[3] The issuers of the obligations or securities may be companies, special purpose entities, state or local governments, non-profit organizations, or sovereign nations.
As trading distances increased, merchants no longer personally knew their customers and became wary of extending credit to people who they did not know in fear of them not being able to pay them back.
The bond markets in the Netherlands and Britain had been established longer but tended to be small, and revolved around sovereign governments that were trusted to honor their debts.
[14] In 1913, the ratings publication by Moody's underwent two significant changes: it expanded its focus to include industrial firms and utilities, and it began to use a letter-rating system.
[13] In the United States, the rating industry grew and consolidated rapidly following the passage of the Glass-Steagall act of 1933 and the separation of the securities business from banking.
[17] As the market grew beyond that of traditional investment banking institutions, new investors again called for increased transparency, leading to the passage of new, mandatory disclosure laws for issuers, and the creation of the Securities and Exchange Commission (SEC).
[29] A market for low-rated, high-yield "junk" bonds blossomed in the late 1970s, expanding securities financing to firms other than a few large, established blue chip corporations.
The "financial engineering" of the new "private-label" asset-backed securities—such as subprime mortgage-backed securities (MBS), collateralized debt obligations (CDO), "CDO-Squared", and "synthetic CDOs"—made them "harder to understand and to price" and became a profit center for rating agencies.
[3] Since the spring of 2010, one or more of the Big Three relegated Greece, Portugal, and Ireland to "junk" status—a move that many EU officials say has accelerated a burgeoning European sovereign-debt crisis.
[67] Under an amendment to the 2010 Dodd-Frank Act, this protection has been removed, but how the law will be implemented remains to be determined by rules made by the SEC and decisions by courts.
[98] During the subprime crisis, when hundreds of billion of dollars' worth[46] of triple-A-rated mortgage-backed securities were abruptly downgraded from triple-A to "junk" status within two years of issue,[47] the CRAs' ratings were characterized by critics as "catastrophically misleading"[99] and "provided little or no value".
Despite over a year of rising mortgage delinquencies,[101] Moody's continued to rate Freddie Mac's preferred stock triple-A until mid-2008, when it was downgraded to one tick above the junk bond level.
[102][103] Some empirical studies have also found that rather than a downgrade lowering the market price and raising the interest rates of corporate bonds, the cause and effect are reversed.
Expanding yield spreads (i.e., declining value and quality) of corporate bonds precedes downgrades by agencies, suggesting it is the market that alerts the CRAs of trouble and not vice versa.
Argues Robert Clow, "When a company or sovereign nation pays its debt on time, the market barely takes momentary notice ... but let a country or corporation unexpectedly miss a payment or threaten default, and bondholders, lawyers and even regulators are quick to rush the field to protest the credit analyst's lapse.
The lowering of a credit score by a CRA can create a vicious cycle and a self-fulfilling prophecy: not only do interest rates on securities rise, but other contracts with financial institutions may also be affected adversely, causing an increase in financing costs and an ensuing decrease in creditworthiness.
Since that time, major agencies have put extra effort into detecting them and discouraging their use, and the US SEC requires that public companies in the United States disclose their existence.
[68][71] Under Dodd-Frank rules, agencies must publicly disclose how their ratings have performed over time and must provide additional information in their analyses so investors can make better decisions.
[71][70] The Economist magazine credits the free speech defence at least in part for the fact that "41 legal actions targeting S&P have been dropped or dismissed" since the crisis.
[125] Ratings for complicated or risky CDOs are unusual and some issuers create structured products relying solely on internal analytics to assess credit risk.
[136] However, when it was discovered that the mortgages had been sold to buyers who could not pay them, massive numbers of securities were downgraded, the securitization "seized up" and the Great Recession ensued.
[161] Governing bodies at both the national and international level have woven credit ratings into minimum capital requirements for banks, allowable investment alternatives for many institutional investors, and similar restrictive regulations for insurance companies and other financial market participants.
[161][165] The Credit Rating Agency Reform Act of 2006 created a voluntary registration system for CRAs that met a certain minimum criteria, and provided the SEC with broader oversight authority.
[181][182] While these other agencies remain niche players,[183] some have gained market share following the Financial crisis of 2007–08,[184] and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group.
[200] Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer-pays model, only Egan-Jones maintains an investor subscription service.
[205] In 2010 Lace Financials, a subscriber-pays agency later acquired by Kroll Ratings, was fined by the SEC for violating securities rules to the benefit of its largest subscriber.
[206] A 2009 World Bank report proposed a "hybrid" approach in which issuers who pay for ratings are required to seek additional scores from subscriber-based third parties.
In 2003, the US SEC submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.
[213] Think tanks such as the World Pensions Council (WPC) have argued that the Basel II/III "capital adequacy" norms favored at first essentially by the central banks of France, Germany and Switzerland (while the US and the UK were rather lukewarm) have unduly encouraged the use of ready-made opinions produced by oligopolistic rating agencies[214][215] Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses, and its high profit margins (which at times have been greater than 50 percent of gross margin) can be construed as consistent with the type of returns one might expect in an industry which has high barriers to entry.
[219] SEC Commissioner Kathleen Casey has said that these CRAs have acted much like Fannie Mae, Freddie Mac and other companies that dominate the market because of government actions.