The Importance Of Credit Rating

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Register to read the introduction… Credit rating is a key informational tool that investors, especially small investors as opposed to sophisticated investors, use in evaluating and selecting the investment. However, there are differences of opinion regarding the informational value of ratings. It is argued that credit ratings are valued not because of their informational content, but because numerous laws and regulations refer to ratings issued by a “nationally recognized statistical rating organization” (“NRSRO”) and give more favourable regulatory treatment to the holder of a security that is rated highly by an NRSRO than a security that is lower or not at all (Kettering, 2008). Issuers get their issues credit rated, in part, to comply with regulations. Almost all agencies base their ratings on the relative, not absolute, probability of default. Credit rating agencies increasingly focus on structured finance and new complex debt products, particularly credit derivatives, which now generate a substantial share of their revenues and profits. With respect to these new instruments, the agencies have become more like “gate openers” than gatekeepers (Partnoy, 2006:60). The rating agencies, at the height of the housing boom, had conferred the AAA (highest) rating on bundles of mortgage- backed securities, despite being clueless about the poisonous mixture of debt inside those bundles. Those securities later were downgraded to BBBs, the second lowest grade (Brummer, 2008:50). The poor quality ratings by the CRAs are partly due to poor methodologies. Ackermann (2008:333) observes, “[t]he methodologies employed by rating agencies have been found wanting in connection with the assessment of the default probabilities of structured …show more content…
To improve reliability of ratings and restore investor confidence, it seems expedient for the regulators to adopt adequate requirements, to govern how and what amount the rating agencies are paid and to provide for the suspension of their licenses if they indulged in unfair practices for CRAs to ensure transparency, reliability and integrity of their ratings. Similarly, stringent rules should be imposed on investment banks so that they have enough capital to weather a storm like subprime crisis in

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