Credit Ratings

A credit rating is an assessment of the creditworthiness of a debt issuer or a specific debt obligation, together with any additional security attached to it. The rating represents an opinion on the ability and willingness of an obligor to deliver payments due to investors. This opinion usually has a form of a letter-based rating, which corresponds to a certain relative (not absolute) probability of default. The rating is often accompanied by an extensive commentary.

Credit ratings can be assigned to countries, municipalities, various types of organizations, or particular debt issues. Sovereign ratings assess the credit risk of national governments and depend on both political and economic factors. These ratings serve as a benchmark for the ratings of other issuers who operate within the same sovereign jurisdiction and represent a so-called ceiling—normally the ratings of other issuers in the same country cannot be higher than the sovereign rating.

Ratings are assigned by specialized organizations—credit rating agencies. There exist many of them worldwide (roughly 130 to 150 as of 2000), and they vary in terms of size, geographical and industry focus, and the methodology that they employ. However, [Page 435]most of these agencies are rather small, and the field is dominated by two major players: Moody's Investors Service Inc. (Moody's) and Standard & Poor's (S&P). The large credit agencies play an important role in capital markets. First, they provide valuation by disseminating timely and supposedly valuable information to the market participants. Second, they indirectly participate in financial regulation: In some countries letter ratings are viewed as useful credit quality benchmarks, and capital requirements are directly linked to credit ratings. For example, the quasi-regulatory role of the major credit agencies has been increased by the Basel II Framework.

There are two main types of ratings: solicited and unsolicited. A solicited rating means that a company itself expressed a wish to be rated and asked an agency to issue it a rating, usually for a fee. An unsolicited rating implies that it was an agency's own decision to rate a company. In the case of unsolicited ratings, an agency usually has to rely on publicly available information only to come up with an assessment. The rationale for the practice of assigning unsolicited ratings is that it discourages a self-selection process in which only low-risk issuers are rated and all others avoid obtaining a credit rating by not requesting it. Rating agencies also use unsolicited ratings to establish their reputation or expand their business into new markets. When a rating is solicited, an agency relies not only on public information, but also makes extensive use of internal data such as company documents, interviews with the company's executives, etc.

There are several reasons why issuers are interested in acquiring a credit rating. The main one is the access to capital markets—in some countries, having a rating is a de-facto prerequisite. Other reasons include building up market reputation, lowering the cost of funding (an unrated entity usually has to pay a larger risk premium), and distinguishing oneself from competitors.

The rating processes used by different agencies can vary significantly. Large agencies use both quantitative and qualitative criteria to assess an issuer, whereas smaller agencies tend to focus on quantitative criteria only. The rating process consists of the assessment of various factors. One of them is the environment, which can vary considerably depending on the nature of the entity under assessment. Meetings with the issuer constitute an important part of the rating process. During these meetings, comprehensive in-depth information is collected and any questions that came up in previous phases are clarified. The rating process also often includes the analysis of a peer group (a group of comparable entities).

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