Question

Why is there a need for three Financial Accounting Ratings Agencies? Are these agencies measuring the same

attributes? If not, what are the critical differences between these agencies? please elaborate

Answer 1

A rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts. The rating assigned to a given debt shows an agency’s level of confidence that the borrower will honor its debt obligations as agreed. Each agency uses unique letter-based scores to indicate if a debt has a low or high default risk and the financial stability of its issuer. The debt issuers may be sovereign nations, local and state governments, special purpose institutions, companies, or non-profit organizations.

The Big Three credit rating agencies are Standard & Poor's (S&P), Moody's, and Fitch Group. S&P and Moody's are based in the US, while Fitch is dual-headquartered in New York City and London, and is controlled by Hearst.

Role of Rating Agencies in Capital Markets: Rating agencies assess the credit risk of specific debt securities and the borrowing entities. In the bond market, a rating agency provides an independent evaluation of the creditworthiness of debt securities issued by governments and corporations. Large bond issuers receive ratings from one or two of the big three rating agencies. In the United States, the agencies are held responsible for losses resulting from inaccurate and false ratings.

The ratings are used in structured financial transactions such as asset-backed securities, mortgage-backed securities, and collateralized debt obligations. Rating agencies focus on the type of pool underlying the security and the proposed capital structure to rate structured financial products. The issuers of the structured products pay rating agencies to not only rate them, but also to advise them on how to structure the tranches.

Rating agencies also give ratings to sovereign borrowers, who are the largest borrowers in most financial markets. Sovereign borrowers include national governments, state governments, municipalities, and other sovereign-supported institutions. The sovereign ratings given by a rating agency shows a sovereign’s ability to repay its debt.

The ratings help governments from emerging and developing countries to issue bonds to domestic and international investors. Governments sell bonds to obtain financing from other governments and Bretton Woods institutions such as the World Bank and the International Monetary Fund.

1. Fitch: The Fitch Publishing Company was founded in 1913 by John Knowles Fitch, a 33-year-old entrepreneur who had just taken over his father’s printing business. Fitch had a unique goal for his company: to publish financial statistics on stocks and bonds.
   
   Fitch expanded the services of his business by creating a system for rating debt instruments based on the company’s ability to repay their obligations. Although Fitch’s rating system of grading debt instruments became the standard for other credit rating agencies, Fitch is now the smallest of the “big three” firms.
   
2. Standard and Poor (S&P): Henry Varnum Poor was a financial analyst with a similar vision to John Knowles Fitch. Like Fitch, Poor was interested in publishing financial statistics, which inspired him to create H.V. and H.W. Poor Company. Luther Lee Blake was another financial analyst interested in becoming a financial publisher. In order to achieve this dream, Blake founded Standard Statistics in 1906, just a year after Poor’s death. Standard Statistics and H.V. and H.W. Poor published very similar information. Hence, it made sense for the two companies to consolidate their assets, and they merged in 1941 to form the Standard and Poor’s Corporation
   Today, Standard and Poor’s not only provides ratings but also offers other financial services, such as investment research, to investors. They are now the largest of the “big three” rating agencies.
   
3. Moody’s: John Moody founded the financial holding company, Moody’s Corporation, in 1909. Although Moody’s provides a number of services, one of their largest divisions is Moody’s Investor Services. While Moody’s has conducted credit ratings since 1914, they only conducted ratings of government bonds until 1970. Moody’s has grown significantly over the years. Presently, Moody’s is the second largest of the “big three” firms.

Difference between S&P and Moody’s:

An S&P rating seeks to measure only the probability of default. Nothing else matters — not the time that the issuer is likely to remain in default, not the expected way in which the default will be resolved. Most importantly, S&P simply does not care what the recovery value is — the amount of money that investors end up with after the issuer has defaulted. Moody’s, by contrast, is interested not in default probability per se, but rather expected losses. Default probability is part of the total expected loss — but then you have to also take into account what is likely to happen, when a default occurs.

The difference, as it applies to the US sovereign credit rating, is enormous. No one doubts America’s ability to pay its debts, and if the US should ever find itself in a position, where it is forced by law to default on a bond payment, that default is certain to be only temporary. Bondholders would get all of their money, in full, within a couple of weeks, and probably within a few days.

If Moody’s were to downgrade the US, then, that would indeed be an implicit suggestion that investors rotate out of Treasury bonds and into safer credits like, um, France and the UK. Which is a silly idea. But S&P isn’t Moody’s, and so I think that Levey is wrong to say that S&P is making that suggestion.

Similarly, Nate Silver has a long post on “why S&P’s ratings are substandard and porous” which starts with the point of view of “an investor looking for guidance on which country’s debt was the safest to invest in.” That is something you (purportedly) get from Moody’s; it’s not what you’re getting from S&P.

1. In the full sample, the average rating for Fitch IBCA is considerably higher than the average rating for Moody’s and S&P. In the 3-rater sample, the average rating for Fitch IBCA is only marginally higher (.3 rating notches) than the other raters. This indicates that firms releasing Fitch IBCA ratings to the public have higher ratings from Moody’s and S&P than firms do without a Fitch IBCA rating. In addition, about 85% of the difference in mean ratings between the full and 3-rater samples is caused by this selection bias. 2. In the 3-rater sample, Fitch IBCA changes its rating less often than Moody’s and S&P. When Fitch IBCA changes ratings, the changes are bigger than the rating changes for the other raters.3. Firms with public Fitch IBCA ratings (and therefore in the 3-rater sample) have more stable Moody’s and S&P ratings than the other full sample firms, more likely upgrades by Moody’s and S&P, and less likely downgrades by Moody’s and S&P.

Moody’s and S&P both maintain a policy of rating most SEC registered, U.S.corporate debt securities, thus ensuring that these issues typically have at least two ratings. These ratings are issued regardless of whether the firm requests a rating. Other rating agencies follow very different policies from Moody’s and S&P in rating debt. For example, Fitch IBCA and Duff & Phelps only rate debt issues upon request from the issuing firm. Both of these agencies charge fees comparable to Moody’s and S&P for their services..