By elmads

Introduction

Three friends of yours went to you and asked for financial help. All are in dire need of capital, each asking for $2,000. Sadly, you can only help one. Where would you base your own judgement as to who you would give your money to? Clearly, your primary question would be: who is the most trustworthy on their word to pay you back their owed money to you on the promised date?

But where would you base that trustworthiness? There are a lot of ways to do this, but think of it as a bank loaning money to an individual. Their financial behaviour, including how they manage their money, their financial earnings power, and where they’ll be using the money, to name a few.

Now bring this same idea to a global view. A nation borrows money from the international capital debt market. Who then determines the creditworthiness and the ability of a certain country to repay its debts to its debtors?

How It Started – The Credit Rating Agency

Railroads are one of the astounding creations of the 19th century. It was a byproduct of the industrial revolution, but others claim that it was the reason why the industrial revolution occurred. Regardless of one’s point of view, whether it was a byproduct or the causality of the said revolution, it was still one of the greatest inventions in human history.

It brought faster transportation of both goods and people; cities were connected; productions became faster; and factories and machines were efficiently built. It brought economic prosperity to the countries that participated in the industrial revolution, such as the United Kingdom and the United States of America.

With the booming 19th-century US economy, several railway businesses were built, and investors wanted to take part in them. Several people wanted to be a part of it; some invested in publicly listed railroad companies, while others, who were more financially risk-averse, only participated in taking the bonds offered by the railroad companies.

📣https://elmads.com/?p=1337 – Bonds Asset Class: Making Money From Debt Of Others
📣https://elmads.com/?p=11948 – Investing in Iron Horses: Railway Mania’s Wealth and Woes

But before individuals took the bonds offered by these railroad companies, they needed to know, with certainty, which business would be able to repay their loans with interest.

This is where the credit rating agency was created. They are an assessor of a company’s or a government’s creditworthiness.

The Core Business Model

1️⃣ Issuer Pay for Ratings — For a government or a company to be able to borrow money, they need someone who will be willing to lend them money. Yet, what would give individuals confidence to lend their money to a borrowing entity? Enter the credit rating agency.

For companies and governments to have a full subscription on their bonds—for people to lend them money—they would need the credit rating agency to assess the level of their creditworthiness as a badge of their trustworthiness to repay their debts to their lenders.

Here, companies and governments pay credit rating agencies to review their credit risk and, in turn, assign a credit rating.

📝NOTE: The Big 3 credit rating agencies are Moody’s, S&P Global, and Fitch. The three of them base the credit worthiness of a company based on letters. See the image below.

2️⃣ Investors Purchase Ratings — Investors use credit ratings as a means to assess the creditworthiness of a bond. Some investors, usually institutions, pay credit rating agencies to access their reports or ask them to assess the creditworthiness of a certain entity.

In summary, credit rating agencies do the research and analysis of the creditworthiness of an institution or government. They sell the research they create to interested investors, while they also get paid for giving a corresponding credit rating to a government or institution that wants to borrow money.

Other Revenue Sources

1️⃣ Fees for other services — Credit rating agencies may offer other services, such as risk management solutions, data analytics, and research reports. They charge fees for these additional services.

2️⃣ Structured Finance Products — Credit rating agencies may be involved in rating complex financial products, including mortgage-backed securities and collateralized debt obligations. They earn fees for providing ratings on these structured finance products.

3️⃣ Subscription Services — Some credit rating agencies offer subscription services to financial professionals and institutions, providing ongoing access to credit ratings and research.

4️⃣ Regulatory Designations — In certain cases, regulatory bodies may designate specific credit rating agencies for regulatory purposes. These agencies may receive compensation related to their regulatory role.

The Dark Side of The Credit Ratings Industry

1️⃣ Issuer Pay for rating revenue stream — the government or company pays the rating agency to evaluate their debt; this can affect the objectivity of the rating. At the end of the day, the evaluator is a person who works for a rating agency.

2️⃣ Oligopolies — currently, Moody’s and Standard & Poor’s have both a 40% market share, while Fitch’s has a 15% market share; the rest of the 5% are for other smaller rating agencies.

3️⃣ Legal Basis — If countries, governments, and corporations would like to borrow money internationally, then they are sometimes required by law to have a credit rating to assess their creditworthiness. The level of credit rating dictates the credit risk they possess.

4️⃣ Opinion — Ratings agencies are not held liable for their research and analysis as it is only considered a legal opinion.

5️⃣ Fortune telling — All analyses will always have inaccuracies, biases, and unpredictable factors that can derail the initial ratings given.

6️⃣ Lagging indicator — ratings given to a country are based on previous data analysed and not in real time. Most data, specifically on a national to global scale, is always a few months, if not years, behind the real-time information.

7️⃣ Structured Finance Products — Ratings agencies can give a wrong credit rating for several reasons, such as conflict of interest and being overwhelmed by the complexity of the financial product. This happened a few years before the 2008 financial crisis with mortgage-backed securities.

The Mortgage-Backed Securities

Having our own place that we can call home has always been everyone’s dream. It is to own a property and a piece of land in our own name, to start a family, and to build memories within the comfort of our own home.

Yet, the hurdle to purchasing our own house is its price. Most homes today are worth more than five times an average person’s gross income. To bridge the gap between the massive amount of money needed to purchase a home and our earnings power, we must take on a mortgage from financial institutions, commonly banks.

📝Note: A mortgage is the debt taken by a person to purchase a property. an agreement between you and a lender that gives the lender the right to take your property if you fail to repay the money you’ve borrowed plus interest.

“Debt is one person’s liability, but another person’s asset.”

—Paul Krugman

All securitized debts in the world are one man’s liability and another man’s asset. What people know about most debt is that the banks own the debt contract, which is true initially, but what most individuals don’t know is that banks sell those debt contracts to investors with fees included so that they could make more money than just receiving the interest payments from their debtors.

Banks securitized debts. This is done by pooling their debt assets and repackaging them into a portfolio, which they will sell to investors.

In the years leading up to 2007, banks securitized mortgages called mortgage-backed securities (MBS). These MBS were sold to investors who were looking for a higher return than government bonds during that time and still had stable cash flow. We’re talking about homes where people who get approved to take on a mortgage undergo a thorough credit check from banks (meaning they’re deemed to have the capacity to pay their mortgage).

Everything went so well that the demand for mortgage-backed securities increased, and more investors wanted to own them due to their higher yield than government bonds with a stable cash flow. Yet, most responsible individuals have mortgages already.

Due to the increase in demand for MBS, mortgage brokers and lenders eased their mortgage approval screening. They approved mortgages even for irresponsible individuals. No down payment and no proof of income required. WTF, isn’t it? Hahaha! This is the root problem that caused the 2007 housing crisis in the US.

Just to keep up with the demand from investors for MBS, and to make more money via fees, mortgage brokers and lenders gave mortgages to subprime individuals.

📝Note: Subprime borrowers are considered to represent a higher risk to lenders. They typically have low credit scores and negative information in their credit reports.

The idea behind this was that even if the borrowers’ default on their repayments, the bank will still be able to get the home—which was increasing in price as time went by—and sell it. a win-win situation.

But that didn’t happen. Due to the large number of subprime home borrowers, a lot of them eventually defaulted, and the stream of income in the mortgage-backed securities owned by investors dried up. No money was coming in anymore, and the banks that received the homes from individuals who defaulted started selling them.

It was a vicious cycle because there were a lot of homes being sold at a rapid pace due to continuous defaults, so the home prices, which were considered to go up forever, started to decline. No one wanted to buy the homes anymore, and the responsible homeowners started to question themselves about why they were still repaying their debts when home prices were falling at a rapid pace.

Just think of it like this: why would you continue paying your $300,000 mortgage when the home prices in your neighbourhood are now worth $100,000? Some responsible homeowners who still had a mortgage and had the capacity to pay the monthly mortgage payments stopped paying because of the absurdity of it.

In the investor’s point of view. The one who owned the mortgage-backed securities. They were pissed because they were holding a worthless piece of paper (mortgage backed security), which, by the way, had a AAA credit rating.

This is where the credit rating industry was heavily scrutinised during the global financial crisis. A rating agency should be able to assess the credit risk of a financial product, which they failed to do.

Some credit rating agencies at that time took part in creating this repackaged MBS, which puts them in the spotlight because it was impossible for them to not know somehow what was happening. People criticised them and deemed that they were greedy; they only prioritised profits above all else and did not uphold their mandate of properly assessing credit worthiness and risk.

Some credit agencies claim that the mortgage-backed securities were too complex for them to properly see all the individuals ‘debts in the packaged portfolio, while others just had a conflict of interest as they took part in making the MBS.

The Credit Rating Industry Post 2007-2008 Financial Crisis

A few years following the 2007-2008 financial crisis, regulatory reforms were made to prevent such economic and financial turmoil from repeating again. The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in 2010, included provisions related to credit rating agencies. Here are some key aspects:

1. Office of Credit Ratings (OCR): Dodd-Frank established the Office of Credit Ratings (OCR) within the U.S. Securities and Exchange Commission (SEC). The OCR oversees registered credit rating agencies, monitors their activities, and ensures compliance with securities laws.
2. Regulatory Oversight: Credit rating agencies are now subject to increased regulatory oversight by the SEC. The goal is to enhance the integrity of the credit rating process and reduce the risk of conflicts of interest.
3. Nationally Recognised Statistical Rating Organisations (NRSROs): The term “Nationally Recognised Statistical Rating Organisation” is used for credit rating agencies that meet specific criteria outlined by the SEC. The Dodd-Frank Act reinforced the SEC’s authority over NRSROs.
4. Prohibition on Certain Practices: Dodd-Frank includes provisions to address conflicts of interest and potential market abuses. For example, it prohibits certain practices that could compromise the independence and objectivity of credit ratings.
5. Annual Examinations: Credit rating agencies registered with the SEC are subject to regular examinations by the OCR to evaluate their compliance with the law.
6. Enhanced Disclosures: The Act requires credit rating agencies to disclose additional information about their rating methodologies, potential conflicts of interest, and the performance of their ratings.
7. SEC’s Rule 17g-5: This rule enables the SEC to access information about the underlying assets of asset-backed securities, allowing for a more thorough evaluation of the rating process.

While these regulatory measures aim to address some of the issues associated with credit rating agencies, opinions differ on their effectiveness. The regulatory landscape continues to evolve, and there are ongoing discussions about potential further reforms to enhance the functioning and accountability of credit rating agencies.

Since the financial crisis, credit rating companies have recovered from their failures and come back stronger than they were before. With the help of these reforms, the rating agencies evolved over time and further enhanced their financial analysis, research and credit rating efficiency.

To Sum It Up

The railroads of the 19th century, considered both a byproduct and a cause of the industrial revolution, were pivotal for economic prosperity. As the US economy thrived, numerous railway businesses emerged, attracting investors. Many opted for bonds issued by these companies, a form of debt security. This surge in investment gave rise to the need for credit rating agencies to assess the creditworthiness of these businesses, ensuring investors could make informed decisions about loan repayment with interest.

Credit rating agencies, including Moody’s, S&P Global, and Fitch (the big 3), operate under two primary models. In the “Issuer Pay” model, companies and governments pay these agencies to assess their creditworthiness, earning a credit rating that enhances their ability to attract lenders. In the “Investors Purchase Ratings” model, investors, particularly institutions, pay credit rating agencies for access to their research and assessments of various entities’ creditworthiness.

As with any other industry, this one is not perfect and has been heavily criticised due to its past incompetency, just as with the banking industry during the 2007–2008 financial crisis. New laws, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, were made to oversee and regulate the industry to reduce the risk of a similar crisis occurring again. A crisis that was born from greed.

Today, the credit rating industry continues to thrive thanks to rising debts.

As per the International Monetary Fund (IMF), global debt stands at approximately $235 trillion. See the chart below.

https://www.imf.org/en/Blogs/Articles/2023/09/13/global-debt-is-returning-to-its-rising-trend

For a country and businesses to be able to borrow money and for an investor to lend their money, they would need some kind of basis of creditworthiness. This is where the credit rating agencies enter the picture. For every debt that has a credit rating in the market, there is revenue for the credit rating agency industry.

The dominance of the credit rating industry and its significance boil down to this.

As long as there is debt and the continuous increase of it in all facets of our world—personal debt, mortgages, car loans, municipal debt, corporate debt, government debt, national debt, and global debt—this industry is here to stay and will continue to dominate for decades and centuries to come.

Knowledge is my Sword and Patience is my Shield,

Evan Louise Madriñan / elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.