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What are credit ratings?

A credit ratingis an assessment of a borrower’s ability to repay its debts. The borrower in question can be an individual, a business, a municipal body, a public authority, a sovereign government or an international organisation. The rating is usually given by one of the credit rating agencies, is valid for a limited period of time and is kept under review. Credit ratings can strongly influence the rate of interest that borrowers have to pay.

Where have you heard about credit ratings?

As an investor, you will have been advised to keep an eye on changes to the credit ratings of important borrowers, including companies whose shares you may hold and governments in whose bonds you may be invested. Financial media cover the more striking changes to corporate and national ratings, especially when the change is downwards. You may have read of one or major countries losing their high credit rating in the aftermath of the 2008 financial crisis. As a private individual, you will have your own credit rating, contained in a credit reportcompiled by a financial information company to advise banks and other lenders as to your creditworthiness.

What you need to know about ratings…

There have been credit ratings of one sort or another ever since the first lender met the first borrower. Those extending credit have always needed some idea as to the likelihood that they will be repaid. Borrowers, aware that the availability and cost of loans will be dependent on what view is taken of them by the lender, have always had an interest in presenting the most solid, creditworthy face to the outside world.

But while the notion of the credit ratingis far from new, the idea that such ratings ought to be determined in as scientific and transparent a way as possible and made publicly available is much more recent. Central to this development was the emergence in the early 20thCentury of professional credit rating agencies, entities that were not themselves lenders but which made their living by advising those who were, suggesting which were the good and less good credit risks.

This formalisation of credit rating became essential for two main reasons. One was the scale on which business was being conducted from the late 19thcentury onwards. No longer could companies and other borrowers turn to a local bank for credit, which knew more about the borrower concerned than any credit rating expert was likely to do.

As firms expanded, first nationwide and then globally, their financing needs led them to corporate bond markets and to large-scale bank lenders, both of which needed a robust, independent assessment of their creditworthiness.

Corporate credit ratings were born.

The other was the changing environment in which governments in developed countries were operating in the period following the Napoleonic Wars. Increasingly unable to exercise the sovereign’s prerogative of simply helping themselves to their subjects’ resources, they were required either to raise tax lawfully or to borrow in capital markets in competition with both corporate borrowers and other governments.

Thus governments, too, came under the scrutiny of the credit rating agencies.

The big three agencies

As with the major corporations to whom they assign ratings, the agencies have experienced considerable consolidation over the years and there are currently three global giants that dominate the industry. They are, in alphabetical order, Fitch RatingsMoody’s Investors Services and Standard & Poor’s S&P.

The oldest in terms of involvement in the ratings business is S&P. It began publishing corporate credit ratingsin 1906, along with ratings for sovereign and local government debt.

Moody’s Investors Service has been in business a little longer than S&P, starting in 1900, but its initial focus on information about shares and bonds of various industries meant it was not until 1914 that it began issuing credit ratings.

Fitch is the baby of the group, having started in 1913 publishing financial statistics rather than ratings. But it was the first, in 1924, to start using the rating system, from AAA downwards, that has become the template for the industry in the years since.

The ratings system

This template has been applied in slightly different fashion by the big three, and there are refinements of each rating to give as nuanced a picture as possible. Broadly, however, the scales are as follows.

Fitch has four categories – AAA, AA, A and BBB – that, in market jargon, denote ‘investment grade’ paper, believed to be safe and issued by reputable borrowers. AAA, obviously, represents the highest-quality borrower, with subsequent grades below that.

It has seven categories that are known variously as ‘speculative’ or ‘non-investment grade’, BB, B, CCC, CC, C, D and NR, this last standing for ‘not rated’. Such paper is sometimes described as ‘junk bonds’. A politer term, reflecting the higher rate of interest such borrowers will have to pay, is ‘high-yield bonds’.

S&P’s rankings are identical to those of Fitch, although it does not include NR, while those of Moody’s are similar to both but BBB is rendered as Baa, BB as Ba, CCC as Caa, CC as Ca and D as C. B is used identically.

While it would be unlikely for a borrower to be rated investment grade by one agency and ‘junk’ by another, the big three frequently diverge, at least at the margins, in their rankings of particular borrowers

The recent past

Credit rating agencies came under serious criticism in the wake of the 2008 financial crisis on a number of fronts.Some were attacked for the system under which they were paid not only by lenders but by the borrowers as well, creating an obvious conflict of interest. This, said some, led to what became a separate source of negative publicity for the agencies, the awarding to bundled-up sub-prime mortgage debt much more generous ratings than it deserved, giving such securities a bogus respectability that helped trigger the crisis.

This was exacerbated when the agencies began to downgrade the sovereign debt of countries such as the US, France and Britain. Some suggested the downgrades could be ignored, given the agencies had ‘been wrong’ about sub-prime debt before the crisis.

Tougher regulation has been put forward as the answer to some of the problems said to have emerged since the financial crisis.

Ratings: the future

Ratings, whether corporate credit ratings, those awarded to world powers or those contained in the credit report of an individual, are the lifeblood of any credit system and allow lenders and borrowers who not only do not know each other but have no way of doing so efficiently to determine risk.

Ratings agencies are ever on the alert for what are known as ‘negative credit events’. That could be a coup d’état in a sovereign state, or it could be a missed mortgage payment by a private individual.

The sophistication of the judgments made by the big three and the relative simplicity of the verdict in a credit reportare both attempts to answer the key question asked since the first lenders set eyes on the first borrower: will I get paid back?

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