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Credit Rating CREDIT RATING AN ANALYSIS OF THE CREDIT RATING AGENCIES ANSHUMAN DUTTA, 1YR DoMS, NITT ROLL NO-215111070 CONTENTS INTRODUCTION--------------------------------------------------------------------------2 ROLE OF CREDIT RATING ON COUNTRIES------------------------------------3 ECONOMIC RESILIENCY--------------------------------------------------------------3 FINANCIAL ROBUSTNESS-------------------------------------------------------------3 STANDARD & POOR---------------------------------------------------------------------5 MOODY’S CORPORATION------------------------------------------------------------7 FITCH-----------------------------------------------------------------------------------------8 USES OF RATING-------------------------------------------------------------------------8 METHODS OF RATING-----------------------------------------------------------------9 RATING USED IN STRUCTURED FINANCE------------------------------------10 CRITICISM------------------------------------------------------------------------------- 10 KEY FACTS ON RATING-------------------------------------------------------------15 CONCLUSION----------------------------------------------------------------------------16 REFERENCE------------------------------------------------------------------------------18 1 INTRODUCTION Credit rating agencies (CRA) are companies that assign credit ratings for issuers of certain types of debt obligations as well as the debt and in certain cases the services of the underlying debt are also provided ratings. The impact of credit rating agencies on financial markets has become one of the most important policy concerns facing the international financial architecture. Ratings indicate a relative credit risk and serve as an important metric by which many investors and regulations measure credit risk. A major problems faced by developing countries is the difficulty in mobilizing funds to increase investment. The level of income is often too low to generate sufficient savings, and the domestic financial system often does a poor job of directing those funds back into domestic capital formation. This makes access to international capital markets an important resource for obtaining funds to raise the level and accelerate the pace of investment and growth. In order to gain access, developing countries must first obtain a favorable rating of their creditworthiness by one or more credit rating agencies. The credit rating represents the credit rating agency's evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. A poor credit rating indicates a credit rating agency's opinion that the company or government has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term economic prospects. The credit score does not take into account future prospects or changed circumstances. HISTORY The use of credit ratings arose in the U.S. out of the desire by the growing investing class to have more information about the many new securities – especially railroad bonds – that were being issued and traded. In the middle of the 19th century, the U.S. railroad industry began expanding 2 across the continent and into undeveloped territories. The industry’s demand for capital exceeded the ability or willingness of banks and direct investors to provide it. In order to reach a broader and deeper capital market, railroads and other corporations began raising new capital through the market for private corporate bonds. Role of credit ratings on countries Countries can issue government bonds denoted in the country’s currency in order to raise capital. Bonds can also be issued in foreign currency, referred to as sovereign bonds. Bonds are often referred to as risk free due to the fact that they are government owned and hence, governments can at any time raise taxes or create extra currency in order to redeem their bonds upon maturity. However, as we have seen recently, the issue of Greece counters this statement. Bonds are rated on various parameters such as: Economic Resiliency The country’s economic strength, captured in particular by the GDP per capita – the single best indicator of economic robustness and, in turn, shock-absorption capacity. Institutional strength of the country, the key question being whether or not the quality of a country’s institutional framework and governance – such as the respect of property right, transparency, the efficiency and predictability of government action, the degree of consensus on the key goals of political action – is conducive to the respect of contracts. Financial Robustness The financial strength of the government. The question is to determine what must be repaid and the ability of the government to mobilize resources: raise taxes, cut spending, sell assets, and obtain foreign currency. The susceptibility to event risk – that is the risk of a direct and immediate threat to debt repayment, and, for countries higher in the rating scale, the risk of a sudden multi-notch downgrade. The issue is to determine whether the debt situation may be (further) endangered by the occurrence of adverse economic, financial or political events. Combining these indicators rating agencies determine degrees of financial robustness and 3 refine the positioning of the country on the rating scale- very high, high, moderate, low or very low. 4 Standard & Poor's Henry Varnum Poor first published the "History of Railroads and Canals in the United States in1860, the forerunner of securities analysis and reporting to be developed over the next century. Standard & Poor’s (S&P) was created in 1941 through the merger with Standard Statistics and Poor’s Publishing. The company provides a wide range of information on financial products and markets. Standard & Poor’s sells investment data, valuations, analysis and opinions. The flagship product is their S&P 500, an index that tracks the high capitalization equity markets in the United States. McGraw-Hill Companies acquired Standard & Poor’s in 1966. In 2001, McGraw Hill Companies had sales of $4.6 billion and income of $377 million. Standard & Poor’s contributed to the total with sales of almost $1.5 billion and operating profit of $435 million. Table 2: Standard and Poor's sovereign ratings methodology profile Poor's sovereign ratings methodology profile Political risk • Stability and legitimacy of political institutions; • Popular participation in political processes; • Orderliness of leadership successions; • Transparency in economic policy decisions and objectives; • Public security; and • Geopolitical risk. Income and economic structure • Prosperity, diversity and degree to which economy is market-oriented; • Income disparities; • Effectiveness of financial sector in intermediating funs availability of credit; • Competitiveness and profitability of non-financial private sector; • Efficiency of public sector; • Protectionism and other non-market influences; and • Labour flexibility. Economic growth prospects • Size and composition of savings and investment; and 5 • Rate and pattern of economic growth. Fiscal flexibility • General government revenue, expenditure, and surplus/deficit trends; • Revenue-raising flexibility and efficiency; • Expenditure effectiveness and pressures; • Timeliness, coverage and transparency in reporting; and • Pension obligations. General government burden • General government gross and net (of assets) debt as a per cent of GDP; • Share of revenue devoted to interest; • Currency composition and maturity profile; and • Depth and breadth of local capital markets. Offshore and contingent liabilities • Size and health of NFPEs; and • Robustness of financial sector. Monetary flexibility • Price behaviour in economic cycles; • Money and credit expansion; • Compatibility of exchange rate regime and monetary goals; • Institutional factors such as central bank independence; and • Range and efficiency of monetary goals. External liquidity • Impact of fiscal and monetary policies on external accounts; • Structure of the current account; • Composition of capital flows; and • Reserve adequacy. External debt burden • Gross and net external debt, including deposits and structured debt; • Maturity profile, currency composition, and sensitivity to interest rate changes; 6 • Access to concessional lending; and • Debt service burden. Source: Standard and Poor's (October 2006). ―Sovereign Credit Ratings: A Primer. Notes: NFPEs: Non-Financial Public Sector Enterprises Moody's Corporation John Moody and Company first published "Moody's Manual" in 1900. The manual published basic statistics and general information about stocks and bonds of various industries. In 1909 Moody began publishing "Moody's Analyses of Railroad Investments", which added analytical information about the value of securities. Expanding this idea led to the 1914 creation of Moody's Investors Service. By the 1970s Moody's began rating commercial paper and bank deposits, becoming the full-scale rating agency that it is today. Table 3: Moody’s Sovereign Categories 1. Economic Structure and Performance - GDP, inflation, population, GNP per capita, unemployment, imports and exports 2. Fiscal Indicators - Government
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