A lot has been said about the role Credit Rating Agencies they have played in recent crises. Even more questions are being asked by the public about the nature of these agencies. In this article we will take a closer look at these and explore some of the pros and cons of these agencies.
What are Credit Rating Agencies?
Credit Rating Agencies are companies (usually private) that determine and assign ratings for companies and other entities issuing debt. The credit rating is a reflection of the entity's credit worthiness, i.e. the ability of the entity to pay back a loan obligation. The credit rating in turn affects the cost of borrowing for the entity (the interest rate at which the entity can borrow). For the non-financially inclined, in a capitalistic society the economy operates on trust. One buys a good from the other at a price they mutually agree on. How would one know if the good they were holding was worth how much they felt it was? So if we were to assume the good here is a bond issued by Company A, the credit rating agency would then study the financial statements of the company to gauge the health. They would look at certain key ratios that give some insight into whether the company (or government entity) will be able to easily meet its debt obligations. Does it have enough cash to meet its short term obligations, what is its debt to asset, debt to equity and debt to book value ratio? There are other ways as well but that is not within the scope of this article.
Similarly credit rating agencies assign ratings for debt issuing foreign countries. For many that are not too familiar with finance, hearing headlines like "S&P lowers US credit rating to AA+" can sound like a foreign language. These ratings range from Triple A to C. Just like companies, government entities are also judged on growth and the ability to pay its debt obligations.
The impact of a credit downgrade
After the financial crisis of 2008, the United States was one of the few countries able to borrow at record low interest rates. Many economists feel that this ability will be threatened by a credit downgrade. Normally this would be true. When a country is faced with a downgrade, its borrowing costs rise. While it might not be so obvious with countries in the upper echelons of the scale, as you go further down towards Junk territory the impact of the credit downgrade is severe. A good example would be Greece and Germany. Both countries are members of the European Union (they share the same currency), yet the cost of borrowing for the Greek government is many times that of the German government.
After the recent credit downgrade to AA+ (Double A plus), while the markets nosedived, there was still enough appetite for US debt. This is not normal. The reason for that has more to do with general pessimism about the state of the global economy and the continuing sovereign debt crisis in Europe.
Does a credit downgrade really matter?
In a word, YES. This is especially true if an entity goes into "junk" territory. In today's financial markets, almost everything is automated. Trades are increasingly triggered based on external variables (example: sell Stock at certain price to protect from large losses). Many institutional investors will not invest in debt that is rated "junk", flooding the market with cheap, unwanted debt which further worsens the problem for the entity by raising interest rates further.
The role of credit rating agencies in the financial crisis of 2008
Credit rating agencies such as Moody's and the Standard and Poor's (Fitch is the other one that makes up the Big Three) were severely criticized for failing to take appropriate action when they had knowledge of problems in the US mortgage market as early as 2006. It was this lack of action that led to a later (mid 2007) mass downgrade of mortgage backed securities and other collateralized debt obligations (CDOs). This mass downgrade is what many economists believe was the trigger for the financial crisis.
What are Credit Rating Agencies?
Credit Rating Agencies are companies (usually private) that determine and assign ratings for companies and other entities issuing debt. The credit rating is a reflection of the entity's credit worthiness, i.e. the ability of the entity to pay back a loan obligation. The credit rating in turn affects the cost of borrowing for the entity (the interest rate at which the entity can borrow). For the non-financially inclined, in a capitalistic society the economy operates on trust. One buys a good from the other at a price they mutually agree on. How would one know if the good they were holding was worth how much they felt it was? So if we were to assume the good here is a bond issued by Company A, the credit rating agency would then study the financial statements of the company to gauge the health. They would look at certain key ratios that give some insight into whether the company (or government entity) will be able to easily meet its debt obligations. Does it have enough cash to meet its short term obligations, what is its debt to asset, debt to equity and debt to book value ratio? There are other ways as well but that is not within the scope of this article.
Similarly credit rating agencies assign ratings for debt issuing foreign countries. For many that are not too familiar with finance, hearing headlines like "S&P lowers US credit rating to AA+" can sound like a foreign language. These ratings range from Triple A to C. Just like companies, government entities are also judged on growth and the ability to pay its debt obligations.
The impact of a credit downgrade
After the financial crisis of 2008, the United States was one of the few countries able to borrow at record low interest rates. Many economists feel that this ability will be threatened by a credit downgrade. Normally this would be true. When a country is faced with a downgrade, its borrowing costs rise. While it might not be so obvious with countries in the upper echelons of the scale, as you go further down towards Junk territory the impact of the credit downgrade is severe. A good example would be Greece and Germany. Both countries are members of the European Union (they share the same currency), yet the cost of borrowing for the Greek government is many times that of the German government.
After the recent credit downgrade to AA+ (Double A plus), while the markets nosedived, there was still enough appetite for US debt. This is not normal. The reason for that has more to do with general pessimism about the state of the global economy and the continuing sovereign debt crisis in Europe.
Does a credit downgrade really matter?
In a word, YES. This is especially true if an entity goes into "junk" territory. In today's financial markets, almost everything is automated. Trades are increasingly triggered based on external variables (example: sell Stock at certain price to protect from large losses). Many institutional investors will not invest in debt that is rated "junk", flooding the market with cheap, unwanted debt which further worsens the problem for the entity by raising interest rates further.
The role of credit rating agencies in the financial crisis of 2008
Credit rating agencies such as Moody's and the Standard and Poor's (Fitch is the other one that makes up the Big Three) were severely criticized for failing to take appropriate action when they had knowledge of problems in the US mortgage market as early as 2006. It was this lack of action that led to a later (mid 2007) mass downgrade of mortgage backed securities and other collateralized debt obligations (CDOs). This mass downgrade is what many economists believe was the trigger for the financial crisis.
No comments:
Post a Comment