What are 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- because they present the lowest risk of default and are considered the “safest” option to see a return on an initial investment.

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

Learn more about Metro Bank stock price

The role of rating agencies in the financial crisis

Many market commentators agree that rating agencies contributed to the 2008 financial crisis. The Big Three wrongly classified various “junk” loans and mortgages – known as subprime – as quality investment rating AAA, AA, A or BBB. These loans proved worthless after the bursting of the US housing bubble, which triggered the ensuing financial crisis.

To explain this properly, we would have to look at what exactly happened to cause the financial crisis of 2008. As early as 1999, banks began selling an increasing number of subprime mortgages to their customers. Any loan classified as subprime is usually sold to consumers with low credit ratings 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 identified that they can bundle these sub-prime mortgages into a single security called a mortgage-backed security (MBS). These proved popular with investors and the market was very profitable 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. Firstly, this is because they were backed by credit default swaps, which is a form of insurance for the lender of a loan in the event of default by the borrower and non-repayment of the lender.

Second, if a rating agency did not assign a high rating, banks or companies could simply turn to their competitors for the rating they wanted. Banks and corporations believed the risk of default was extremely low because people simply weren’t defaulting on their mortgages.

However, many of these subprime mortgages were adjustable rate mortgages (ARMs). Interest rates on ARMs start small – making the mortgage initially attractive to buyers – before steadily increasing over time. For this reason, many borrowers did not fully understand the terms of the loans they were taking out and they began to default as interest rates rose.

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

It is claimed that if rating agencies had not given high ratings to mortgage-backed securities at the height of the financial crisis, there would never have been a market for them, and banks or corporations would have had difficult to sell them to investors.

By giving these mortgage-backed securities investment grade ratings, rating agencies gave them their stamp of approval, leading market participants to believe that they were not open to excessive levels of credit risk. In fact, these mortgage-backed securities were deceptively risky.

Investors who spotted the unsustainable growth and made bets against the US housing market managed to cash in heavily. This came at the expense of American consumers who defaulted on their mortgage obligations and lost their homes.

Who regulates credit rating agencies?

Regulation was tightened on credit rating agencies following the 2008 financial crisis. This was particularly notable in the United States with the introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was adopted in 2010.

The legislation created requirements in an effort to prevent any bank from becoming too big to fail, as well as review Federal Reserve (Fed) bank bailouts and monitor 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 geographical area. For example, the Securities and Exchange Commission (SEC) is responsible for regulating credit rating agencies based in the United States.

Credit rating agencies summarized

  • Credit rating agencies provide an assessment of implied credit risk for companies, stocks, government, corporate or municipal bonds, mortgage-backed securities and secured debt securities
  • There are three main 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 indicate similar information.
  • Many believe that credit rating agencies were partly responsible for the financial crash of 2008 by incorrectly assigning low-risk ratings to mortgages and high-risk loans.
  • Following the crash, credit rating agencies have come under increased scrutiny and the agency responsible for oversight varies by geographic location.

Footnotes

1 S&P Global Ratings, 2019

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