Credit Rating

The major rating agencies

Three firms dominate global credit ratings:

• Standard & Poor's (S&P Global Ratings) — uses scales from AAA down to D for default.
• Moody's — uses Aaa down to C, with slightly different notch labels.
• Fitch — same scale as S&P.

For consistency, most discussion uses the S&P/Fitch scale. The major thresholds:

• AAA — highest possible. US Treasuries (until 2011), German Bunds, Microsoft, Johnson & Johnson historically.
• AA — extremely strong capacity to pay.
• A — strong capacity, but somewhat more susceptible to adverse conditions.
• BBB — adequate capacity. Lowest investment-grade rating.
• BB and below — speculative ("junk"), with elevated default risk.
• CCC, CC, C — increasingly distressed.
• D — already in default.

A "+" or "-" modifier (or "1" or "3" for Moody's) refines within each notch — BBB+ is stronger than BBB, which is stronger than BBB-.

What ratings affect

Beyond signaling, ratings have direct mechanical effects on financial markets:

• Borrowing costs — issuers with higher ratings pay lower interest rates. The yield gap between AAA and BB+ corporates is typically several hundred basis points, often growing in market stress.
• Institutional mandates — many investors are restricted by mandate to investment grade only. Pension funds, insurance companies, and certain mutual funds drop holdings if they fall below BBB-.
• Bank capital requirements — under Basel rules, banks hold less capital against highly-rated assets and more against lower-rated ones. This directly affects what banks find economical to hold.
• Repo and collateral — what counts as acceptable collateral in repo markets and central-bank operations is rating-driven.
• Insurance and counterparty risk — derivatives counterparties are evaluated partly on credit rating.

How ratings are assigned

The process generally involves:

1. The issuer pays the rating agency for the rating (this is the "issuer-pays" model and is itself controversial).
2. Analysts review financials, business model, industry, capital structure, and management.
3. They model default probability and recovery in distress scenarios.
4. A rating committee assigns the final rating.
5. Ratings are reviewed periodically and updated as conditions change.

The issuer-pays model has well-documented conflict-of-interest issues that contributed to the 2008 financial crisis (where many mortgage-backed securities received AAA ratings that proved wildly inaccurate). Reforms since have tightened oversight but not changed the fundamental structure.

Famous downgrades

• US Treasuries (2011) — S&P downgraded the US from AAA to AA+ amid the debt-ceiling crisis. Moody's later followed in 2023. The downgrade had limited market impact because Treasuries remained the global benchmark.
• Lehman Brothers (2008) — was investment grade days before its bankruptcy filing. Used as a textbook case of ratings lagging market reality.
• Many MBS in 2008 — securities rated AAA in 2006-2007 were downgraded en masse during the financial crisis, exposing the limits of pre-crisis modeling.
• Several European sovereigns during 2010-2012 — Greece, Portugal, Ireland, Italy were downgraded multiple notches, reflecting the eurozone crisis.

Sovereign ratings

Sovereign credit ratings rate national governments' debt. They affect:

• Government borrowing costs.
• The yield "ceiling" within the country (corporates rarely exceed sovereign rating in the same currency).
• Currency stability and capital flows.
• Acceptability as official reserves.

Major economies typically run AA or AAA. Emerging markets vary widely. Ratings can take years to recover after major downgrades; some countries have been on watchlists or near junk for extended periods (Italy at BBB- range for years, with only narrow margins above sub-investment-grade).

What ratings don't capture well

Several recurring failure modes:

• Slow to react to deteriorating conditions — ratings tend to lag market spreads, sometimes by months. By the time a rating action arrives, the market has often already priced in the risk.
• Linear underestimation of tail risk — moving from AAA to AA implies a meaningful change in default probability; the model assumptions sometimes turn out wrong in extreme cases.
• Fragmented coverage — many smaller issuers and structured products have shallow analyst coverage.
• Conflict of interest — issuer-pays creates incentives for ratings inflation.

Ratings remain useful as a coarse classification but are best used alongside market data (credit spreads), independent analysis, and skepticism about precision.