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How do Credit Rating Agencies Work?

how do credit rating agencies work

What is a Credit Rating?

A Credit Rating is a score given to a borrower which is an expression of credit risk. that is, the likelihood that the borrower will repay a loan. If the borrower is a healthy business making a lot of profit there is a high likelihood that the lender will get back his principal & the agreed-upon interest. If the borrower is a "junk" company, the lender has less likelihood of getting his money back with interest (higher probability that the borrower will default ). The credit rating look like grades you get in school (A, A+, B-, etc.).

The ratings range from AAA* to D (fail grade). In the international bond markets, most countries and businesses are rated this way. Here are the "grades" of Eurozone countries:

Who does this rating?

There are dedicated companies that perform this credit rating. In theory, in anyone could start their own credit rating agency (think of it like a movie review website), but in practice only the top agencies are recognized for legal purposes (the U.S. Securities and Exchange Commission confers the legal status " Nationally Recognized Statistical Ratings Organization " (NRSRO) on credit rating agencies that the regulators have determined provide accurate enough ratings to enable a legal requirement that certain lenders (e.g. commercial banks, pension funds) not lend to debtors who are determined by the rating agencies to not be of "investment grade"). In the USA, there are these top 3: Standard & Poor's , Moody's Investors Service and Fitch Ratings . S&P traces its origin to 1860, among the oldest financial companies around.

These companies have been around for more than a century and have built a reputation for a fair*/trustworthy* rankings of the borrower.

How do they rate a company/nation?

When it comes to countries, S&P has a 5-8 member team that analyzes the following things:

  1. Political Risk . If the country is in turmoil, it has a less chance of repaying anything.
  2. Regulatory risk. If

    they are enacting really stupid and foolish rules that shoots them in the foot.

  3. External risk. Is there are threat of war or trade sanctions?
  4. Fiscal risk. Is the government borrowing too much and spends way over?
  5. Economic risk. Is the productivity of the country slowing down and the GDP growth coming down? If economy is in turmoil, the government can tax people less.

When it comes to businesses and non-profits, they see the following:

  1. The quality of the assets. Are there new buildings and other assets that are worthy enough that the lender could take as collateral if borrower fails to repay.
  2. Quality of the management team. Are they led by smart, visionary people who can run an organization?
  • Quality of the business. Is it profit making? Are the sales growing? Are there are major market risks?
  • Financial Balance Sheet. How much have they already borrowed? Can they service this much debt? What is their existing monthly payment to the loan?
  • When my business school was rated, rating agencies looked for GMAT scores of average applicants, newness of the buildings, etc. because these are the things that matter to the success of the business school.

    Why does the rating matter?

    Credit ratings signify how risky a borrower is. The worse the rating, the harder it is to get a loan anywhere. Even when you get the loans, it will be at a lot higher interest rate. For instance, if you are rated AAA you could borrow at 2-3% annual interest rate. However, if you are rated C ("junk" grade) you have to pay more than 10% on interest rate.

    Let us take the case of India. India has $350 billion in external debt ministr. At 2% interest, we will pay an annual interest of $7 billion (Rs.35000 Crores). At 10% interest, we will pay an interest of $35 billion (Rs.175,000 Crores). [1 Crore = 100 million Indian rupees].

    Category: Credit

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