Credit rating agencies are intermediaries that determine the financial capabilities of countries, multinational corporations, and local companies. Credit rating agencies are known to act as a linkage between issuers and buyers of debt securities. Moreover, credit rating agencies determine the risks of securities before such securities are sold to willing buyers. In various countries, the credibility of CRAs has been under scrutiny since they tend to influence the prices of securities in the financial market. However, research shows that CRAs play a critical role in the financial market both at the country and company level.
Since credit rating agencies influence the financial activities in the market, indeed, their presence in the market cannot be ignored. Therefore, this paper identifies one of the credit rating agencies in the financial market and goes a notch higher to evaluate the role of the chosen agency, as well as its relevance in the market.
Influence of rating on the creditworthiness of issuers
- CRAs have the capacity to obtain information related to the performance of an organization.
- The credit rating agencies could perhaps manipulate the obtained data in order to prevent price inflation. A security would only have a high market value if it were rated highly by a credit rating agency. Only companies with high-quality standards are rated highly.
- Potential purchasers would always gather information from various ratings of Standards and Poor before making final decisions regarding acquisition of securities.
- Companies that are rated highly have higher chances of selling their securities at a reasonable price. However, those companies performing poorly are always rated low. Investors would not be interested in stocks of companies performing dismally in the financial market. Research shows that some companies would be performing well in the financial market yet they are rated low. This would mean that a company would be making adequate profits yet its credit rating is very low. This is proof that credit rating agencies influence the selling and purchasing of securities in the financial market.
- Credit rating agencies play a critical role in ensuring that companies maintain high standards of service in the financial market. In the financial market, the credit features of a company are similar across various rating agencies.
- A company would not claim to be performing well in the market yet all credit rating companies give it a low score. The similarity of data among CRAs affects companies in the financial market since potential buyers would be made to believe that the ratings are genuine. Some issuers argue that CRAs are biased in their ratings.
- The law provides that the issuer cannot be selecting the same credit rating agency whenever it feels like evaluating the values of securities. If a company’s performance is poor, all CRAs would give negative results meaning that it would scare away potential customers. Many customers would tend to trust the ratings and would therefore accept them at the face value (Fang 2005, p. 35). Investors would be reluctant to assess the rating procedure but would instead trust the ratings.
Selected CRA: Standard and Poor
Standard and Poor (S&P) is an American-owned credit rating agency, which specializes in conducting financial research. Moreover, the agency participates in evaluation of stocks and bonds to determine their creditworthiness. The agency is an international organization operating in several countries under different brand names. In the US, it is popularly referred to as the S&P 500. Major competitors in the credit rating market include Moody’s Investor Service and Fitch Company. Since it is a credit rating agency, the company conducts research before issuing ratings on both private and public companies. In the US, the company issues both short-term and long-term credit rating services. Regarding long-term credit rating, the agency rates borrowers using a certain scale. The scale is numbered from AAA to D. Within each level, the agency provides intermediate ratings such as BBB+, BBB, and BBB-.The agency offers other services apart from rating companies, such as offering financial advisory services. It would advise the company on whether its performance is expected to improve, fall, or remain neutral.
The importance and role of the standard and poor rating
Expansion of Money Markets
The credit rating company has helped in generating risk measures for companies, which makes it possible for issuers to obtain information and comprehend the credit risk involved in the process of investment. People in their places of work can access ratings before applying for loans and other credit facilities. With this rating, it makes it easier for companies to borrow money from financial institutions such as banks. Based on the rating, corporations can also give loans such as bonds and treasury bills from governments.
Regulating Financial Markets
Money markets have been regulated using the ratings from Standards and Poor. Ratings by this agency have made it possible to classify bonds. For a corporate bond to be graded, it must have a rating of more than BBB.
Appraisal of Risk premium
Most banks have used the ratings from Standards and Poor to calculate the amount of risk premium on bonds and loans issued out to customers. Credit rating is very important for customers. Companies with lower ratings might get loans at a higher risk premium as compared to those with good credit ratings.
Improved lucidity in the Credit Markets
Credit rating makes it easier for regulators to bring about lucidity and fairness in the credit markets. Credit rating makes it easy for the issuer to determine the creditworthy individuals. This in turn makes it easier for issuers to tell who gets a loan and who does not.
This process starts with a call from clients to carry out a preliminary appraisal of a deal. Issuers prefer initial indication, irrespective of whether it is a single loan or a group of mortgage loans. The request to conduct this is put forward by the issuer, banks, or borrowers during an official meeting aimed at formalizing the deal. The first round evaluations usually entail a small table assessment of the security. On the other hand, the preliminary assessment for sole borrower arrangement and huge amount borrowers may call for a medium, large, or a mixture of loan deals, and could necessitate an exhaustive evaluation of the security. After the first round appraisal, the results are then disclosed to the issuer to enable him or her to make a decision on the economic feasibility of the deal. In the case of medium and fusion deals, the findings are sent in the structure of the credit support array at the rating type requested. If the users of this result accept the findings, they prepare a commitment letter with terms and conditions. The letter is then sent to the issuer. The letter would contain all relevant information, including the charges and time spent.
An analytical squad of experts in charge of the process is always assigned the duty of managing the transaction rating process. The team reviews the preliminary information supplied by the issuer during the site visit. It is also expected to appraise and assess all other reports and information provided by other issuers. Environment assessment is conducted, as well as other assessments related to the assets. This process takes on average six weeks. During this time, the team concentrates more on cash flow scrutiny. The team keeps in touch with the issuer on matters relating to the asset. This guides the lender in coming up with the credit facility. After the asset analysis, the lead consultant appears before the credit committee to present his or her findings. During this stage, legal matters and other factors regarding the asset are discussed. This would be aimed at determining the creditworthiness of the borrower. Finally, the committee members vote on the credit support rank. The outcome is then communicated to banker or the issuer. If the outcome is acceptable to the issuer, Standards and Poor Company places it on its website in the ‘news and analysis’ section. This would be accessible to all potential investors. In between the valuation and the closing stages, S & P continues to carry on with the appraisal process. Any changes would affect the ratings or the deal.
The relevance of their rating
The relevance of S&P in the estimation of risky premiums is undisputed. Financial institutions such as banks would utilize the information provided by S&P to estimate the premium to be charged on loans. If the rating were poor, the bank would tend to charge high premiums and if the rating were high then the bank would charge a low premium. Therefore, S&P plays a critical role as far as lending is concerned. Countries and corporations with low ratings would pay high premiums because their securities would not attract investors. Such companies have high chances of collapsing. The activities of credit rating agencies in the financial markets bring about sanity in the credit market. Companies would strive to achieve transparency in order to improve their ratings. This would guarantee high standards. Since companies would be aware that credit rating is important, they would strive to put in place measures that would allow internal evaluation (DeMarzo 2005, p. 2760).
In a special policy report released in 2003 by the Derivatives Study Center (a copy attached), credit rating agencies were heavily criticized for providing inaccurate financial information. Companies are assigned high ratings yet they are the first ones to fall when economy is hit by the financial crisis. Many investors rushed into buying CDO bonds hoping that such bonds would give them maximum returns in the US. In 2010, a report by Standard and Poor’s Guide to Credit Rating Essentials criticized the practices of the company (a copy of the report is attached). The agency rated CDO bonds high but the bonds were later unsalable because their values had fallen greatly even before the financial crisis. Investors were forced to dispose of their securities at a loss because no one was willing to withhold them. Investors knew that the prices of such securities were expected to fall further. For example, investors who traded in the CDO incurred a total loss of $340.7 million. It is surprising to note that S&P had rated the bonds under AAA class meaning that they were the most valuable. Some critics have accused S&P of conspiring with issuers to trick unsuspecting investors who end up making losses. In real sense, S&P is supposed to be objective to promote credibility in the financial market. S&P was responsible for the 2008-2009 economic crises because it failed to downgrade stocks that had already been lowered by other credit agencies such as Moody.
List of References
DeMarzo, M 2005, “The pooling and trenching of securities: a model of informed Services”, Journal of Finance, Vol. 6, no. 1, pp 2729-2761.
Fang, L 2005, “Investment Bank Reputation and the Price and Quantity of Underwriting Intermediation,” Review of Financial Studies, Vol. 18, no. 1, pp 1-35.