Credit Rating Agencies - Credit and Finance Risk Analysis

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Credit Rating Agencies

SEC Credit Rating Agency Examination Report (July 2008)

House Committee on Oversight & Government Reform: Credit Rating Agencies and the Financial Crisis (October 22, 2008)

On Friday, May 7, 2010, Moody's Investor Service publicly indicated (in the March 31, 2010 10-Q filing, filed May 7, 2010) that the company had received a Wells Notice from the U.S. Securities & Exchange Commission (SEC) on March 18, 2010, which is a public notice from the SEC that it is commencing an investigation and may bring a civil action. The SEC is alleging that the company made "false and misleading" statements submitted as part of an application to register as an NRSRO (Nationally Recognized Statistical Rating Organization) in June 2007. The issue is related to the professional conduct of members of the European committee that rates constant proportion debt obligations (CPDOs) in April 2007. Moody's indicates that a violation in professional conduct by an individual employee does result in the policy or statements to be false and misleading. ir.moodys.com/secfiling.cfm?filingID=1193125-10-113077 (see page 20)

Permanent Subcommittee on Investigations will commence third inquiry into the role of the credit rating agencies, starting April 23, 2010.
http://hsgac.senate.gov/public/index.cfm?FuseAction=Press.MajorityNews&ContentRecord_id=2778a107-5056-8059-7625-aa17151c8b72

On September 17, 2009, the Securities and Exchange Commission voted unanimously to take several rulemaking actions to increase oversight of credit ratings agencies:

Disclosing History of Ratings Activity: The Commission voted to adopt an amendment requiring NRSROs to disclose their history of ratings actions. Such actions include upgrades, downgrades, affirmations and withdrawals. The requirement applies to any rating that the NRSRO initially made as of June 26, 2007. The disclosure, to be made no less than two years after the action is taken for subscriber-paid ratings and no less than one year after for issuer-paid ratings, needs to be made online and in a searchable format.
Ensuring All NRSROs Have Access to Similar Information: Requires that an NRSRO - that is paid by an arranger to rate a structured finance product - to disclose to other NRSROs that it is in the process of determining such a credit rating. The amendment would also require that the NRSRO obtain a representation from the arranger that the arranger will provide the same information to other NRSROs seeking to rate the product.
Reporting on Compliance Reviews: Requires NRSROs to provide the SEC with a report describing their compliance reviews for the most recently ended fiscal year.
Providing More Information on Conflicts of Interest: Requires the NRSRO to indicate the percentage of the NRSRO's net revenue attributable to the 20 largest users of credit rating services of the NRSRO
Providing Additional Information About the Magnitude of Conflicts: requires that the NRSROs to make publicly available information about each person who paid for a credit rating. Under the proposed rule, NRSROs would post on their Web sites a consolidated report at the end of each fiscal year that shows the percent of the net revenue earned by the NRSRO for that fiscal year for providing services and products to that person other than credit rating services, and the relative standing of the person (top 10%, top 25%, top 50%, bottom 50%, or bottom 25%) in terms of the amount of net revenue earned by the NRSRO attributable to that person.
Removing References to NRSRO Credit Ratings in Rules and Forms: The Commission voted to adopt amendments that eliminate references to NRSRO credit ratings in certain SEC rules and forms.

www.sec.gov/news/press/2009/2009-200.htm

On September 2, 2009, U.S. District Judge Shira Scheindl, U.S. District Court, Southern District of New York (Manhattan), entered an opinion (and would not dismiss) with regard to the case of Abu Dhabi Commercial Bank (and King County, Washington, co-plaintiff) v. Morgan Stanley, No. 08-7508. The opinion essentially challenges the previous arguments by Moody’s and McGraw-Hill Cos. (the owner of Standard & Poor’s), that investors may not sue over deceptive ratings of private-placement notes because those opinions are protected by Frist Amendment free speech rights. Without ruling on the actual merits of the lawsuit, the judge indicated that the opinions by the ratings companies may be the basis for a lawsuit "if the speaker does not genuinely and reasonably believe it or if it is without basis in fact." In addition, because the ratings agency did not actually disseminate their opinions on the credit quality of a specific portfolio of structured securities issued by a special investment vehicle (SIV) named Cheyne Finance, and why the securities should have received a AAA rating, to the general public, and rather, provided their opinion to only a specific group of investors ("commercial speech"), the opinions are therefore not covered under the First Amendment guarantee. It is unclear if this is a potential landmark decision related to the operations of the credit rating agencies. It should be noted that the court dismissed 10 of the original 11 claims brought in the initial suit.
U.S. District Court, Southern District of New York, Case No. 08-7508

On December 3, 2008, the Securities and Exchange Commission approved several policies and procedures to increase the transparency and accountability at credit rating agencies, and address potential conflicts of interest.: Requires an NRSRO or NRSRO applicant to provide transition statistics for each asset class of credit ratings for which it is registered or is seeking registration, broken out over 1, 3, and 10 year periods. The amended instructions would clarify that all ratings transitions (i.e., upgrades as well as downgrades) must be included in these statistics as well as that default statistics must show defaults relative to the initial rating and incorporate defaults that occur after a credit rating is withdrawn.; Requires an NRSRO to make publicly available a random sample of 10% of their issuer-paid credit ratings and their histories documented for each class of issuer-paid credit rating for which the NRSRO is registered and has issued 500 or more ratings.; Requires an NRSRO to make and retain records of all rating actions related to a current rating from the initial rating to the current rating. The second new recordkeeping requirement would be implemented by adding a new paragraph (a)(2)(iii) to Rule 17g-2, which would require that if a quantitative model is a substantial component of the credit rating process for a structured finance product, an NRSRO must keep a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued. The third new recordkeeping requirement would be implemented by adding a new paragraph (b)(8) to Rule 17g-2, which would require that an NRSRO retain records of any complaints regarding the performance of a credit analyst in determining, maintaining, monitoring, changing, or withdrawing a credit rating.; Requires an NRSRO to provide the Commission with an annual report of the number of credit rating actions that occurred during the fiscal year for each class of security for which the NRSRO is registered.; Prohibits an NRSRO from issuing a credit rating with respect to an obligor or security where the NRSRO or an affiliate of the NRSRO made recommendations to the obligor or the issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the obligor or issuer of the security.; Prohibits a person within an NRSRO who has responsibility for participating in determining credit ratings or for developing or approving procedures or methodologies used for determining credit ratings from participating in any fee discussions, negotiations, or arrangements.; Prohibits an NRSRO from allowing a credit analyst who participated in determining or monitoring the credit rating to receive gifts, including entertainment, from the obligor being rated or from the issuer, underwriter, or sponsor of the securities being rated, other than items provided in the context of normal business activities, such as meetings, that have an aggregate value of no more than $25.; Requires NRSROs that are hired by arrangers to perform credit ratings for structured finance products to disclose to other NRSROs (and only other NRSROs) the deals for which they were in the process of determining such credit ratings. The arrangers would need to provide the NRSROs they hire to rate structured finance products with a representation that they will provide information given to the hired NRSRO to other NRSROs.

www.sec.gov/news/press/2008/nrsrofactsheet-120308.htm

On June 25, 2008, the Securities & Exchange Commission (SEC) proposed that money market funds be allowed to invest in certain short-term debt at the fund management's discretion and without regard for public ratings assigned by Moody's and Standard & Poor's. The SEC will also be considering whether public ratings issued by Moody's and Standard & Poor's should be utilized in determining tier one capital at investment banks.
www.sec.gov/rules/proposed/2008/ic-28327.pdf (.pdf format)

On June 18, 2007, the Federal Reserve Board stopped using Fitch Investors Service as a credit rating source. Classification as AA or A2/P2 for Commercial Paper rate calculations and classification as Tier-1 or Tier-2 for outstanding calculations are done using Moody's Investors Service and Standard & Poor's.

In the United States, the Securities and Exchange Commission (SEC) designates credit rating agencies under Nationally Recognized Statistical Rating Organization (NRSRO) review. On September 24, 2007, the Securities and Exchange Commission issued orders granting the registrations of seven credit rating agencies as NRSRO. The firms are the first to be registered with the Commission under the Credit Rating Agency Reform Act of 2006. Egan-Jones Rating Company was approved on December 21, 2007. LACE Financial Corp. was registered on February 11, 208. Realpoint LLC was registered on June 23, 2008. The 10 firms registered as NRSROs are:: A.M. Best Company, Inc. (Release No. 34-56507); DBRS Ltd. (Dominion Bond Rating Service Limited) (Release No. 34-56508); Egan-Jones Rating Company (Release No. 34-57031); Fitch, Inc. (Release No. 34-56509); Japan Credit Rating Agency, Ltd. (Release No. 34-56510); LACE Financial Corp. (Release No. 34-57300); Moody’s Investors Service, Inc. (Release No. 34-56511); Rating and Investment Information, Inc. (Release No. 34-56512); Realpoint LLC (Release No. 34-58000); Standard & Poor’s Ratings Services (Release No. 34-56513)

Under the Credit Rating Agency Reform Act, an NRSRO may be registered with respect to up to five classes of credit ratings:: (1) financial institutions, brokers, or dealers; (2) insurance companies; (3) corporate issuers; (4) issuers of asset-backed securities; (5) issuers of government securities, municipal securities, or securities issued by a foreign government

A.M. Best Company, Inc., is registered with respect to the first four classes of credit ratings; the other six firms are registered with respect to all five classes.

These rating agencies review governments (sovereign debt, state and municipal and agencies that issue debt), corporations, various types of banks and financial institutions, and special purpose vehicles or issues / securitizations. The reports and actual credit ratings assigned by these agencies have an affect on how much an entity will pay for debt borrowings and also have an effect on whether certain investors will actually hold the debt of the entity. These rating agencies do not contract with investors or the public to perform this service. Rather, it is the issuing companies and public organizations that pay for credit ratings of themselves. The agencies will also sometimes issue unsolicited ratings although this practice has become somewhat controversial (especially if an unsolicited rating is lower than a seemingly comparable entity that solicited and paid for the rating). The rating agencies are also compensated for making their research available to credit granting financial institutions.

In the past, Moody's, Standard & Poor's, and Fitch rating agencies provided excellent, in-depth reports of various companies, industries and financial vehicles. However, their first problem was that they are in the same position as all professional credit analysts: they do not have the ability to predict the future. In addition, they, along with accountants and regulators, will sometimes also be incapable of determining corporate fraud. Thus, the day after any review is publicly released it is now merely a history lesson and may also provide interesting "what-if" scenarios.

It has been well publicized where the rating agencies have been caught completely off-guard when credit situations developed. In some cases, warnings and downgrades occurred after problems became well publicized. Conversely, after having been burned the agencies can also be conservative in re-evaluating a company that had been downgraded in the past. Overall, Moody's and S&P have indicated similar ratings for the same entities and combined have had a fairly good track record of predicting the repayment probability of the issuers that they have reviewed. However, while the reports from these companies are very helpful they cannot be entirely relied upon as the only due-dilligence or decision-making process that a credit analyst should attempt to complete as past performance is never a guarantee of future performance. Secondly, there are distinctions to be made between issuers that may be awarded similar ratings. Finally, because the rating agencies have separate and different methodologies, it is possible that a potential issuer could shop among the agencies to obtain the most beneficial rating.

The problem that the NRSROs are now encountering is related to the analysis of residential mortgage asset-backed securities and Collateralized Debt Obligations (CDOs). The agencies appear to have inaccurately assigned investment grade ratings to tranches of securities originated in 2005 through 2007, which very quickly deteriorated and were rapidly down-graded to non-investment grade. Unfortunately, for the NRSROs it is a "no win" situation: they either have to admit that they did not entirely understand the structure of the securitization or that certain analysts willfully ignored the real potential risk of the structure.

Credit Agency:	Moody's	S&P	Fitch IBCA
Investment Grade
Best Quality / Extremely Strong / Highest Quality	Aaa	AAA	AAA
High Quality / Very Strong / Very High Quality	Aa	AA	AA
Upper Medium Grade / Strong / High Quality	A	A	A
Medium grade / Adequate / Good Quality	Baa	BBB	BBB
Non-Investment Grade
Lower Medium Grade / Speculative - Less Vulnerable / Speculative	Ba	BB	BB
Low Grade / More Vulnerable / Highly Speculative	B	B	B
Poor Quality / Currently Vulnerable / High Default Risk	Caa	CCC	CCC
Highly Speculative / Currently Highly Vulnerable / High Default Risk	Ca	CC	CC
Extremely Poor / Imminent default / High Default Risk	C	C	C
In Default / Default	C	D	D

Regardless of adverse economic conditions or outright fraud, Moody's and Standard & Poor's did not provide adequate analysis / warning of a credit situation with Parmalat, WorldCom, Inc., Enron Corp., Adelphia, Armstrong World Industries, Long Term Capital Management, and the South Korean financial crisis of the late 1990s, and the collapse of Barings Bank in February 1995. There is also the controversy, as indicated above, related to the subprime mortgage market problems in 2007: Moody's and S&P were the entities that rated many structured CDOs Triple-A and then turned around and downgraded them to "junk" status. The credit rating agencies indicate that there is no recourse to them in the event they fail to properly identify or indicate a credit situation or change in the creditworthiness of an entity (in addition, the credit rating agencies have successfully argued in court cases that their ratings are protected under First Amendment rights). However, the NRSRO credit rating agencies are in a precarious position: if they attempt to "lead" markets then they could be blamed for a crisis related to a rating or ratings change, but if they follow the markets then what relevancy are they providing? Similarly, are they really making a decision about a credit or merely providing just an opinion and the final decision really is up to the credit analyst?

In Korea, the Seoul Credit Rating & Information, Inc., rates Korean commercial paper issuers and asset-backed securities.
www.scri.co.kr/eng/index.jsp

In Bahrain, the Islamic International Rating Agency (IIRA) rates sovereign, credit, corporate and Shari’a issues by the the Islamic financial services industry.
www.iirating.com/

In the People's Republic of China, the Dagong Global Credit Rating Co.,Ltd., rates local issue corporate, financial institution and asset-backed issues.
www.dagongcredit.com/

In Pakistan, the JCR-VIS Credit Rating Co. Ltd. (JCR-VIS), which has been affiliated with Japan Credit Rating Agency for 6 years, rates local banks, mutual funds, corporate, asset-backed securitizations and medium-term and long-term issues
www.jcrvis.com.pk/