How do credit rating agencies make money?

I mean the big ones like Standard & Poor’s or Moody’s which rate governments and corporations, not the ones which rate private persons. How do they make money? Do they charge the entities which they rate a fee for rating them (which the rated entities pay because nobody would borrow them any money without a rating), or do they sell their information to the media? Is this information copyrighted?

Related to this: Has there ever been a major scandal of a government or corporation bribing employees of such entities for getting a better rating?

S&P, Fitch and Moody’s make money by charging fees to the companies that desire a rating. They will also do unsolicited ratings and then send companies a bill. Often companies will pay since they are afraid that the rating might get dinged if they don’t.

Pretty nice scam isn’t it?

They also sell subscriptions to their detailed ratings reports, although the ratings themselves are free.

I don’t know of anyone bribing the agencies for a better rating. Besides, in the current racket, I mean business model, companies will keep paying as long as you keep giving good ratings. Is that a bribe or a protection scam?

I don’t see how this is a “scam”, really.

The purposes of these ratings is for people interested in buying debt to have some way of gauging the default risk of the debt issuer. It’s a credit quality rating, a whole different ball game than, say, Morgan Stanley’s analysts giving such-and-such company’s stock a “Strong Buy” versus “Neutral” or “Sell” rating.

When a company issues debt it is asking people to lend it money in return for interest (that’s what a bond is). The first go round, they have “no credit history”.

In a similar situation, if you personally are a first time borrower with no credit history, your options (other than doing without the loan) are basically to find a bank to issue you a loan at likely very high interest rates, if you can even find one willing to do so, or to pay a fee to get a credit evaluation report that the bank will accept.

What Moody’s, S&P, Fitch, etc. do is the same thing, issue a credit evaluation report, but here the company is not seeking a loan from any specific bank but from the market at large. Hence the need for it to be publically available.

The reason the company being rated is the one paying for the evaluation is because without such a rating, the market for their debt is much, much smaller. Most institutional purchasers of debt (mutual funds, pension plans and whatnot) will only buy bonds rated by specific agencies, usually at a minimum credit quality (which is why getting downgraded below BBB is a big deal).

Regarding “unsolicited ratings” (which is the part that really sounds the most suspicious), this article sums it up:

In other words, the recipient of an unsolicited review by Moody’s or S&P can either take the opportunity to become a “full client”, i.e., set up a review and present financial statements and business plans to the agency that may not have been easily publically available for the initial rating (and also become a “dues paying member”), or simply ignore the rating. They’re not exactly “billed” for an unsolicited rating and are under no obligation to “upgrade” their status.

The upside is that the market operates more easily as a lot of the demand for a bond depends on the availability of the credit rating. The majority of the time, the debt issuer was eventually going to hook up with one of the major rating agencies anyway, so this is a timesaver both the market and the issuer appreciate.

The downside is the potential for “squeezing” non-members into becoming members by adhering to stricter guidelines (resulting in lower ratings) for unsolicited versus solicited reviews. This is true, but is also playing with fire; the three major ratings issuers (Moody’s, S&P and Fitch) have their pride of place solely because of their reputation for impartiality. If that trust were abrogated they could easily lose their standing, or even their status with the SEC as an NRSRO.

Unsolicited ratings also serve as a “reality check” for solicited ones. If they’re wildly different then one might question whether or not a higher, solicited rating is reflective of some kind of quid pro quo between the agency and the issuer. This is again mostly academic as rating agencies perceived to be swayable in this way won’t retain the trust of the market and will become unused.

Lemme 'splain.

There is an interesting practice called notching that rating agencies will do to bonds that were not rated by them. Now I am in the structured finance world rather than corporates. One of the big issues related to CDO’s which are securities packed from other securities.

So say there are ten securities that I intend to package into a CDO. Eight were rated by agency X and two were rated by agency Y. If I go to agency X for a rating on the CDO, they will ‘notch’ me down a rating or so since I did not get all the underlying securities rated by them.

At the bottom end of the investment grade scale, this can have a devastating impact on bonds. In practice, it translated into agency Y getting less rating business since issuers were afraid that their securities would get ‘notched’. If that’s not a scam, I don’t know what is.

As far as quality. These outfits are hardly proactive when it comes to these ratings. A monkey with a severe learning disability could lower a companies ratings after the company lowers earnings expectations or has some sort of credit event. Hell, these outfits had GM as investment grade credit for a good bit of time after the default swap market was pricing it in the toilet.

As far as losing credibility, what’s the check on that? Uncle Sam allows the rating agencies to maintain a stranglehold on the business. It’s extremely difficult if not impossible to get the prized NRSRO designation from the government. So if an institution has a rating requirement, then they have the choice of Moe, Larry and Curly (or Dominion).

That’s interesting. I’m not a trader in credit derivatives myself, but I do work on software that reports on credit analysis based on them, and I didn’t realize that basket CDOs were ever rated “as a whole” – we analyze them based on the ratings of the underlying components, and usually with a methodology involving ratings from multiple agencies, such as Lehman’s methodology for “higher of the lowest two of Moodys/S&P/Fitch”.

I’m curious: can you explain a bit further as to who would be interested in a directly assigned rating on a CDO? It seems odd to me that there might be a spread between the aggregate rating of a basket versus what the assigned rating of the basket would be… Unless it’s credit tranche or something, but that’s a different animal altogether. And anyway most buy-side credit rating based restrictions and guidelines I’m aware of (such as pension plans requiring investment in no worse than BBB rated securities) often also forbid significant investing into derivative instruments, so what’s the point?

True also, which is why my work has increasingly involved analyzing the CDS market :slight_smile:

In theory truly blatant bad behavior would get the designation revoked… But I’ve never heard of that happening. Then again I’m not a close follower of the market, just a casual observer with some knowledge of how It’s Supposed To Work (which doesn’t always match What Is Really Going On).

No its tranching. I just wanted to keep it simple. But if you notch the underlying bonds, that ultimately affects the subordination on the CDO tranches. But CDO managers who didn’t want the hassle of notching just paid more for Moody’s rated assets. That just led more ABS issuers to get Moody’s ratings. (Nice business model)

Of course I thought it would be better when I got out of fixed income and moved into real estate acquisition. And then I met appraisers.