Credit rating agencies have a lot of influence on the value of assets held by ordinary investors – yet, for many, they are not household names.
When credit rating agency Standard & Poor’s – or S&P as it is sometimes known – downgraded its assessment of Greek government debt a sharp fall in financial markets followed. In technical terms, it lowered its rating from BBB to BB+, a level that is known to investors as “speculative grade” or “junk”.
What’s in a rating?
Credit rating agencies assign ratings to countries and financial companies that issue debt. They also rate financial products. The ratings refer to the likelihood of a “default” – or the chance the country, company or product will not meet their legal obligations (such as meeting scheduled payments). It is not a measure of how much investors stand to lose if a default happens. The strongest rating is a “triple-A” (AAA or Aaa), while anything below BBB- (also known as Baa3) is deemed below investment grade or “junk”. In total, there are 22 grades.
Credit where it’s due
The largest credit rating agencies are Moody’s, S&P and Fitch. According to one estimate there are as many as 72 credit rating agencies. Credit rating agencies argue the ratings make markets more efficient. They say they ultimately lower borrowing costs for financially sound institutions by providing investors with an indication of the relative risk of default between different countries, companies and products. Organisations with a “junk” rating will likely find it harder to borrow money and pay higher interest rates when they do take a loan.
Ratings war: who is rating the ratings agencies?
Credit rating agencies have come under fire for their performance in recent crises. After the failure of Enron in 2001, they were blamed for being too slow to cut their ratings. Moreover, critics reportedly say a conflict of interest arises because some credit rating agencies are paid by the organisations that they rate. In particular, credit ratings agencies were condemned for giving triple-A ratings to structured financial products (such as those based on mortgage debts) that ended up failing and contributing to the 2008 global financial crisis.
Downgraded wealth ratings can have a spin off for individuals
Although credit rating agencies do not rate individuals, their actions can affect households’ financial wealth. A lower rating can lead to a fall in a company’s share price, for example, or shift an entire stock market index. At a country-by-country level, a downgrade of a country’s sovereign debt can result in higher interest rates on state borrowing. This, in turn, can be passed on to households in the form of higher costs for mortgages and other loans. The lesson for countries, businesses and individuals is to not take on more debt than can be repaid in good conditions – or if there is an unexpected change in circumstances.
Clarity Economics’ lead consultant