What Rating Agencies Do
Rating agencies assess the financial strength of companies and governmental entities, both domestic and foreign, particularly their ability to meet the interest and principal payments on their bonds and other debt. Rating agencies also carefully study the terms and conditions of each specific debt issue. The rating for a given debt issue reflects the agency's degree of confidence that the borrower will be able to meet its promised payments of interest and principal as scheduled. The rating for a given debt issue may differ somewhat from the overall credit rating for the issuer, depending on its specific terms.
Debt issues with the highest credit ratings from the agencies will incur the lowest interest rates. Investors’ confidence in borrowers' ability to meet their payment obligations is highly influenced by the rating agencies’ analyses. Meanwhile, the interest rate demanded by investors on a given debt issue is inversely correlated with the creditworthiness of the borrower: stronger borrowers pay less, weaker borrowers pay more.
The credit rating agencies perform similar work to consumer credit bureaus. The credit scores that the latter produce for individuals similarly influence the rates of interest at which individuals may borrow.
Working as an analyst at a rating agency is one way to pursue a career in securities research. The larger rating agencies tend to have large numbers of entry-level openings and internships so that they can monitor the vast number of debt securities on the market. They thus help train a large number of people who eventually work elsewhere in the financial services industry, in a similar capacity.
Rating agencies are targets of reform efforts, having received mounting criticism in recent years for the quality of their research. Many observers claim that they are poor financial forecasters, too slow to spot negative trends in the issuers that they track, and too late to revise their ratings. There also are conflicts of interest because (with the exception of Egan-Jones, a small firm that charges the users of its ratings and reports) issuers select and pay the rating agencies for their bonds. In a 2008 survey of investment professionals by the CFA Institute, 11% of respondents claim to have seen rating agencies upgrading bond ratings under pressure from issuers. Meanwhile, a 2003 Federal Reserve study acknowledged the conflicts but concluded that there were only minor distortions, finding that rating agencies place considerably more value on guarding their reputations than on satisfying clients.
Three firms dominate this sector. Per The Wall Street Journal ("Call to Downsize Giants of Ratings," 8/10/2011), here are their total ratings and the share that each represents of the over 2.8 million ratings issued collectively by the ten Nationally Recognized Statistical Rating Organizations (NRSROs) designated and monitored by the SEC:
- S&P (1,190,500 ratings, or 42.2%)
- Moody's (1,039,187 ratings, or 36.9%)
- Fitch (505,024 ratings, or 17.9%)
According to a Piper Jaffray research analyst quoted in the aforementioned WSJ article, the largest three rating agencies collectively earn 95% of the revenues in this sector. An indication of their relative clout is that, whereas Standard & Poor's shook the markets with its 8/5/2011 downgrade of U.S. federal debt to AA+, Egan-Jones already had done the same much earlier, yet was ignored.
The remaining seven NRSROs account for only an additional 81,955 ratings, or 2.9%. They are, with the years that they were started:
- A.M. Best (founded 1899, first ratings issued in 1907)
- DBRS (1976)
- Japan Credit Rating Agency (1985)
- Rating and Investment Info. (1986)
- Egan-Jones Ratings (1995)
- Morningstar Credit Ratings (2001)
- Kroll Bond Rating Agency (2011; Jules Kroll founded investigators Kroll Associates in 1984)
Combined, Standard & Poor's and Moody's rate about 80% of all corporate and municipal (state and local government) bond issues. They are generally seen as a head above Fitch. The oldest member of the ten NRSROs is A.M. Best, a small, but respected, specialist in rating insurance companies.