What are credit rating agencies and how do they work?

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With Fitch, market participants can choose to buy or invest in securities rated AAA to BBB- as they have the lowest risk of default and are considered the “safest” option to obtain a initial return on investment.

Fitch’s speculative ratings could point to potentially higher returns, but the risk of default is much greater. For example, in October 2019, Fitch Ratings downgraded Metro Bank’s (MTRO) credit rating to BB from BB + after the bank misclassified loans in January 2019 and canceled a 7.5% bond offering. end of September 2019. This downgrade of Fitch shows that Metro Bank was considered to have a slightly higher risk of default following the failure of its high yield bond offering.

Find out more about the Metro Bank share price

The role of credit rating agencies in the financial crisis

Many market commentators agree that credit rating agencies contributed to the 2008 financial crisis. The Big Three misclassified various “junk” loans and mortgages – known as subprime – as AAA, AA, A or BBB investment. These loans turned out to be worthless after the US housing bubble burst, which triggered the ensuing financial crisis.

To explain this correctly, we need to look at what exactly happened to cause the 2008 financial crisis. As early as 1999, banks started selling an increasing number of subprime mortgages to their customers. Any loan classified as subprime is typically sold to consumers with poor credit scores or below average savings. As a result, there is an inherently high risk of default with subprime loans.

However, many banks and financial institutions have indicated that they can consolidate these subprime mortgages into a single title called a mortgage backed security (MBS). These proved popular with investors and the market was very profitable as long as house prices continued to rise and homeowners continued to make their mortgage payments on time.

Many mortgage-backed securities have been rated BBB or better. First, it was because they were backed by credit default swaps, which are a form of insurance for the lender of a loan in the event that the borrower defaults and does not repay the lender.

Second, if a rating agency did not give a high rating, banks or companies could simply go to their competition to get the rating they want. Banks and businesses thought the risk of default was extremely low because people just weren’t defaulting on their mortgages.

However, many of these subprime mortgages were Variable Rate Mortgages (ARMs). Interest rates on ARMs start small – which makes mortgage lending initially attractive to buyers – before rising steadily over time. Because of this, many borrowers did not fully understand the terms of the loans they were taking and began to default as interest rates rose.

As people started to default on their mortgages, the housing bubble started to burst and the entire market for mortgage-backed securities and credit default swaps collapsed with it.

It is argued that if credit rating agencies had not given mortgage-backed securities high marks in the midst of the financial crisis, there would never have been a market for them, and banks or businesses would have struggled to sell them to investors.

By assigning these mortgage-backed securities investment grade ratings, the rating agencies affixed them their seal of approval, leading market participants to believe that they were not exposed to levels. excessive credit risk. In fact, these mortgage backed securities were deceptively risky.

Investors who spotted unsustainable growth and made bets against the US real estate market managed to cash in heavily. This was to the detriment of American consumers who defaulted on their mortgage payments and lost their homes.

Who regulates credit rating agencies?

Regulations regarding credit rating agencies were tightened following the 2008 financial crisis. This was particularly noticeable in the United States with the introduction of the Dodd-Frank law on Wall Street reform and protection. of Consumers, which was adopted in 2010.

The legislation created requirements in an attempt to prevent any bank from getting too big to fail, as well as reviewing Federal Reserve (Fed) bank bailouts and monitoring high-risk derivatives. He also created a number of new oversight agencies within the US and global financial system, in the hope that increased oversight in the US would help prevent a repeat of the 2008 financial crisis.

Credit rating agencies are regulated by different bodies depending on the geographic area. For example, the Securities and Exchange Commission (SEC) is responsible for regulating credit rating agencies based in the United States.

For Europe, the European Securities and Markets Authority (ESMA) regulates credit rating agencies; in the UK this role will be taken over by the Financial Conduct Authority (FAC) once the UK leaves the EU. In its regulatory capacity, ESMA aims to ensure “the integrity, accountability, good governance and independence of credit rating activities in order to ensure quality ratings and high levels of investor confidence. “.2

Rating agencies summarize

  • Rating agencies provide an assessment of implicit credit risk for companies, stocks, government, corporate or municipal bonds, mortgage-backed securities and secured debt securities
  • There are three main credit rating agencies, known as the Big Three: Moody’s, Standard and Poor’s and Fitch Ratings.
  • Standard and Poor’s and Fitch Ratings use the same rating scale and modifiers, while Moody’s uses slightly different modifiers to denote similar information.
  • Many believe that the credit rating agencies were partly responsible for the 2008 financial crash by wrongly assigning low risk ratings to mortgages and high risk loans.
  • In the aftermath of the crash, credit rating agencies have come under increased scrutiny, and the agency responsible for oversight varies depending on geographic location.

Footnotes

1 S&P Global Ratings, 2019
2 ESMA, 2019

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