User:Mysidae/Role in capital markets (revised)

Role in capital markets
Credit rating agencies assess the relative credit risk of borrowing entities (issuers of debt), specific debt securities or structured finance instruments. By serving as information intermediaries, credit rating agencies theoretically reduce information costs, increase the pool of potential borrowers and promote liquid markets. These functions may increase the supply of available risk capital in the market and promote economic growth. Some rating agencies rate the creditworthiness of governments and their securities.

Ratings use in bond market
Credit rating agencies provide assessments about the creditworthiness of bonds issued by corporations, governments, and packagers of asset-backed securities. In market practice, a significant bond issuance generally has a rating from one or two of the Big Three agencies. Ratings are not recommendations about buying, selling, or holding a particular security or about the suitability of a particular security for a particular investor. Ratings simply express the agencies' informed opinions about creditworthiness.

To determine a bond's rating, a credit rating agency will analyze the accounts of the issuer and the legal agreements attached to the bond. The resultant credit rating is effectively a forecast reflecting the bond's perceived chance of default, expected loss, or a similar metric. These relative risks are mapped onto discrete rating grades that are usually expressed through some variation of an alphabetical combination of lower and upper case letters. Fitch and S&P use the same ranking designators (from the most creditworthy to the least): AAA, AA, A, and BB for investment-grade long term credit risk, and BB, CCC, CC, C, and D for "speculative" long term credit rask. Moody's long-term designators are: Aaa, Aa, A, Baa for investment grade, and Ba, B, Caa, Ca, and C for speculative grade. Rating agencies often attach modifiers to further distinguish and rank ratings within each of the broader classifications. Fitch and S&P use plusses and minuses (e.g., AA+ and AA-) and Moody's uses numbers (Aa1 and Aa3).

Higher grades are intended to represent a lower probability of default. One study by a rating service (Moody's) claimed that over a "5-year time horizon" bonds it gave its highest rating (Aaa) to had a "cumulative default rate" of just 0.18%, the next highest (Aa2) 0.28%, the next (Baa2) 2.11%, 8.82% for the next (Ba2), and 31.24% for the lowest it studied (B2). Over a longer time horizon it stated "the order is by and large, but not exactly, preserved".

The process for rating a convertible bond is similar, although the assessment criteria is different enough that bonds and convertible bonds issued by the same entity may still receive different ratings. Some bank loans may receive ratings to assist in wider syndication and attract institutional investors.

CRA's typically signal in advance their intention to consider rating changes. Fitch, Moody's and S&P all use negative "outlook" notifications to indicate the potential for a downgrade within the next two years (one year in the case of speculative-grade credits), and negative "watch" notifications to indicate that a downgrade is likely within the next 90 days

Although the three largest credit rating agencies—Standard & Poor's, Moody's Investor Service, and Fitch Ratings—maintain substantial market share within the field, they are not the only sources of credit information. Many smaller rating agencies also exist, mostly serving non-U.S. markets. All of the large securities firms have internal fixed income analysts who offer information about the risk and volatility of securities to their clients. And specialized risk consultants working in a variety of fields offer credit models and default estimates.

At least in the US, rating agencies are not liable for misstatements in securities registration as courts have ruled ratings are opinions protected by the First Amendment. One rating agency disclaimer reads: "The ratings ... are and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities."

Accuracy and responsiveness
Credit rating agencies have been criticized by industry observers and government officials for sometimes issuing inaccurate ratings that fail to properly assess the creditworthiness of corporate bonds and other debt securities, and appear unresponsive to market signals and internal warning signs indicating financial instability. Such criticisms are often aired in the wake of financial disasters or corporate meltdowns which the rating agencies seemingly failed to predict, such as the Asian and Russian financial crises, Enron and WorldCom bankruptcies, and the U.S. subprime mortgage crisis. Credit rating agencies maintain that their ratings are simply opinions about credit risk, not guarantees. Furthermore, bonds assigned a low credit rating by rating agencies have been shown to default more frequently than bonds which receive a high credit rating, suggesting that ratings still serve as a useful indicator of credit risk. However, credit rating agencies do not always detect debt issuers' financial problems, and ratings may thus be inaccurate or based on flawed assumptions.

Several explanations of the rating agencies' inaccurate ratings and forecasts have been offered. First, that the methodologies employed by agencies during the rating process may be inherently flawed. For instance, a 2008 report by the Financial Stability Forum singled out methodological shortcomings—especially inadequate historical data—as a contributing cause to the rating agencies' underestimation of the risk in structured finance products before the subprime mortgage crisis. Second, that a number of issues associated with the agencies' perceived conflict of interest—a consequence of the issuer-pays business model—may result in skewed or misleading ratings. Third, that the rating agencies may be significantly understaffed and thus unable to properly assess every debt instrument. Fourth, that agency analysts may be underpaid relative to similar positions with investment banks and Wall Street firms, resulting in a low retention rate for the most talented analysts. Fifth, that the functional use of ratings as regulatory mechanisms may inflate their reputation for accuracy.

The 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act mandated improvements to the regulation of credit rating agencies, and addressed several issues relating to the accuracy of credit ratings specifically. Under Dodd-Frank rules, agencies must publicly disclose how their ratings have performed over time, and must provide additional information in their analyses so investors can make better decisions. An amendment to the act also specifies that ratings aren’t protected by the First Amendment as free speech or by securities laws that say opinions can’t be wrong, and that rating agencies may be held liable for ratings that the agencies should have known were inaccurate. Implementation of this amendment has proven difficult due to conflict between the SEC and the rating agencies.

In the European Union, there is no specific legislation governing contracts between issuers and credit rating agencies. General rules of contract law apply in full, although holding agencies liable for breach of contract is difficult. In 2012, An Australian federal court held Standard & Poor's liable for inaccurate ratings.

Ratings use in structured finance
Credit rating agencies play a key role in structured financial transactions, a term that may refer to asset-backed securities (ABS), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs), and derivatives.

Credit rating agencies began issuing ratings for mortgage-backed securities in the mid-1970s. In subsequent years, the ratings were applied to other types of asset-backed securities. Issuers of structured finance products embraced these ratings as they allowed investors who are subject to ratings-based constraints to access the securities market. Many investors simply prefer that a structured finance product be rated by a credit rating agency. However, not all structured finance products receive a credit rating agency rating. Ratings for complicated or risky CDOs are unusual and some issuers create structured products relying solely on internal analytics to assess credit risk.

Credit ratings for structured finance instruments may be distinguished from ratings for other debt securities in several important ways. First, the rating of such securities may involve back and forth interaction and analysis between the sponsor of the trust that issues the security and the rating agency. During this process, the sponsor may submit proposed structures to the agency for analysis and feedback until the sponsor believes the targeted rating can be achieved for different tranches—subsegments of bundled investments with similar underlying risks. The agency may also express opinions regarding the types of assets that could secure the debt and obtain the desired credit ratings.

Second, credit rating agencies employ varying methodologies to rate structured finance products, but generally focus on the type of pool of financial assets underlying the security and the proposed capital structure of the trust. This approach often involves a quantitative assessment in accordance with mathematical models, and may thus introduce a degree of model risk. However, bank models of risk assessment have proven less reliable than credit rating agency models, even in the base of large banks with sophisticated risk management procedures.

Third, the payment "waterfall" created by tranching is contractually complex, even in transactions with only a few tranches. Tranches are often likened to buckets capturing cascading water, where the water of monthly or quarterly repayment flows down to the next bucket (tranche) only if the one above has been filled with its full share and is overflowing. The higher up the bucket in the income stream the higher the credit ratings and lower its interest payment. Making accurate repayment prognoses is thus more difficult than in the case of other debt ratings.

Subprime mortgage crisis
Credit rating agencies were criticized for understating the risk involved with particular structured finance products after the 2006-2008 subprime mortgage crisis. Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors. More generally, the failure of rating agencies to correctly predict structured debt defaults has raised questions as to whether the rating system for such securities is fundamentally flawed because of its perceived lack of due diligence and misapplication of rating methodologies. In the wake of the global financial crisis, various legal requirements were introduced to increase the transparency of structured finance ratings. The European Union now requires credit rating agencies to use an additional symbol with ratings for structured finance instruments in order to distinguish them from other rating categories.

Conflict of interest
Conflict of interest issues in structured finance rating are distinct, reflecting differences in both the market structure and the investors' demand for rating coverage. Issuers of structured finance products often need to secure a high rating for their offerings in order to market them to investors subject to ratings-based constraints, such as pension funds and life insurance companies. A small number of arrangers of structured finance products—primarily investment banks—drive a large amount of business to the ratings agencies, and thus have a much greater potential to exert undue influence on a rating agency than a single corporate debt issuer.

A 2013 Swiss Finance Institute study of structured debt ratings from Standard & Poor's, Moody's Investors Service, and Fitch Ratings found that agencies provide better ratings for the structured products of issuers that provide them with more overall bilateral rating business. This effect was found to be particularly pronounced in the run-up to the subprime mortgage crisis. Alternative accounts of the agencies' inaccurate ratings before the crisis downplay the conflict of interest factor and focus instead on the agencies' overconfidence in rating securities, which stemmed from faith in their methodologies and past successes with subprime securitizations.

Ratings use in sovereign debt
Credit rating agencies also issue credit ratings for sovereign borrowers, including national governments, states, municipalities, and sovereign-supported international entities. Sovereign borrowers are the largest debt borrowers in many financial markets. Governments from both advanced economies and emerging markets borrow money by issuing government bonds and selling them to private investors, either overseas or domestically. Governments from emerging and developing markets may also choose to borrow from other governments and international organizations, such as the World Bank and the International Monetary Fund.

Sovereign credit ratings represent an assessment by a rating agency of a sovereign's ability and willingness to repay its debt. The rating methodologies used to asses sovereign credit ratings are broadly similar to those used for corporate credit ratings, although the borrower's willingness to repay receives extra emphasis since national governments may be eligible for debt immunity under international law, thus complicating repayment obligations. In addition, credit assessments reflect not only the long-term perceived default risk, but also short or immediate term political and economic developments. Differences in sovereign ratings between agencies may reflect varying qualitative evaluations of the investment environment.

National governments may solicit credit ratings to generate investor interest and improve access to the international capital markets. Developing countries often depend on strong sovereign credit ratings to access funding in international bond markets. Once ratings for a sovereign have been initiated, the rating agency will continue to monitor for relevant developments and adjust its credit opinion accordingly.

A 2010 International Monetary Fund study concluded that ratings were a reasonably good indicator of sovereign-default risk. However, credit rating agencies were criticized for failing to predict the 1997 Asian financial crisis and for downgrading countries in the midst of that turmoil. Similar criticisms emerged after recent credit downgrades to Greece, Ireland, Portugal, and Spain, although credit ratings agencies had begun to downgrade peripheral Eurozone countries well before the Eurozone crisis began.

Information services
By providing credit opinions about securities, credit rating agencies effectively reduce information asymmetries between the issuers of securities (borrowers of funds) and the investors (lenders of funds) regarding the creditworthiness of the borrower. Issuers of debt are often more informed about the factors that determine credit quality than investors. CRAs provide investors with an independent evaluation and assessment of the ability of issuers to meet their debt obligations in a timely manner.

The major CRAs maintain surveillance of their outstanding ratings on an ongoing basis. Consequently, ratings have been used as a monitoring tool of debt security by some existing and potential debt holders. The surveillance process may involve the same assessment techniques and metrics used in the determination of the initial rating, but with updated figures about the issuer’s operations and general macroeconomic forecasts. When the agencies issue a rating, they may also provide additional forward-looking information. For example, some rating agencies may also provide rating outlooks, which indicate the potential direction of issuers' credit risks over the intermediate term, typically six months to two years. An outlook may be positive, meaning that the issuer's credit profile may be improving and therefore the rating may be raised; negative, meaning that an issuer's credit profile may be deteriorating and therefore the rating may be lowered; neutral, indicating a neutral outlook; or developing, meaning that the issuer's credit is in flux, and therefore a rating may be raised or lowered depending on how the facts and circumstances develop.

CRA ratings have also been used in a "certification" role, whereby ratings are used to distinguish between securities with different risk characteristics for regulatory purposes, set investment guidelines and eligibility standards for securities used as collateral or investment, and act as a credit-quality threshold in financial contracts more generally.

Government regulators
Regulatory authorities and legislative bodies in the United States and other jurisdictions rely on credit rating agencies' assessments of a broad range of debt issuers, and thereby attach a regulatory function to their ratings. This regulatory role is a derivative function in that the agencies do not publish ratings for that purpose. Governing bodies at both the national and international level have woven credit ratings into minimum capital requirements for banks, allowable investment alternatives for many institutional investors, and similar restrictive regulations for insurance companies and other financial market participants. The use of credit ratings by regulatory agencies is not a new phenomenon. In the 1930s, regulators in the United States used credit rating agency ratings to prohibit banks from investing in bonds that were deemed to be below investment grade. In the following decades, state regulators outlined a similar role for agency ratings in restricting insurance company investments. From 1975 to 2006, the U.S. Securities and Exchange Commission (SEC) recognized the largest and most credible agencies as Nationally Recognized Statistical Rating Organizations, and relied on such agencies exclusively for distinguishing between grades of creditworthiness in various regulations under federal securities laws. The Credit Rating Agency Reform Act of 2006 created a voluntary registration system for CRAs that met a certain minimum criteria, and provided the SEC with broader oversight authority.

The practice of using credit rating agency ratings for regulatory purposes has since expanded globally. Today, financial market regulations in many countries contain extensive references to ratings. The Basel III accord, a global bank capital standardization effort, relies on credit ratings to calculate minimum capital standards and minimum liquidity ratios.

The use of agency ratings for regulatory purposes is a common subject of criticism, as is the relationship between regulators and rating agencies. Observers note that the extensive use of credit ratings for regulatory purposes can have a number of unintended effects, including dramatic market price fluctuations and possible systemic reactions. Critics note that high ratings give investors a false sense of security, particularly in complex structured finance instruments. Finally, it is argued that regulation of rating agencies by the Securities and Exchange Commission and Federal Reserve Bank eliminates competition between the agencies, and reinforces an oligopolistic market structure.

Some academics and industry observers have proposed eliminating the SEC's designation of some rating agencies as Nationally Recognized Statistical Rating Organizations (NRSROs), while others favor ending regulatory dependence on credit ratings entirely. The primary objection to such proposals is that CRA ratings are perceived to be an important component of the financial market regulatory regime. Supporters of alternative policy approaches note that the withdrawal of NRSRO designation and similar reforms would not mean an "anything goes" attitude towards the safety of bonds. Credit spreads and credit default swaps have been suggested as market-based regulatory alternatives to CRA ratings. Because credit spreads are determined by the market as a whole, a credit-spread based system would not necessitate regulatory licenses for third-party agencies.

In response to the subprime mortgage crisis, legislators in many jurisdictions have begun reducing rating reliance in laws and regulations. The 2010 Dodd–Frank Act mandates United States federal agencies remove statutory references to credit rating agencies and replace them with appropriate alternatives for evaluating creditworthiness. Proposed alternatives have included market indicators such as stock price volatility for some assets, and fiscal health country profiles produced by the Organisation for Economic Co-operation and Development for sovereign debt ratings. The Basel III accord retains references to credit ratings with regard to minimum capital standards and minimum liquidity ratios for banks.