Credit rating agencies refer to companies which assign credit ratings for issuers of debts and the debt instruments. They can also provide credit ratings to the servicers of the underlying debt. The issuers of securities include companies, state and local governments, special purpose entities as well as governments which provide debt like securities such as treasury bills and bonds on the stock exchange. Credit rating involves determining the credit worthiness of the issuer of securities. The credit worthiness refers to the ability to pay back a loan (El Namaki, 2). This has an impact on the interest rate which is charged on the security which is being issued. Credit worthiness helps investors in selecting which entity they will invest in.
The credit rating agencies have a role of advising investors about the credit worthiness of the issuers of securities. Most of the investors depend on the credit rating agencies, to make investment decisions. The credit rating agencies may downgrade or upgrade the quality of the credit issuers which greatly affects the cost of borrowing (El Namaki, 2). However, these ratings downgrade faced a lot of opposition from the European Union and also from individual countries. This is because some credit ratings may be misleading which may affect the value of investment. For instance, a company may be rated as credit worth, which may not be true and this may cause financial losses to investors. However, credit ratings still plays a key role to many investors as they depend on it in making investment decisions.
Use of credit ratings
Credit ratings are mostly used by governments, issuers, investors, as well as the investment banks. They are used by investors, to make investment decisions as they provide independent measurements of credit risks. They help in improving the market efficiency through reducing the cost of transactions for both the lenders and borrowers. Credit ratings are also used by the bond issuers, to verify their own credit worthiness as well as the value of their instruments (El Namaki, 3). Issuers of securities also make use of the credit rating agencies to rate their financial transactions. The government regulators apply credit ratings when regulating activities carried out by financial institutions such as banks. For instance, the banking regulators may permit banks to use approved credit rating agencies to determine credit ratings.
Structured financial transactions may also require using the credit rating agencies. Structured financial transactions involve a series of loan with different characteristics (El Namaki, 4). Credit rating is used to establish the interest rate charged on a certain loan depending on the quality of loans and assets. Companies with structured financial arrangements use credit rating agencies to structure a series of loans. The credit rating agencies provide opinions to these companies concerning the possibility that a certain debt security will not be serviced over a certain period of time.
Effects of credit rating downgrade
Credit rating down grade involves a lack of confidence in a company or the government to pay its debt over time. In this case, the credit rating agencies declare that a company or the government has low or no credit worthiness (Mui par, 3). This implies that the company or the government may be unable to meet its loan obligations. For instance, some countries in Europe have had their credit ratings being down graded due to the Euro crisis. Credit rating agencies in the US have also downgraded some companies and the country due to default on debt obligations. The banking sector is mostly affected by credit downgrades as the downgrades have a long term impact in this sector. Credit rating downgrade may have several impacts to the company and to the entire country at large.
High interest rates
Credit down grades involves higher risk, which causes higher interest rates. This means that the interest rate that the government or a company pays to service the debt will increase. Increase in interest rates will lead to an increase in the cost of borrowing. Countries with high risk will pay high interest rates. Increase in the interest rate paid by the federal government may also lead to an increase in the interest rates paid on consumer loans (Dragon par, 1). This is because most of consumer loans are closely related to the government securities such as bonds and the treasury bills. Interest rates on credit cards and home equity loans will also increase. Credit down grade may make house owners to default paying mortgages due to the high cost of borrowing. This means that due to the increase in interest rates some homeowners may be unable to make payments leading to default (Mui par, 1). The high cost of borrowing which is caused by a rise in interest rates will discourage people from borrowing. This will lead to a reduction on small businesses as most of them rely on credit from banks and other financial institutions. This will in turn increase unemployment rate as the businesses will be forced to lay down workers. It will also discourage spending and encourage savings among consumers which will affect the economy of a country negatively.
Increased cost of borrowing will reduce economic activities. This will have a negative impact on the GDP of a country as it causes less tax revenue and additional debt (Dragon par, 2). This will reduce investment as most of the investors buy shares to get growing profits. A slow economy implies that profits will not grow rapidly. The relative value of shares in the market will go down which will cause a decrease in the price of shares. Most of the investors also rely on borrowing in order to make investments. Increase in the cost of borrowing will discourage investors from borrowing, hence a reduction in investment. Most investors depend on credit rating agencies for investment decisions. When a firm is downgraded by the credit rating agencies many investors will shun away from investing in such a firm.
Credit rating agencies helps in influencing financial decision among the investors. They help investors on choosing the appropriate entity in which to invest. Credit downgrades have a significant impact on the investors. This is because they lose confidence in the firm which has been downgraded (Hutchinson par, 2). Credit downgrades also lead to a higher interest rate which increases the cost of borrowing. This discourages borrowing as well as an investment which affects the economy of a country negatively. It will lead to a reduction in the GDP of a nation as well as increasing unemployment. Credit rating agencies plays an important role in guiding investors to make the right investment decisions. However, these agencies have been criticized because of misleading the investor. This calls for the need of reforming the credit rating industry.
Dragon. “Effects of credit rating downgrade of America to AA+”. Finance Manila. 2011. financemanila.net. Web.
Hutchinson, Martin. “Impact of a U.S. Credit Rating Downgrade.” NuWire Investor. 2011. nuwireinvestor.com. Web.
El Namaki, M.S.S. “From Credit Faking to Credit Rating: The Rise and Fall of the Credit Industry.” Capital Business Magazine. n.d.: 22-25. vubs.ch. Web.
Mui, Ylan Q. “Five ways the downgrade in U.S. credit rating affects you”. The Washington Post. 2011. washingtonpost.com. Web.