The Rating Agencies and Their Credit Ratings What They Are, How They Work, and Why They are Relevant

by Langohr, Herwig; Langohr, Patricia

• ISBN13: 9780470018002
• ISBN10: 0470018003
• Edition: 1st
• Format: Hardcover
• Copyright: 2009-03-02
• Publisher: Wiley

Summary

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

Author Biography

The rating agencies and their credit 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, and member of the SIFMA Rating Agency Task Force

“The Langhors 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

Table of Contents

Foreword	p. ix
Preface	p. xiii
Introduction	p. 1
Context and Premises	p. 1
The Benchmarking of Default Prospects Remains Deeply Rooted in Business Analysis	p. 1
Credit Ratings Play a Unique Role in Overcoming Information Asymmetries on the Information Exchanges	p. 9
Under the Spotlight as Unique Infomediaries, the CRAs became Strictly Regulated	p. 13
Book Chapters	p. 17
Supporting Materials	p. 18
Credit Rating Foundations	p. 21
Credit Ratings	p. 23
The World of Corporate Defaults	p. 24
What are Corporate Defaults	p. 27
The Drivers of Corporate Defaults	p. 35
Recovery Rates from Defaults	p. 39
Credit Rating Scales	p. 40
Fundamental Ordinal Credit Rating Scales	p. 43
Rating Scales and Observed Bond Market Credit Spreads	p. 64
Market-Implied Cardinal Rating Scales and Default Probabilities	p. 72
The Interpretation of Credit Ratings	p. 74
Interpreting from the Scale	p. 75
Correctly Interpreting versus Misinterpreting Ratings	p. 78
Special Issues	p. 85
Credit Ratings: Summary and Conclusions	p. 88
The Raison d'Etre of Credit Ratings and their Market	p. 89
Needs for Credit Ratings - or the Demand Side of Ratings	p. 89
Principals: Issuers/Borrowers	p. 91
Principals: Fixed Income Investors	p. 99
Prescribers	p. 104
Credit Ratings as a Solution to Information Asymmetry: Economic Analysis	p. 111
Economics of Ratings: Intuition	p. 111
Economics of Ratings: Analysis	p. 113
The Economic Analysis of Ratings: Summary and Implications	p. 124
Credit Rating Segments - or Scale and Scope of the Rated Universe	p. 126
Industry Segments or Type of Rated Issuers	p. 126
Product Segments or Types of Rated Issues	p. 138
Geographical Segments or Location of the Obligor	p. 149
Summary	p. 158
Technical Appendix	p. 158
How to Obtain and Maintain a Credit Rating	p. 161
The Rating Preparation	p. 161
The Issuer Client	p. 163
The Rating Adviser-Intermediary	p. 165
The Credit Rating Agency Supplier	p. 168
The Rating	p. 170
The Rating Action	p. 170
Rating Follow-Up	p. 174
The Rating Agreement	p. 179
Quality of the Rating Process	p. 187
Objectivity	p. 188
Diligence	p. 189
Transparency	p. 191
Credit Rating Analysis	p. 195
The France Telecom Credit Rating Cycle: 1995-2004	p. 197
From Sovereign Status to Near Speculative Grade (1995-2002)	p. 198
How Sovereign Aaa Status of June 1995 Adjusts to Corporate Aa1 in July 1996	p. 198
A Company that went Public on Aa1 Status in October 1997 is Downgraded to Aa2 in December 1999	p. 200
Rapid Extension of FT's Reach and Two Notches Downgrade to A1 in September 2000	p. 202
A Wake-up Call: the Orange IPO and Surprise Two Notches Down-grade to A3 in February 2001	p. 211
The Slide Downward to Baa1 in September 2001	p. 219
Looming Crisis and Two Notches Downgrade to Baa3 in June 2002	p. 222
Turning Point and Rating Recovery (Fall 2002-Winter 2004)	p. 229
Improvement in Outlook in September 2002	p. 229
A New Start in October 2002 and Recovery Actions	p. 238
Recovery Implementation and the Sequence of Rating Upgrades through February 2005	p. 244
Analysis and Evaluation	p. 247
Risk Shifting at France Telecom and its Fundamental and Market-Implied Ratings	p. 248
The Restraint of the CRAs during the 2002 Crisis	p. 253
The Value of Ratings to Issuers	p. 254
Credit Rating Analysis	p. 257
Fundamental Corporate Credit Ratings	p. 257
Corporate Credit Risk2	p. 257
Credit Risk of Corporate Debt Instruments	p. 260
Putting it All Together: the Rating8	p. 265
Corporate Ratings Implied by Market Data	p. 274
The Concept	p. 274
Mechanics of Extracting Default Probabilities from Market Prices21	p. 276
Market-Implied Ratings	p. 284
Special Sector Ratings	p. 286
Sovereign Ratings	p. 286
Financial Strength Ratings	p. 291
Structured Finance Instruments Ratings	p. 296
Technical Appendix	p. 304
Step 1: Computing the Implied Market Value of Assets and Asset Volatility	p. 305
Step 2: Computing the Distance to Default	p. 305
Step 3: Calculating the Default Probability Corresponding to the Distance to Default	p. 306
Credit Rating Performance	p. 307
Relevance: Ratings and Value	p. 307
Structural Relevance: Rating and Credit Spreads	p. 310
Impact Relevance: Rating Actions and Security Price Changes	p. 325
Evaluation: How Relevant are Fundamental Credit Ratings?	p. 331
Preventing Surprise in Defaults: Rating Accuracy and Stability	p. 332
Metrics of Accuracy and Stability	p. 334
Analysis of the Prevention of Surprise in Defaults	p. 353
Summary, Evaluation and Conclusion	p. 356
Efficiency Enhancement: Stabilization in Times of Crisis?	p. 356
The Asian Macroeconomic Financial Crisis	p. 356
The Western Microeconomic Equity Crisis	p. 363
The Subprime Mortgage Related Crisis	p. 364
Criticisms: the Ratings in Crisis?	p. 369
The Credit Rating Business	p. 373
The Credit Rating Industry	p. 375
The Rise of the Credit Rating Agencies	p. 375
Origins	p. 375
Macroeconomic Forces Shaping the Current Industry	p. 378
The Current Structure of the Industry	p. 384
Industry Specifics and How They Affect Competition	p. 407
Agencies Compete for the Market rather than in the Market	p. 407
The Business Model and Profit Drivers	p. 411
Some Dynamic Aspects of Competition among CRAs: A Small Number of Players can be Consistent with Intense Rivalry	p. 418
Industry Performance	p. 419
Performance for CRA Shareholders	p. 419
Performance of Ratings as a Public Good	p. 420
Performance for Issuers	p. 427
Performance for Investors	p. 427
Conclusion	p. 428
Regulatory Oversight of the Credit Rating Industry	p. 429
The Regulatory Uses of Ratings	p. 430
Prudence	p. 435
Market Access	p. 436
Investor Protection	p. 439
The Regulation of the Industry	p. 440
The Regulatory Options	p. 440
Worldwide Regulatory Initiative: the 2004 IOSCO Code of Conduct	p. 443
The 2005 European Union Policy on Credit Rating Agencies	p. 444
The US 'Credit Rating Agency Reform Act of 2006'	p. 448
Analysis and Evaluation	p. 455
The EU and the US Approaches Compared	p. 455
The Positions of the Main Stakeholders	p. 461
Comments and Evaluation on Regulatory Options	p. 466
Summary and Conclusions	p. 469
The Challenges Facing Rating Agencies Today	p. 469
From Regulatory Legitimacy to Market Legitimacy	p. 469
Financial Innovation	p. 472
Growth and Globalization	p. 473
Conclusion	p. 473
References	p. 475
Index	p. 495
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