INSEAD Library

Includes bibliographical references and index

Credit rating agencies play a critical role in capital markets, guiding the asset allocation of institutional investors as private capital moves freely around the world in search of the best trade-off between risk and return. However, they have also been strongly criticised for failing to spot the Asian crisis in the early 1990s, the Enron, WorldCom and Parmalat collapses in the early 2000s and finally for their ratings of subprime-related structured finance instruments and their role in the current financial crisis. This book is a guide to ratings, the ratings industry and the mechanics and economics of obtaining a rating. It sheds light on the role that the agencies play in the international financial markets. It avoids the sensationalist approach often associated with studies of rating scandals and the financial crisis, and instead provides an objective and critical analysis of the business of ratings. The book will be of practical use to any individual who has to deal with ratings and the ratings industry in their day-to-day job.

Digitized

The Rating Agencies and their Credit Ratings What They Are, How They Work and Why They Are Relevant Contents Foreword Preface 1 Introduction 1.1 Context and Premises 1.1.1 The Benchmarking of Default Prospects Remains Deeply Rooted in Business Analysis 1.1.2 Credit Ratings Play a Unique Role in Overcoming Information Asymmetries on the Information Exchanges 1.1.3 Under the Spotlight as Unique Infomediaries, the CRAs became Strictly Regulated 1.2 Book Chapters 1.3 Supporting Materials PART A CREDIT RATING FOUNDATIONS 2 Credit Ratings 2.1 The World of Corporate Defaults 2.1.1 What are Corporate Defaults? 2.1.2 The Drivers of Corporate Defaults 2.1.3 Recovery Rates from Defaults 2.2 Credit Rating Scales 2.2.1 Fundamental Ordinal Credit Rating Scales 2.2.2 Rating Scales and Observed Bond Market Credit Spreads 2.2.3 Market-Implied Cardinal Rating Scales and Default Probabilities 2.3 The Interpretation of Credit Ratings 2.3.1 Interpreting from the Scale 2.3.2 Correctly Interpreting versus Misinterpreting Ratings 2.3.3 Special Issues 2.4 Credit Ratings: Summary and Conclusions 3 The Raison d'Être of Credit Ratings and their Market 3.1 Needs for Credit Ratings ­ or the Demand Side of Ratings ix xiii 1 1 1 9 13 17 18 21 23 24 27 35 39 40 43 64 72 74 75 78 85 88 89 89 3.1.1 Principals: Issuers/Borrowers 3.1.2 Principals: Fixed Income Investors 3.1.3 Prescribers 3.2 Credit Ratings as a Solution to Information Asymmetry: Economic Analysis 3.2.1 Economics of Ratings: Intuition 3.2.2 Economics of Ratings: Analysis 3.2.3 The Economic Analysis of Ratings: Summary and Implications 3.3 Credit Rating Segments -- or Scale and Scope of the Rated Universe 3.3.1 Industry Segments or Type of Rated Issuers 3.3.2 Product Segments or Types of Rated Issues 3.3.3 Geographical Segments or Location of the Obligor 3.4 Summary 3.5 Technical Appendix 4 How to Obtain and Maintain a Credit Rating 4.1 The Rating Preparation 4.1.1 The Issuer Client , 4.1.2 The Rating Adviser-Intermediary 4.1.3 The Credit Rating Agency Supplier 4.2 The Rating 4.2.1 The Rating Action 4.2.2 Rating Follow-Up 4.2.3 The Rating Agreement 4.3 Quality of the Rating Process 4.3.1 Objectivity 4.3.2 Diligence 4.3.3 Transparency PART B CREDIT RATING ANALYSIS 5 The France Telecom Credit Rating Cycle: 1995-2004 5.1 From Sovereign Status to Near Speculative Grade (1995-2002) 5.1.1 How Sovereign Aaa Status of June 1995 Adjusts to Corporate Aal in July 1996 5.1.2 A Company that went Public on Aal Status in October 1997 is Downgraded to Aa2 in December 1999 5.1.3 Rapid Extension of FT's Reach and Two Notches Downgrade to Al in September 2000 5.1.4 A Wake-up Call: the Orange IPO and Surprise Two Notches Downgrade to A3 in February 2001 5.1.5 The Slide Downward to Baal in September 2001 5.1.6 Looming Crisis and Two Notches Downgrade to Baa3 in June 2002 5.2 Turning Point and Rating Recovery (Fall 2002--Winter 2004) 5.2.1 Improvement in Outlook in September 2002 5.2.2 A New Start in October 2002 and Recovery Actions 91 99 104 111 111 113 124 126 126 138 149 158 158 161 161 163 165 168 170 170 174 179 187 188 189 191 195 197 198 198 200 202 211 219 222 229 229 238 5.2.3 Recovery Implementation and the Sequence of Rating Upgrades through February 2005 5.3 Analysis and Evaluation 5.3.1 Risk Shifting at France Telecom and its Fundamental and MarketImplied Ratings 5.3.2 The Restraint of the CRAs during the 2002 Crisis 5.3.3 The Value of Ratings to Issuers 6 Credit Rating Analysis 6.1 Fundamental Corporate Credit Ratings 6.1.1 Corporate Credit Risk 2 6.1.2 Credit Risk of Corporate Debt Instruments 6.1.3 Putting it All Together: the Ratings 8 6.2 Corporate Ratings Implied by Market Data 6.2.1 The Concept 6.2.2 Mechanics of Extracting Default Probabilities from Market Prices 21 6.2.3 Market-Implied Ratings 6.3 Special Sector Ratings 6.3.1 Sovereign Ratings 6.3Q Financial Strength Ratings 6.3.3 Structured Finance Instruments Ratings 6.4 Technical Appendix 6.4.1 Step 1: Computing the Implied Market Value of Assets and Asset Volatility 6.4.2 Step 2: Computing the Distance to Default 6.4.3 Step 3: Calculating the Default Probability Corresponding to the Distance to Default 7 Credit Rating Performance 7.1 Relevance: Ratings and Value 7.1.1 Structural Relevance: Rating and Credit Spreads 7.1.2 Impact Relevance: Rating Actions and Security Price Changes 7.1.3 Evaluation: How Relevant are Fundamental Credit Ratings? 7.2 Preventing Surprise in Defaults: Rating Accuracy and Stability 7.2.1 Metrics of Accuracy and Stability 7.2.2 Analysis of the Prevention of Surprise in Defaults 7.2.3 Summary, Evaluation and Conclusion 7.3 Efficiency Enhancement: Stabilization in Times of Crisis? 7.3.1 The Asian Macroeconomic Financial Crisis 7.3.2 The Western Microeconomic Equity Crisis 7.3.3 The Subprime Mortgage Related Crisis 7.3.4 Criticisms: the Ratings in Crisis? PART C THE CREDIT RATING BUSINESS 8 The Credit Rating Industry 8.1 The Rise of the Credit Rating Agencies 244 247 248 253 254 257 257 257 260 265 274 274 276 284 286 286 291 296 304 305 305 306 307 307 310 325 331 332 334 353 356 356 356 363 364 369 373 375 375 8.1.1 Origins 8.1.2 Macroeconomic Forces Shaping the Current Industry 8.1.3 The Current Structure of the Industry 8.2 Industry Specifics and How They Affect Competition 8.2.1 Agencies Compete for the Market rather than in the Market 8.2.2 The Business Model and Profit Drivers 8.2.3 Some Dynamic Aspects of Competition among CRAs: A Small Number of Players can be Consistent with Intense Rivalry 8.3 Industry Performance 8.3.1 Performance for CRA Shareholders 8.3.2 Performance of Ratings as a Public Good 8.3.3 Performance for Issuers 8.3.4 Performance for Investors 8.4 Conclusion 9 Regulatory Oversight of the Credit Rating Industry 9.1 The Regulatory Uses of Ratings 9.1.1 Prudence 9.1.2 Market Access 9.1.3 Investor Protection 9.2 The Regulation of the Industry 9.2.1 The Regulatory Options 9.2.2 Worldwide Regulatory Initiative: the 2004 IOSCO Code of Conduct 9.2.3 The 2005 European Union Policy on Credit Rating Agencies 9.2.4 The US 'Credit Rating Agency Reform Act of 2006' 9.3 Analysis and Evaluation 9.3.1 The EU and the US Approaches Compared 9.3.2 The Positions of the Main Stakeholders 9.3.3 Comments and Evaluation on Regulatory Options 10 Summary and Conclusions 10.1 The Challenges Facing Rating Agencies Today 10.1.1 From Regulatory Legitimacy to Market Legitimacy 10.1.2 Financial Innovation 10.1.3 Growth and Globalization 10.2 Conclusion References Index 375 378 384 407 407 411 418 419 419 420 427 427 428 429 430 435 436 439 440 440 443 444 448 455 455 461 466 469 469 469 472 473 473 475 495