The credit ratings

A credit rating is an evaluation of the relative credit worthiness and credit risk associated with a person or a company. The countries too can receive credit ratings, which usually express the level of risk to which potential investors would expose themselves on entering the financial environment of the country in question. Most often, the credit ratings are used to indicate a borrower’s potential to respect a credit relationship and repay debt in a timely fashion, whether the prospective borrower is an individual or a business. A credit rating thus indicates in quantifiable terms the statistically calculated likelihood that an entity will prove a reliable borrower. The credit ratings take a multitude of elements into account in a bid to provide as little bias and as much reliability to lenders as possible; they compute information derived from an entity’s financial history, current assets and liabilities using a complex (and very secret) formula.

We can regard credit ratings as the broader equivalent of credit scores, applicable to a larger variety of entities. A credit score is in fact an element of a person’s credit rating – a very important one, that is – however, other aspects of that person’s financial background are also taken into account when computing their credit rating. Lenders who look into a person’s credit rating may choose to place more (or even all) emphasis on that person’s credit score, or else look further and take other aspects into account as well. For companies, computing the credit rating is a much more complex process.

Like the credit scores, the credit ratings can have a highly significant impact on an entity’s financial behaviour and opportunities. As far as individuals and companies are concerned, credit ratings are drawn using specific information from the entities’ financial background and include data regarding past payments history, credit use (calculated as the ratio between the amount of revolving debt and the credit limit available), length of credit history, types of credit employed and the amount and types of credit for which an entity has applied recently. All this data is put together, analyzed, reworked into a standard format and made available (upon demand) to various lenders.

The credit ratings influence a wide variety of decisions, not all of them financial in nature. While typically designed to be used by lenders (such as banks) and investors, the credit ratings are known to be used (in certain circumstances) by employers looking to establish the trustworthiness of a potential employee; also by financial services providers looking to adjust insurance premiums and determine the amount of a utility or leasing deposit. In this respect, a credit rating functions much the same way as a credit score does: a high rating is good, a lower rating, not so good; a high rating ensures relatively easy access to credit, while most of the banks will hesitate to grant loans for people with poor credit rating.

The credit ratings

Unlike the credit scores, the credit ratings are not quantified via a number. Rather, since a credit rating is regarded as a financial indicator, what is a good credit rating may remain an elusive question. In fact defining what a good credit rating means is a flexible process, as lenders may regard one particular aspect of an individual’s or a company’s credit rating as being more relevant than other aspects.

As mentioned above, there are three basic types of ratings: personal credit ratings (applied to individuals), corporate credit ratings (applied to businesses) and sovereign credit ratings (applied to sovereign entities such as countries). Personal credit ratings are calculated taking into account a number of factors, such as an individual’s credit score (which reflects his ability to repay credit), his saving and spending patterns as well as any outstanding debt. Some lenders might place a lot of emphasis on one of the elements mentioned above, like on an individual’s credit score.

There are several credit score models, the most popular of which is that developed by FICO. The most important element in a FICO credit score, which can be analyzed as a separate element of that person’s credit rating, is the payment history. The latter makes up 35 percent of the final credit score figure. The score is dragged back by late mortgage or credit card payments. Also among the main factors which influence an individual’s credit score is the so-called rate of credit usage. That represents 30 percent of the final score and it is very often employed as an independent indicator for credit rating calculation. Credit usage defines the amount of incurred debt as compared to the amount of credit available to a consumer at a particular time. In technical terms, credit usage is expressed as the ratio of revolving debt to the total revolving credit. The lower an individual’s credit utilization ratio is, the greater are his chances of getting a high FICO score. Also relevant are the duration of a person’s credit history (15 percent of their FICO score), the types of credit employed and the amount of recently obtained credit, each making up 10 percent of the final FICO score. In addition to these elements, a FICO score can be negatively influenced by the amount of money an individual owes due to a tax lien or any type of court judgment and by the existence of consumer finance credit accounts.

A consumer’s credit rating is heavily influenced by their credit score, then the latter is a good place to start the assessment. FICO credit scores rank between 300 and 850, with the average (or median) score being around 723. Credit scores are frequently readjusted based on recent events and aligned within separate scoring models employed by the main three US credit bureaus, namely Experian, TransUnion and Equifax.

The credit ratings

Once an individual’s credit rating has been established, it can be used as a stand-alone indicator or else compared to the credit ratings of other consumers with similar revenue information and credit history. Once all mathematical variables have been computed, the would-be borrower is included in a particular category and any pending financial decisions are taken accordingly. If a consumer’s rating has fallen below 600, he or she is usually considered a risk borrower, which translates to being charged higher interest rates. The credit rating may be boosted by timely payments, by paying off credit cards and by lowering the debt to income ratio (the previously mentioned credit usage).

A company’s credit rating is regarded as a very important financial indicator, relevant mostly to would-be investors of debt securities such as bonds. An organization’s credit rating is thus its true business card in the world of credit: a good credit rating opens the door to higher investment volumes, lower interest rates and higher credit limits, while a lower rating leads to a higher interest rate being applied to the particular security being issued. Poor credit ratings may effectively block a company’s access to credit or prompt lenders to ask for additional collaterals. Thus, when it comes to corporate credit ratings, an organization is assessed in its capacity of debt obligations issuer. Credit rating opinions are based on analysis by experienced professionals who evaluate and interpret information received from issuers and other available sources to form a considered opinion. Sometimes, the servicers of the underlying debt are also provided ratings, as are the debt instruments themselves. Among the most frequently encountered types of securities issuers are organizations, special purpose entities, national governments, state and local governments and non-profit organizations. When the credit ratings for an issuer are computed, they take into account the (statistically calculated) likelihood that the entities in question will prove credit-worthy, reliable borrowers that will fulfill their financial obligations with minimum risk of defaulting.

The organizations that assign credit ratings for companies are called credit rating agencies. Among the best known such agencies are Moody’s, Fitch Ratings and Standard & Poor’s. The Standard & Poor’s and Moody’s credit rating scales use similar concepts and employ letters to rate a company’s credit worthiness. Thus, Standard & Poor’s bank credit rating goes from AAA, AA, A, BBB to BB, B, CCC, CC, C and D, with AAA meaning “excellent” and D meaning “very poor”, while Moody’s rating ranks as follows: AAA, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C, with AAA being “excellent” and C meaning “very poor”. In both cases, anything lower than BBB (according to Standard & Poor’s bank credit rating) or lower than a Baa rating (according Moody’s rating) is deemed a speculative or junk bond.

One thing we should keep in mind when it comes to credit ratings is that they are not a fixed reality, but rather opinions about relative credit risk. Standard & Poor’s for instance claims that its ratings express nothing more than the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time. While the credit ratings may also be seen as attesting to the credit quality of an individual debt issue (for example a corporate or municipal bond) and the relative likelihood that the issue may default, they must not be seen as straightforward investment advice, since they are not buy, hold, or sell recommendations. In fact, the credit ratings merely constitute one factor investors may take into account when making their final investment decisions. Also, credit ratings are not indications of the market liquidity of a debt security and they must not be regarded as guarantees for credit quality. In addition to international credit rating agencies like Standard & Poor’s, regional and niche rating agencies also exist. The latter usually specialize in particular geographical regions or industries.

Unlike other types of opinions, credit ratings opinions are not intended to be a prognosis but rather they are intended to provide investors and market participants with information about the relative credit risk of issuers and individual debt issues that the agency rates. With the advent of the financial crisis in 2008, the value of such credit ratings has come under closer scrutiny. Consequently, the Securities and Exchange Commission, the independent US agency in charge of enforcing the federal securities laws and regulating the securities industry, has submitted a report to US Congress regarding its plans to investigate the alleged anti-competitive practices of credit rating agencies, including issues regarding possible conflicts of interest.

Finally, sovereign credit ratings refer to the creditworthiness of sovereign entities such as countries. The sovereign credit ratings define the potential risk levels associated with a country’s investing environment; they are employed by investors interested in entering foreign markets and take into account such elements as the stability of state’s political climate, the overall state of the economy, corruption, etc. On many occasions, such ratings have proven useful to governments seeking market access; however the difficulty of assessing sovereign risk has led to public controversies sparking over particular rating assignments.