How Credit Ratings Work

Despite their failings during the financial crisis, history shows that credit ratings assigned by S&P Global (NYSE: SPGI) and Moody's (NYSE: MCO) work -- their ratings are strongly correlated to the likeliness that a particular bond will default.

So what's in it for the ratings agencies like Moody's and S&P? How do these two companies make money? In this segment of Industry Focus: Financials, join host Gaby Lapera and Jordan Wathen as they discuss how the ratings agencies get paid for providing a valuable service to the markets.

A full transcript follows the video.

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This video was recorded on June 26, 2017.

Gaby Lapera: To give listeners an idea of how effective these ratings generally are, I have this chart in front of me. If you would like me to send it to you, I'm super happy to do that. It has all the grades, AAA through CA-C, which is not good. If you're AAA, you have a 0.2% chance of defaulting on your bond over the course of 10 years, versus if you are a CA-C, you have an 85% chance of defaulting on your bond over the course of 10 years. That's a pretty big difference. And obviously, we have, like, 100 years' worth of data, so we can actually see whether or not Moody's and S&P are doing a good job doing these ratings. And generally, they are.

Jordan Wathen: Right. That's the big thing. A lot of people read about the crisis of 2008, and they leave with the opinion that the ratings agencies and the ratings are virtually worthless. But in reality, the truth is, if you go down the list of the grades by quality, you will find that defaults actually do increase as the quality of the rating goes down. So, a lower rated bond is more likely to default than a higher rated bond, which is exactly what these credit rating agencies want to happen. They want to see that their ratings are accurate. And over history, we've seen that they are accurate.

Lapera: Yeah. And the ratings scale kind of works the same as that kindergarten teacher's grades that you were referring to earlier. AAA is the best, then there's AA, then there's A, BAA, BA, B, CAA, CA-C for Moody's, but they vary. S&P just does A's and B's. But, the more letter something has, the better it is, and the higher it is in the alphabet, the better it is. So, use that to create your matrix, I suppose. Or, I'll send you this chart, if that was a super confusing verbal explanation of it. We know that companies really need these ratings in order to sell their bonds. But how do Moody's and S&P make their money? That's part of it?

Wathen: If we go back 100 years ago, the whole bond rating system was based on the idea that the company, let's say Moody's or S&P, which both published manuals, investors would pay for those manuals. Over time, that business has changed. What happens today is investors still pay, to a small degree, for these ratings. But by and large, what happens now is, when a company wants to issue a bond, it goes to Moody's or S&P, and it pays a fee based on the issuance, the size of the bond that the issue. It's basically a percentage, and it's maybe 10 basis points at the most, or 0.1% of the amount they wish to borrow. But, on a $10 billion bond, that becomes a rather significant amount.

Lapera: Yeah. They also charge for initial credit assessment fees and annual surveillance fees, so that they can maintain the rating.

Wathen: Right. Initially, they'll pay a small fee, maybe $50,000 or $100,000, to basically fly people out there to take a look at the books and start to understand the business. Then they pay the issuance fee, which is by far the biggest driver of revenue for Moody's, S&P, or Fitch. Then they also pay that ongoing surveillance fee to keep looking at the bond or the company each year, and what they'll do, if the rating doesn't change, they'll say, we reaffirm our initial rating on that bond.

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Moody's. The Motley Fool has a disclosure policy.