Before conversing this topic deeply, we should go through a little theoretical discussion on this matter. The credit rating agencies became a vital financial institution recently due to the increase of their influence in the financial world stage. Firstly we are going to define the terms and terminologies of the credit and the credit agency and then the concepts in a chronological way.CreditCredit is the trust which allows one party (lender) to provide money or resources to another party(borrower) where that second party does not reimburse the first party immediately (thereby generating a debt), but instead promises either to repay or return those resources (or other materials of equal value) at a later date.
The resources provided may be financial (e.g. granting a loan), or they may consist of goods or services. Credit encompasses any form of deferred payment. Credit is extended by a creditor, also known as a lender, to a debtor, also known as a borrower.
Trade creditIn commercial trade, the term “trade credit” refers to the approval of delayed payment for purchased goods. Credit is sometimes not granted to a buyer who has financial instability or difficulty. Companies frequently offer trade credit to their customers as part of the terms of a purchase agreement. Organizations that offer credit to their customers frequently employ a credit manager.Consumer creditConsumer debt can be defined as “money, goods or services provided to an individual in the absence of immediate payment”. Common forms of consumer credit include credit cards, store cards, motor vehicle finance, personal loans (installment loans), consumer lines of credit, retail loans (retail installment loans) and mortgages. This is a broad definition of consumer credit and corresponds with the Bank of England’s definition of “Lending to individuals”. Given the size and nature of the mortgage market, many observers classify mortgage lending as a separate category of personal borrowing, and consequently residential mortgages are excluded from some definitions of consumer credit, such as the one adopted by the U.S. Federal Reserve.The cost of credit is the additional amount, over and above the amount borrowed, that the borrower has to pay. It includes interest, arrangement fees and any other chargesBank-issued creditBank-issued credit makes up the largest proportion of credit in existence. The traditional view of banks as intermediaries between savers and borrower is incorrect. Modern banking is about credit creation. Credit is made up of two parts, the credit (money) and its corresponding debt, which requires repayment with interest. The majority (97% as of December 2013) of the money in the UK economy is created as creditWhy do we need credit in the business worldEvery individual, organization and any business entity entitled the use of credit in the financial transitions they involve. For instance, business have capital structure that includes an external liability that business owe; financing larger projects always requires the use of credit financing. The need of credit is inevitably important because without credit financing the business can’t grow nor be able to make huge profits of their limited capitals. After the importance of credit emerges, there is a question how an investor knows which business is applicable to lend money so that business can repay the debt on its due date? Or which business is not qualified to get credit? Knowing the score of credit of every business can make easier to evaluate different levels of interest rate Minimizing the default and risks surrounded on credit financing call for an independent agencies that can assess the abilities of organizations to repay their debts on their due dates. The need of these independent agencies opens the door of major financial institutions which are called credit rating agenciesWhat is Credit Rating Agency?Credit rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debt Capacity. Debt capacity refers to the total amount of borrower bushiness can take and repaid the period of the agreement.A business can cause to takes on debt for few reasons, which are increasing production or marketing, expanding capacity, or obtaining new businesses. How do lenders evaluate the amount debt the company own? The rating assigned to a given debt shows an agency’s level of confidence that the borrower will find its debt obligations as agreed. Each agency has reputation on the debt amount in order to indicate if a debt has a low or high default risk. Systemic risk can be defined as the risk associated with the collapse or failure of a company, industry, financial institution or an entire economy. It is the risk of a major failure of a financial system, whereby a crisis occurs when providers of capital lose trust in the users of capital and the financial stability of its issuer. The debt (lenders) issuers may be nations, local and state governments, those has special purpose institutions, companies, or non-profit organizations.When the financial crisis of 2008, credit agencies have been criticized for giving high credit rating to debts that later turned out to be high-risk investments. They finally failed to know the risks that would have warned depositors against investing in certain types of debts such as mortgage-backed securities; Mortgage-Backed Security (MBS) is an investment that is secured by a mortgage or a collection of mortgages. An MBS is an asset-backed security that is traded on the secondary market, and that enables investors to profit from the mortgage business. Credit Rating agencies have also been criticized for possible conflict of interest between them and issuers of securities. Issuers of securities pay the rating agencies for providing rating services, and therefore, the agencies may be reluctant to give very low ratings to securities issued by the people who pay their salaries. The Big Three Credit Rating AgenciesThe credit rating industry is dominated by three big agencies, which control 95% of the rating business. The most top firms include Moody’s Investor Services, Standard and Poor’s (S&P) is a market leader in the provision of standards and investible indices, as well as credit ratings for companies and countries, and other financial information services.(S&P), and Fitch Group. Moody’s and S& P are all in the United States, and they control almost 80% of the international market. Fitch is located in the United States and London and controls approximately 15% of the global market. The big three agencies came under heavy criticism when the global financial crisis occur after the global financial crisis for giving favorable ratings to insolvent institutions like Lehman Brothers. They were also blamed for every thing which resulted to happen or collapse of the real estate market in the United States. In a report titled Financial Crisis Inquiry Report, the big three rating agencies were accused of being the enablers of the 2008 financial meltdown. In a bid to tame the market dominance of the big three, Euro zone countries have encouraged financial firms and other companies to do their own credit assessments, instead of relying on the big three rating agencies. Role of Credit Rating Agencies in Capital MarketsThe role of credit rating agencies or what we call rating service is to evaluate, guard, and calculate the credit risk of loans or debt securities and borrowing entities. In the bond market, a rating agency provides an independent evaluation of the lender of debt securities issued by governments and corporations. Large bond issuers receive ratings from one or two of the big three rating agencies. In the United States, the agencies are held responsible for losses resulting from inaccurate and false ratings.The ratings are used in structured financial transactions such as asset-backed securities, mortgage-backed securities, and collateralized debt obligations. Rating agencies focus on the type of pool underlying the security and the proposed capital structure to rate structured financial products. The issuers of these products pay rating agencies to not only rate them, but also to advise them on how to structure the shares.Rating agencies also give ratings to sovereign borrowers, who are the largest borrowers in most financial markets. Sovereign borrowers may include national governments, state governments, municipalities, and other sovereign-supported institutions. The sovereign ratings given by a rating agency shows a sovereign’s ability to repay its debt. The ratings help governments rising and developing countries to issue bonds to domestic and international investors. Governments sell bonds to obtain financing from other governments and institutions such as the World Bank and the International Monetary Fund. Benefits of Credit Rating AgenciesEverything is a double edge knife it has its problem and advantage so let’s look the benefits of credit rating agency into several levels. First and foremost let’s look at the consumer level; the agency’s ratings are used by banks to settle on the risk premium to be charged on loans and bonds. A poor credit rating shows that the loan has a higher risk premium, and this prompts an increase in the interest charged to individuals and entities with a low credit rating. A good credit rating allows borrowers to easily borrow money from the public debt market or financial institutions at a lower interest rate and vice verse is true.At the corporate level, companies planning to issue a security must find a rating agency to rate their debt. Rating agencies which we know clearly such as Moody’s, Standards and Poor’s, and Fitch perform the rating service for a fee. Investors depend on these ratings to decide on whether to buy or not to buy a company’s securities. Although investors can also rely on the ratings given by financial intermediaries and underwriters, ratings provided by international agencies are considered more reliable and accurate since they have access to a lot of information that is not publicly available.At the country level, investors depend on the ratings given by the credit rating agencies to make investment decisions. Many countries sell their securities in the international market, and a good credit rating can help them access high-value investors. A favorable rating may also attract other forms of investments like foreign direct investments to a country. In addition, a low credit rating or relegation of a country from a high rating to a low rating can discourage investors from purchasing the bonds or making direct investments in the country. For example, the downgrading of Greece, Portugal, and Ireland by S&P in 2010 worsened the European sovereign debt crisis.Credit ratings also help in the development of financial markets. Rating agencies provide risk measures for various entities, and this allows investors to understand the credit risk of various borrowers. Institutions and government entities can access credit facilities without having to go through lengthy evaluations by each lender. The ratings provided by rating agencies also serve as a standard for financial market regulations. Some laws now require certain public institutions to hold investment grade bonds, which have a rating of BBB or higher.Standard and Poor’s Corporate Bond RatingsAAA: This is the highest rating assigned by Standard and Poor’s for debt obligation and indicates an extremely strong capacity to pay principal and interest.AA: Bonds rated AA also qualify as high-quality debt obligations. Their capacity to pay principal and interest is very strong, and in the majority of instances they differ from AAA issues only in small degreeA: Bonds rated A have a strong capacity to pay principal and interest, although they are susceptible to the adverse effects of changes in situation and economic conditions.BBB: Bonds rated BBB are regarded as having an enough capacity to pay principal and interest.they normally show enough protection measures , adverse economic conditions or changing situation are more possible to lead to a weakened capacity to pay principal and interest for bonds in this group than for bonds n the A group.BB: Bonds rated BB, B, CCC, and CC are regarded, on balance, as B: mainly speculative with respect to the issuer’s capacity to pay.CCC: interest and repay principal in agreement with the terms of the obligation.CC: BB indicates the lowest degree of speculation and CC the highest. While such bonds will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions.C: The rating C is reserved for income bonds on which no interest is being paidD: Bonds rated D are in default, and payment of principal and/or interest is in arrears. Plus (+) or Minus (-): To provide more detailed indications of credit quality, the ratings from AA to BB may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. Business modelsCredit rating agencies make revenue from a many activities related to the production and distribution of credit ratings. The sources of the revenue are usually the issuer of the securities or the investor. Most agencies operate below one or a combination of business models: the subscription model and the issuer-pays model. However, agencies may offer additional services using a combination of business models.Under the subscription model, the credit rating agency does not make its ratings freely available to the market, so investors pay a subscription fee for access to ratings. This revenue provides the main source of agency income, although agencies may also provide other types of services. Under the issuer-pays model, agencies charge issuers a fee for providing credit rating assessments. This revenue stream allows issuer-pays credit rating agencies to make their ratings freely available to the broader market.The subscription approach was the prevailing business model until the early 1970s, when Moody’s, Fitch, and finally Standard & Poor’s adopted the issuer-pays model. Several factors contributed to this transition, including increased investor demand for credit ratings, and widespread use of information sharing technology such as fax machines and photocopiers which allowed investors to freely share agencies’ reports and undermined demand for subscriptions. Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer-pays model, only Egan-Jones maintains an investor subscription service. Smaller, regional credit rating agencies may use either model. For example, China’s oldest rating agency, Chengxin Credit Management Co., uses the issuer-pays model. The Universal Credit Ratings Group, formed by Beijing-based Dagong Global Credit Rating, Egan-Jones of the U.S. and Russia’s RusRatings, uses the investor-pays model, while Dagong Europe Credit Rating, the other joint-venture of Dagong Global Credit Rating, uses the issuer-pays model.A 2009 World Bank report proposed a “hybrid” approach in which issuers who pay for ratings are required to seek additional scores from subscriber-based third parties. Other proposed alternatives include a “public-sector” model in which national governments fund the rating costs, and an “exchange-pays” model, in which stock and bond exchanges pay for the ratings. Crowd sourced, collaborative models such as Wikirating have been suggested as an alternative to both the subscription and issuer-pays models, although it is a recent development as of the 2010, and not yet widely used.Asset-Backed and Mortgage-Backed SecuritiesAsset-backed securities (ABS) and mortgage-backed securities (MBS) are two important types of asset classes. MBS are securities created from the pooling of mortgages, and then sold to interested investors, whereas ABS have evolved out of MBS and are created from the pooling of non-mortgage assets. These are usually backed by credit card receivables, home equity loans, student loans and auto loans. The ABS market was developed in the 1980s and has become increasingly important to the U.S. debt market. There are three parties involved in the structure of ABS and MBS: the seller, the issuer and the investor. Sellers are the companies that generate loans and sell them to issuers. They also take the responsibility of acting as the servicer, collecting principal and interest payments from borrowers. Issuers buy loans from sellers and pool them together to issue ABS or MBS to investors. They can be a third-party company or special-purpose vehicle (SPV). ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to acquire additional funding. Investors of ABS and MBS are usually institutional investors and they use ABS and MBS to obtain higher yields than government bonds, as well as to provide a way to diversify their portfolios.Both ABS and MBS have prepayment risks, though these are especially pronounced for MBS. Prepayment risk is the risk of borrowers paying more than their required monthly payments, thereby reducing the interest of the loan. Prepayment risk can be determined by many factors, such as the current and issued mortgage rate difference, housing turnover and path of mortgage rate. If the current mortgage rate is lower than the rate when the mortgage was issued or housing turnover is high, it will lead to higher prepayment risk. The path of the mortgage rate might be difficult to understand, so we will explain with an example. A mortgage pool begins with a mortgage rate of 9%, then drops to 4%, rises to 10% and finally falls to 5%. Most homeowners would refinance their mortgages the first time the rates dropped, if they are aware of the information and are capable of doing so. Therefore, when the mortgage rate falls again, refinancing and prepayment would be much lower compared to the first time. Prepayment risk is an important concept to consider in ABS and MBS