Credit Ratings

A credit rating aims to determine before a loan is made whether an individual, corporation, or country is willing, able, and likely to repay a debt. Lenders are the main users of credit ratings, but insurance companies have used credit ratings to determine insurance premiums, and employers have used credit ratings in evaluating job applicants. Utility and leasing deposits can also vary in amount according to credit ratings. Those with poor credit ratings end up either borrowing at high interest rates or unable to borrow at all.

The main pieces of information that go into credit ratings are financial history and current assets, liabilities, and income. Financial history includes obvious warning signs such as instances of bankruptcies and defaults, but it also includes late payments by borrowers who otherwise have clean credit histories. In the United States, credit bureaus such as Experian, Equifax, and TransUnion assign credit scores for individuals. Credit rating agencies such as Moody’s and Standard and Poor’s assign credit ratings for corporations and sovereign governments.

Credit ratings are a relatively new development in the history of financial markets. They appeared after financial markets achieved a high level of development in the United States. The wide expanse of the United States, with its railroads and telegraphs, multiplied the number of business transactions between individuals who were otherwise strangers. The mid-1800s saw the rise of mercantile credit agencies in the United States. These credit agencies assessed the credit worthiness of merchants. In 1909, John Moody began furnishing credit ratings on railroad bonds, and a year later extended his rating service to include utility and industrial bonds. Poor’s Publishing Company and Standard Statistics Company issued their first ratings in 1916 and 1922, respectively. In 1941, Standard Statistics Company and Poor’s Publishing Company merged to form Standard and Poor’s, one of the most widely known credit ratings agencies for securities. Fitch Publishing Company began rating bonds in 1924. In 1982, Duff and Phelps began providing ratings for a wide range of companies.

As capital markets displaced banking institutions as the main mechanism for channeling international capital flows, the demand for credit rating agencies grew outside the United States. The last decades of the 20th century saw Moody’s open offices in Tokyo, London, Paris, Sydney, Frankfurt, and Madrid. Standard and Poor’s opened offices Tokyo, London, Paris, Melbourne, Toronto, Frankfurt, Stockholm, and Mexico City. Duff and Phelps entered into joint ventures in Mexico and several Latin American countries. U.S. credit rating agencies have the strongest presence in the global market for creditable security ratings, followed by credit rating agencies in Japan, Canada, and the United Kingdom.

Originally, the sale of publication and related material provided the revenue to pay for the rating service, and the companies who were the object of the credit ratings incurred no charges. After the default of Penn Central in 1970, investors discovered that a company with a household name was not necessarily a good investment risk. Other companies began having trouble rolling over their commercial paper. Companies began seeking ratings from credit rating agencies to reassure jittery investors. Fitch and Moody’s both started charging companies for ratings in 1970; Standard and Poor’s started charging soon after. By 1987, 80 percent of Standard and Poor’s revenue came from fees charged the firms who were rated.

The practice of depending on the rated companies for revenue has raised questions about whether the rating agencies have an incentive to award high ratings to keep its customers happy. The subprime mortgage crisis of 2008 put the spotlight on the rating agencies and the role they had played in assigning investment grades to securities that were backed by risky home mortgages. Critics charged that the credit rating agencies such as Standard and Poor’s were paid handsome fees for complicity in the crisis.