Credit ratings provide retail and institutional investors with information that assists them in determining whether issuers of bonds and other debt instruments and fixed-income securities will be able to meet their obligations. In issuing letter "grades," credit rating agencies (CRAs) provide objective analyses and independent assessments of companies and countries that issue such securities. Here is a basic history of how the ratings and the agencies developed in the U.S. and grew to aid investors all over the globe.
An Overview of Credit Ratings
Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take into account the overall economic conditions of a country, including the volume of foreign, public and private investment, capital market transparency and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country. The sovereign rating is often the prerequisite information institutional investors use to determine if they will further consider specific companies, industries and classes of securities issued in a specific country.
Credit ratings, debt ratings or bond ratings are issued to individual companies and to specific classes of individual securities such as preferred stock, corporate bonds and various classes of government bonds. Ratings can be assigned separately to short-term and long-term obligations. Long-term ratings analyze and assess a company's ability to meet its responsibilities with respect to all of its securities issued. Short-term ratings focus on the specific securities' ability to perform given the company's current financial condition and general industry performance conditions. (For more information see What Is A Corporate Credit Rating?)
The Big Three Agencies
The global credit rating industry is highly concentrated, with three agencies – Moody's, Standard & Poor's and Fitch – controlling nearly the entire market.
John Knowles Fitch founded the Fitch Publishing Company in 1913, providing financial statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In 1924, Fitch introduced the AAA through D rating system that has become the basis for ratings throughout the industry. With plans to become a full-service global rating agency, in the late 1990s Fitch merged with IBCA of London, subsidiary of Fimalac, S.A., a French holding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Ratings Co. Beginning in 2004, Fitch began to develop operating subsidiaries specializing in enterprise risk management, data services and finance-industry training with the acquisition of a Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Training. (For information on bond ratings systems see Bond Ratings Agencies: Can You Trust Them.)
Moody's Investors Service
John Moody and Company first published "Moody's Manual" in 1900. The manual published basic statistics and general information about stocks and bonds of various industries. From 1903 until the stock market crash of 1907, "Moody's Manual" was a national publication. In 1909 Moody began publishing "Moody's Analyses of Railroad Investments," which added analytical information about the value of securities. Expanding this idea led to the 1914 creation of Moody's Investors Service, which, in the following 10 years, would provide ratings for nearly all of the government bond markets at the time. By the 1970s Moody's had beuan rating commercial paper and bank deposits, becoming the full-scale rating agency that it is today.
Standard & Poor's
Henry Varnum Poor first published the "History of Railroads and Canals in the United States" in 1860, the forerunner of securities analysis and reporting to be developed over the next century. Standard Statistics formed in 1906, which published corporate bond, sovereign debt and municipal bond ratings. Standard Statistics merged with Poor's Publishing in 1941 to form Standard and Poor's Corporation, which was acquired by The McGraw-Hill Companies, Inc. in 1966. Standard and Poor's has become best known by indexes such as the S&P 500, a stock market index that is both a tool for investor analysis and decision-making, and a U.S. economic indicator. (See A Trip through Index History to learn more about Standard & Poor's indexes.)
Nationally Recognized Statistical Rating Organizations
Beginning in 1970, the credit ratings industry began to adopt some important changes and innovations. Previously, investors subscribed to publications from each of the ratings agencies and issuers paid no fees for performance of research and analyses that were a normal part of the development of published credit ratings. As an industry, credit ratings agencies began to recognize that objective credit ratings significantly helped issuers: They faciliated access to capital, by increasing a securities issuer's value in the market place, and decreased the costs of obtaining capital. Expansion and complexity in the capital markets coupled with an increasing demand for statistical and analytical services led to the industry-wide decision to charge issuers of securities fees for ratings services.
In 1975, financial institutions, such as commercial banks and securities broker-dealers, sought to soften the capital and liquidity requirements passed down by the Securities and Exchange Commission (SEC). As a result, nationally recognized statistical ratings organizations (NRSRO) were created. Financial institutions could satisfy their capital requirements by investing in securities that received favorable ratings by one or more of the NRSROs. This allowance is the result of registration requirements coupled with greater regulation and oversight of the credit ratings industry by the SEC. The increased demand for ratings services by investors and securities issuers, combined with increased regulatory oversight, has led to growth and expansion in the credit ratings industry.
Regulation and Legislation
Since large CRAs operate on an international scale, regulation occurs at several different levels.
The U.S. Congress passed the Credit Rating Agency Reform Act of 2006, allowing the SEC to regulate the internal processes, record-keeping and certain business practices of CRAs. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 further grew the regulatory powers of the SEC, including requiring a disclosure of credit rating methodologies.
The European Union has never produced a specific or systematic legislation or created a singular agency responsible for the regulation of CRAs. There are several EU directives, such as the Capital Requirements Directive of 2006, that affect rating agencies, their business practices and their disclosure requirements. Most directives and regulations are the responsibility of the European Securities and Markets Authority.
Ever since the financial crisis and Great Recession of 2007 to 2009, credit rating agencies have come under increased scrutiny and regulatory pressure. It was believed that CRAs provided ratings that were too positive, leading to malinvestment. New rules in the EU have made CRAs liable for improper or negligent ratings that cause damage to an investor.
Some have argued that regulators have helped to prop up an oligopoly in the credit rating industry, providing rules that act as barriers to entry for small- or mid-sized agencies.
The Bottom Line
Investors may utilize information from a single agency or from multiple rating agencies. Investors expect credit rating agencies to provide objective information based on sound analytical methods and accurate statistical measurements. Investors also expect issuers of securities to comply with rules and regulations set forth by governing bodies, in the same respect that credit rating agencies comply with reporting procedures developed by securities industry governing agencies.
The analyses and assessments provided by various credit rating agencies provide investors with information and insight that facilitates their ability to examine and understand the risks and opportunities associated with various investment environments. With this insight, investors can make informed decisions as to the countries, industries and classes of securities in which they choose to invest.