So we've seen the role of regulators in ensuring market efficiency. We've also seen how shareholders can engage with corporations in whose equity or debt they trade. But what about the role of the rating agencies? Where else can investors turn for information of direct relevance to intrinsic value in the assets in which they want to trade?. It's all about due diligence. So why in fact do markets need rating agencies? Well, they're there to provide the market, to provide investors with an objective analysis and independent assessment of companies and countries that issue debt securities to determine whether they will, in fact, be able to meet their obligations under those debt contracts within a particular time frame. Those that do it for you include, Standard & Poor's, Moody's and Fitch. They're in fact the top three, although there are others nowadays. But what about the auditors? Why couldn't they provide this particular service? Why have a second layer of assessors look in to the financial statements and accounts of corporations? Well, as it turns out, what Standard & Poor's, Moody's and Fitch do is, in fact, quite different from what auditors do when they're assessing solvency and liquidity of corporations. And do they just do this service to enhance the debt markets? Well, no, as it turns out, the ratings that these agencies provide have a signaling impact as much on equity markets as they do on debt markets, nowadays. So, here's a comparison of those three rating agencies. Slightly different ratings being used by Standard & Poor's and Moody's, but basically, they line up neatly. Going from AAA rated corporations, which are truly of highest quality to D or C for Moody's rated corporations, which are truly highly speculative, if not already in default. A further distinction you see in the table on the left is a set of ratings which we classify as investment grade. From AAA to BBB for Standard & Poor's, as distinct from speculative grade. And the names speak for themselves where we go from BB rating, double B rated companies, to D rated companies. Increasingly poorer quality of the issuer, of the issue that is being rated. So an example for Kellogg's, our corporation of choice, Moody's provided a rating action. That means it issued a new rating. On February the 12th, 2014, on an issue that Kellogg's did on that very date, which was a Baa2 rating. The two indicating a subcategory on Moody's of the Baa, which is a medium grade rating. For Kellogg's, 500 million Euro notes issued. At the same time, it was also providing a commercial paper rating. And you can see in the table on the right hand side that for short term debt, there is a different rating scale going from A-1 for Standard and Poor's to D. But for Moody's, it's Prime-1 to Not prime. A somewhat simplified rating for various levels of quality. So, how do these rating agencies arrive at their rating? They take into account both business risks and financial risks. So, the environment, including political, industry, company, and profitability of the sector within which the corporation operates. And the financial risk, which can be derived from the financial statements. Combining the two scores for business risk and financial risks allows them to arrive at a single rating of quality. Having scanned business risk and financial risk, rating agencies next utilize benchmarks for various rating classes. And the default experience within each of these rating classes to arrive at a measure for the risk of default of the corporation at a particular risk horizon, a particular point in time. Rating agencies then also provide a measure for the risk of loss given default. Keep in mind that not all might be lost. If the corporation is expected to default in five year's time, in the preceding four years, the corporation might quite well be able to repay its debt in full. And only the remaining payments will be at risk. Finally, rating agencies attach the rating either to the issuer, the corporation itself, where they measure the capacity and the willingness of the corporation to meet its commitments, its obligations. As distinct from a credit rating that's attached, as in the previous example for Kellogg's, to a specific issue. Where the specific details, the covenants, as they were attached to that particular issue, might have a bearing on these metrics of risk of default and the loss given that default. So, now you know how rating agencies put a rating to an issue, to an issuer. Let's look at the evidence of ratings across U.S. companies. In the early 1970s, 60 U.S. companies attracted the highest quality AAA rating. That number started to drop dramatically since then. By 2000, there were only 15 such companies left. And right now, in 2015, it is just four. So, what has happened? Where has all this quality disappeared? Well, here are some clues, but obviously not the complete story. Companies nowadays are much more indebted than they were in the 1970s. The composition of companies listed on the exchange has changed rather dramatically as well. Growth companies are now by far dominant on the exchange. In fact, 50% of companies are speculative great issuers. Higher risk environment has got something to do with it, just in the aftermath of the global financial crisis. These are just some possible explanations of the disappearing AAA rated high quality corporation. Using Standard & Poor's data, here's a bit of evidence on rating changes and rating transitions for individual corporations. So, the graph that you see here tells you how many companies were upgraded, the blue line. How many companies were, in fact, downgraded, the red line. And how many companies defaulted, the green line. As it turns out about one in five issuers changes rating every single year. That's quite substantial. You can see that over this timeframe from 1981 to 2011, the number of downgrades exceeded the number of upgrades, quite persistently. You can also see that there's an inverse relationship between the number of upgrades and the number of defaults. That should also tell you something. Moving to the rating transitions, the following graph tells you how a corporation is expected to perform over time, in terms of its rating. So, ratings change stepwise. Well, what does that mean? Well, let's start with the green line. The green line is a currently AAA rated corporation. What the rating transition graph tells you is that with about 85% probability, this AAA rated company will still be a AAA rated company next year. Then moving to the right on the green line, that same currently AAA rated company has a probability of about 8% of being downgraded to a AA rated corporation. But that's about it. In one year's time, the worst that can happen to our AAA rated corporation is being downgraded to a AA rated corporation. Admittedly, there's a little bit of chance, a tiny bit of chance, that it will be downgraded two steps rather than simply one step to a A rated cooperation. But that's a small probability, indeed. Now, compare that to a currently CCC rated corporation. As indicated by the red line, the CCC rated corporation has a probability of about 45% of still being a CCC rated corporation next year. If you follow that line to the right, you can see that there's about a 28% probability that the corporation will be downgraded to a D rated corporation. And there is about 12% probability that the CCC corporation will, in fact, be upgraded to a B rated corporation. So, for the CCC corporation, there's a possibility of both going up, improving quality, or being downgraded to a single D rated corporation. Obviously, for the AAA rated example I just gave you, the only way to is down. And that is actually quite telling because what happens eventually with all corporations? Well, this graph tells you something about the time to default. From the AAA rated corporation in this particular graph on the left, the blue line tells you that a currently AAA rated corporation will take about 18 and a bit years until default. That is the average years from rating category to the default outcome. For a CCC rated corporation, it won't take that long at all, as you can see. On average, it will only take one year for a CCC corporation to go into default. What that tells you is that creative destruction catches up with the AAA as much as with the CCC, just at a different pace. So, one question that has been posed a lot in the last few years since the financial crisis is about rating performance. Are those ratings provided by the three rating agencies merely tracing what is happening, or are they, in fact, somewhat predictive? So, can investors actually learn something beyond what they can observe directly from the financial statements of those corporations? There's even been some suggestion that rating downgrades are causing problems themselves. So, rather than be predictive, they could actually be the cause of problems by revealing or by providing bad news to investors. Then, they better be right about their assessment of the financial circumstances, as they will evolve for those corporations in the next few years. It's clear that there is a bit of a probability cliff, as you might call it, for the CCC rated corporations. But maybe that is not so much of a surprise given that they are already well and truly into the speculative category. So again, resorting to Standard & Poor's rating information. The graphs that you see here tell you something about the performance of the ratings attached to corporations. So, what you see in the left-hand graph is the total number of defaulting corporations, as indicated by the blue line. And then, the two other lines indicate investment-grade defaults, the red line, and speculative-grade defaults. It's pretty obvious from this graph that investment-grade defaults hardly ever result in actual defaults. But the story is entirely different for speculative grade defaults that make up the vast majority of the total defaults. Of course, partly that is caused by the the fact that they are already on their way to default, if you believe that story of creative destruction. It might also be a reflection of very high risk exposure. And the vulnerability in very risky business conditions. So, if you pick up on the spikes in this graph, you see defaults spiking up in 1990. You see defaults again picking up in 1999 until 2003. And you see a big spike in defaults fairly recently in 2009. Each of those spikes coincides with a particular market crash, in fact. So, just focusing on the 99 until 2003, that episode was characterized by the tech stock crash. And the more recent spike that you see in 2009 is a direct reflection of what happened in the recent global financial crisis. Another way of looking at the performance of the rating agencies is in the graph on the right hand side. Where you can see that corporate default rates, by rating, clearly indicates that the rating agencies, by and large, got it right by attaching CCC ratings to those corporations indicated by the red line. AAA, BBB+ rated companies, that's where Kellogg's features have, in fact, got very low percentages of corporate default rates. So, those graphs suggests that rating agencies are, in fact, not doing such a bad job at all. Yet rating agencies have been severely criticized in the aftermath of the global financial crisis. For example, for not picking up some very risky positions on financial statements of financial institutions, high quality rated financial institutions. And that critical discussion really focused on the independence of the rating agencies. A discussion, not unlike the discussion we had in the previous course, on the independence of auditors. So, some of the questions worth asking here include, are rating agencies perhaps captured by their corporate clients, thereby securing future business? Are there perhaps too few rating agencies? Should we move beyond the big three and invite other rating agencies to make this a more competitive market? And finally, should there be unsolicited ratings? Should rating agencies be invited by, perhaps regulators to provide such ratings, rather than the corporations they rate?