The Rating Agencies and Their Credit Ratings

The Rating Agencies and Their Credit Ratings: What They Are, How They Work, and Why They Are Relevant is a guide to ratings, the ratings industry, and the mechanics and economics of obtaining a rating. The book sheds light on the role that the agencies play in the international financial markets.

Credit rating agencies play a critical role in capital markets, guiding the asset allocation of institutional investors as private capital moves freely around the world in search of the best trade-off between risk and return. However, they have also been strongly criticised for failing to spot the Asian crisis in the early 1990s, the Enron, WorldCom and Parmalat collapses in the early 2000s and finally for their ratings of subprime-related structured finance instruments and their role in the current financial crisis.

This book is a guide to ratings, the ratings industry and the mechanics and economics of obtaining a rating. It sheds light on the role that the agencies play in the international financial markets. It avoids the sensationalist approach often associated with studies of rating scandals and the financial crisis, and instead provides an objective and critical analysis of the business of ratings. The book will be of practical use to any individual who has to deal with ratings and the ratings industry in their day-to-day job.

Reviews

"Rating agencies fulfil an important role in the capital markets, but given their power, they are frequently the object of criticism. Some of it is justified but most of it portrays a lack of understanding of their business. In their book The Rating Agencies and their Credit Ratings, Herwig and Patricia Langohr provide an excellent economic background to the role of rating agencies and also a thorough understanding of their business and the problems they face. I recommend this book to all those who have an interest in this somewhat arcane but extremely important area."
-Robin Monro-Davies, Former CEO, Fitch Ratings.

"At a time of unprecedented public and political scrutiny of the effectiveness and indeed the basic business model of the Credit Rating industry, and heightened concerns regarding the transparency and accountability of the leading agencies, this book provides a commendably comprehensive overview, and should provide invaluable assistance in the ongoing debate."
-Rupert Atkinson, Managing Director, Head of Credit Advisory Group, Morgan Stanley and member of the SIFMA Rating Agency Task Force

"The Langohrs have provided useful information in a field where one frequently finds only opinions or misconceptions. They supply a firm base from which to understand changes now underway. A well-read copy of this monograph should be close to the desk of every investor, issuer and financial regulator, legislator or commentator."
-John Grout, Policy and Technical Director, The Association of Corporate Treasurers

Foreword ix
Preface xiii
1 Introduction 1
1. 1 Context and Premises 1
1. 1. 1 The Benchmarking of Default Prospects Remains Deeply Rooted in Business Analysis 1
1. 1. 2 Credit Ratings Play a Unique Role in Overcoming Information Asymmetries on the Information Exchanges 9
1. 1. 3 Under the Spotlight as Unique Infomediaries, the CRAs became Strictly Regulated 13
1. 2 Book Chapters 17
1. 3 Supporting Materials 18
Part A Credit Rating Foundations 21
2 Credit Ratings 23
2. 1 The World of Corporate Defaults 24
2. 1. 1 What are Corporate Defaults? 27
2. 1. 2 The Drivers of Corporate Defaults 35
2. 1. 3 Recovery Rates from Defaults 39
2. 2 Credit Rating Scales 40
2. 2. 1 Fundamental Ordinal Credit Rating Scales 43
2. 2. 2 Rating Scales and Observed Bond Market Credit Spreads 64
2. 2. 3 Market-Implied Cardinal Rating Scales and Default Probabilities 72
2. 3 The Interpretation of Credit Ratings 74
2. 3. 1 Interpreting from the Scale 75
2. 3. 2 Correctly Interpreting versus Misinterpreting Ratings 78
2. 3. 3 Special Issues 85
2. 4 Credit Ratings: Summary and Conclusions 88
3 The Raison d'Etre of Credit Ratings and their Market 89
3. 1 Needs for Credit Ratings - or the Demand Side of Ratings 89
3. 1. 1 Principals: Issuers/Borrowers 91
3. 1. 2 Principals: Fixed Income Investors 99
3. 1. 3 Prescribers 104
3. 2 Credit Ratings as a Solution to Information Asymmetry: Economic Analysis 111
3. 2. 1 Economics of Ratings: Intuition 111
3. 2. 2 Economics of Ratings: Analysis 113
3. 2. 3 The Economic Analysis of Ratings: Summary and Implications 124
3. 3 Credit Rating Segments - or Scale and Scope of the Rated Universe 126
3. 3. 1 Industry Segments or Type of Rated Issuers 126
3. 3. 2 Product Segments or Types of Rated Issues 138
3. 3. 3 Geographical Segments or Location of the Obligor 149
3. 4 Summary 158
3. 5 Technical Appendix 158
4 How to Obtain and Maintain a Credit Rating 161
4. 1 The Rating Preparation 161
4. 1. 1 The Issuer Client 163
4. 1. 2 The Rating Adviser-Intermediary 165
4. 1. 3 The Credit Rating Agency Supplier 168
4. 2 The Rating 170
4. 2. 1 The Rating Action 170
4. 2. 2 Rating Follow-Up 174
4. 2. 3 The Rating Agreement 179
4. 3 Quality of the Rating Process 187
4. 3. 1 Objectivity 188
4. 3. 2 Diligence 189
4. 3. 3 Transparency 191
Part B Credit Rating Analysis 195
5 The France Telecom Credit Rating Cycle: 1995-2004 197
5. 1 From Sovereign Status to Near Speculative Grade (1995-2002) 198
5. 1. 1 How Sovereign Aaa Status of June 1995 Adjusts to Corporate Aa1 in July 1996 198
5. 1. 2 A Company that went Public on Aa1 Status in October 1997 is Downgraded to Aa2 in December 1999 200
5. 1. 3 Rapid Extension of FT's Reach and Two Notches Downgrade to A1 in September 2000 202
5. 1. 4 A Wake-up Call: the Orange IPO and Surprise Two Notches Downgrade to A3 in February 2001 211
5. 1. 5 The Slide Downward to Baa1 in September 2001 219
5. 1. 6 Looming Crisis and Two Notches Downgrade to Baa3 in June 2002 222
5. 2 Turning Point and Rating Recovery (Fall 2002-Winter 2004) 229
5. 2. 1 Improvement in Outlook in September 2002 229
5. 2. 2 A New Start in October 2002 and Recovery Actions 238
5. 2. 3 Recovery Implementation and the Sequence of Rating Upgrades through February 2005 244
5. 3 Analysis and Evaluation 247
5. 3. 1 Risk Shifting at France Telecom and its Fundamental and MarketImplied Ratings 248
5. 3. 2 The Restraint of the CRAs during the 2002 Crisis 253
5. 3. 3 The Value of Ratings to Issuers 254
6 Credit Rating Analysis 257
6. 1 Fundamental Corporate Credit Ratings 257
6. 1. 1 Corporate Credit Risk2 257
6. 1. 2 Credit Risk of Corporate Debt Instruments 260
6. 1. 3 Putting it All Together: the Rating8 265
6. 2 Corporate Ratings Implied by Market Data 274
6. 2. 1 The Concept 274
6. 2. 2 Mechanics of Extracting Default Probabilities from Market Prices21 276
6. 2. 3 Market-Implied Ratings 284
6. 3 Special Sector Ratings 286
6. 3. 1 Sovereign Ratings 286
6. 3. 2 Financial Strength Ratings 291
6. 3. 3 Structured Finance Instruments Ratings 296
6. 4 Technical Appendix 304
6. 4. 1 Step 1: Computing the Implied Market Value of Assets and Asset Volatility 305
6. 4. 2 Step 2: Computing the Distance to Default 305
6. 4. 3 Step 3: Calculating the Default Probability Corresponding to the Distance to Default 306
7 Credit Rating Performance 307
7. 1 Relevance: Ratings and Value 307
7. 1. 1 Structural Relevance: Rating and Credit Spreads 310
7. 1. 2 Impact Relevance: Rating Actions and Security Price Changes 325
7. 1. 3 Evaluation: How Relevant are Fundamental Credit Ratings? 331
7. 2 Preventing Surprise in Defaults: Rating Accuracy and Stability 332
7. 2. 1 Metrics of Accuracy and Stability 334
7. 2. 2 Analysis of the Prevention of Surprise in Defaults 353
7. 2. 3 Summary, Evaluation and Conclusion 356
7. 3 Efficiency Enhancement: Stabilization in Times of Crisis? 356
7. 3. 1 The Asian Macroeconomic Financial Crisis 356
7. 3. 2 The Western Microeconomic Equity Crisis 363
7. 3. 3 The Subprime Mortgage Related Crisis 364
7. 3. 4 Criticisms: the Ratings in Crisis? 369
Part C The Credit Rating Business 371
8 The Credit Rating Industry 375
8. 1 The Rise of the Credit Rating Agencies 375
8. 1. 1 Origins 375
8. 1. 2 Macroeconomic Forces Shaping the Current Industry 378
8. 1. 3 The Current Structure of the Industry 384
8. 2 Industry Specifics and How They Affect Competition 407
8. 2. 1 Agencies Compete for the Market rather than in the Market 407
8. 2. 2 The Business Model and Profit Drivers 411
8. 2. 3 Some Dynamic Aspects of Competition among CRAs: A Small Number of Players can be Consistent with Intense Rivalry 418
8. 3 Industry Performance 419
8. 3. 1 Performance for CRA Shareholders 419
8. 3. 2 Performance of Ratings as a Public Good 420
8. 3. 3 Performance for Issuers 427
8. 3. 4 Performance for Investors 427
8. 4 Conclusion 428
9 Regulatory Oversight of the Credit Rating Industry 429
9. 1 The Regulatory Uses of Ratings 430
9. 1. 1 Prudence 435
9. 1. 2 Market Access 436
9. 1. 3 Investor Protection 439
9. 2 The Regulation of the Industry 440
9. 2. 1 The Regulatory Options 440
9. 2. 2 Worldwide Regulatory Initiative: the 2004 IOSCO Code of Conduct 443
9. 2. 3 The 2005 European Union Policy on Credit Rating Agencies 444
9. 2. 4 The US 'Credit Rating Agency Reform Act of 2006' 448
9. 3 Analysis and Evaluation 455
9. 3. 1 The EU and the US Approaches Compared 455
9. 3. 2 The Positions of the Main Stakeholders 461
9. 3. 3 Comments and Evaluation on Regulatory Options 466
10 Summary and Conclusions 469
10. 1 The Challenges Facing Rating Agencies Today 469
10. 1. 1 From Regulatory Legitimacy to Market Legitimacy 469
10. 1. 2 Financial Innovation 472
10. 1. 3 Growth and Globalization 473
10. 2 Conclusion 473
References 475
Index 495