputation that has been built up over decades. That’s why there are not many really global and successful rating agencies in the world. The most famous and reputable agencies in the world are American Standard & Poor’s, Moody’s, and Fitch Ratings, they are also called the “big three”.
Rating values from AAA to BBB are considered reliable and belong to the investment category. Anything below is considered doubtful of creditworthiness and falls into the non-investment category. Breakdown into categories is a certain indicator for conservative and large institutional investors about the issuer’s reliability. The movement of debt obligations from one category to another can cause serious capital movements.
Along with rating assignment, it is possible to indicate the outlook for future movements in the rating:
- Positive outlook – credit rating growth is likely.
- Negative outlook – downgrade of the credit rating is possible
- Stable outlook – it is likely that the rating is at the same level.
With a downgrade of the credit rating to a certain level, you may lose the opportunity to be credited at all, and the minimum threat of downgrade is that credits will become more expensive.
The credit rating itself has never been and will never be a recommendation to buy or sell any assets. Ratings show only one characteristic – the level of creditworthiness of individual companies or states. And even companies and states with AAA rating are subject to such phenomenon as default. The difference is that among companies with AAA rating there will be single cases of bankruptcy, while among companies with lower bankruptcy rates there will be much more frequent failures.
The main purpose of these organizations is profit, regardless of their international or national operations. This fact is the main reason for doubts about the objectivity of rating agencies.
Doubts in the reliability of the analysis were also warmed up in America itself on the wave of the 2007-2009 crisis, when the experts of the Big Three failed to give a timely forecast of the mortgage collapse and bankruptcy of Lehman Brothers, the leading bank. They began to downgrade the ratings of banks and corporations post facto, following the situation rather than warning it.
Rating agencies continue to have a serious impact on financial markets. For example, the decision of Standard and Poor’s to downgrade the U.S. credit rating in August 2011 from the maximum AAA to AA+ caused panic on stock exchanges and collapse of quotations around the world.
The essence of the rating agency’s work and the assignment of ratings is perfectly shown in the movie “Game on the Downside.