Herwig Langohr was Professor of Finance and Banking at Insead, in Fontainebleau, France, which he joined in 1976, specialising in corporate finance, financial services and corporate governance. He visited numerous academic institutions such as The Wharton School, The Darden School and the Universität Konstanz (Germany). He was holder of the Goldschmidt Chair in Corporate Governance at the Solvay Business School (Brussels). Professor Langohr served on several boards of directors, in particular on the Board of Directors and the Audit Committee of both the financial services group KBC Group N.V. and KBC Insurance N.V. He was Dean MBA and member of the Executive Committee at INSEAD from 1993-1995. He was also a frequent director of Executive Programs and a regular advisor in corporate finance and strategy in the banking sector. He was a contributor to academic journals such as The Journal of Monetary Economics, The Journal of Financial Economics and The Journal of Money, Credit and Banking; to numerous professional journals and newspapers and a regular publisher of case studies. He passed away at the age of 64 on May 28^th 2008.

Patricia Langohr is Professor of Economics at the Essec Business School, in Cergy, France, since 2005. Her research specializes in industrial organization, dynamic models of competition and the financial services industry. She teaches microeconomics, industrial organization and business economics. Prior to that, she was a researcher at the Price and Index Number Research division of the Bureau of Labor Statistics in Washington D.C. Professor Langohr obtained her PhD in Managerial Economics and Strategy from the Kellogg School of Management at Northwestern University in December 2003. She has a Diploma in Economics from the Humboldt Universität in Berlin and a Maîtrise in Monetary Economics and Banking from the Université Paris IX Dauphine.

Credit ratings have become a universal phenomenon throughout the capital markets, relied upon by investors, issuers and regulators alike. Issuers understand the fundamental effect of their rating on financing costs, and investors make buying (and selling) decisions based heavily on these scores. Regulators have incorporated credit ratings into everything from allowable investment alternatives for institutional investors to required capital for global banking firms.

Credit rating agencies and their output are vital in overcoming the information asymmetries of the capital market. The Rating Agencies and their Credit Ratings is a comprehensive explanation of what they are, how they function and why they are relevant, addressing a broad range of issues from the credit rating process and the performance of credit ratings, to the nature of competition in the credit rating industry and its regulation.

The book is organised into three distinct sections. Part A provides an introduction to credit ratings, their broad and diverse applications, and describes the credit rating process. Part B focuses on credit rating analysis, providing analysis of how rating actions and inactions interact with the market. Finally, Part C examines the credit rating industry, explaining where it comes from, what its main characteristics are, how the main players compete, and what results it produces for issuers, investors and shareholders.

Written by experienced Professors Herwig Langohr and Patricia Langohr, this book provides a unique and exhaustive introduction to credit ratings, developing the reader’s understanding of credit ratings and the credit rating agencies that produce them. It combines breadth of perspective, substantiation of arguments and depth in reflection, provided by the analysis of extensive field interviews, academic research, rating agency data and regulatory hearings and testimony.

HERWIG LANGOHR was Professor of Finance and Banking at INSEAD, in Fontainebleau, France, which he joined in 1976, specialising in corporate finance, financial services and corporate governance. Professor Langohr served on several boards of directors, including the Board of Directors and the Audit Committee of the financial services group KBC Group N.V. He was also a regular advisor in corporate finance and strategy in the banking sector. He contributed to academic journals such as The Journal of Monetary Economics, The Journal of Financial Economics and The Journal of Money, Credit and Banking and a number of professional journals. He passed away on 28 May 2008 at the age of 64.

PATRICIA LANGOHR is Professor of Economics at the ESSEC Business School, in Cergy, France, since 2005. Her research specializes in industrial organization, dynamic models of competition and the financial services industry. Prior to that, she was a researcher at the Bureau of Labor Statistics in Washington D.C. Professor Langohr obtained her PhD in Managerial Economics from Kellogg at Northwestern University. She has a Diploma in Economics from the Humboldt Universität in Berlin and a Maîtrise in Monetary Economics and Banking from the Université Paris IX Dauphine.

The Rating Agencies and Their Credit Ratings

What They are, How They Work, and Why They are RelevantBy Herwig Langohr Patricia Langohr

John Wiley & Sons

Copyright © 2008 Herwig Langohr and Patricia Langohr
All right reserved.
ISBN: 978-0-470-01800-2

Chapter One

Introduction

Not all that glitters is gold. Often have you heard that told. Shakespeare: The Merchant of Venice.

1.1 CONTEXT AND PREMISES

1.1.1 The Benchmarking of Default Prospects Remains Deeply Rooted in Business Analysis

There is not in this country ... a central point at which all companies are required to present annual statements of their affairs. It is not uncommon for leading companies to publish no reports whatsoever. Some make them unwillingly, with no design to convey information upon the subjects to which they relate. Results that are full and explicit are accessible only to a small number of parties interested. Fewer still have the means of comparing results for consecutive years, without which it is impossible to form a correct opinion as to the manner in which the work has been conducted or of its present or prospective value.

Henry Varnum Poor rendered the description above in 1860. He was editor of The American Railroad Journal. The country was the United States. The audience was a group of London-based investors being asked to fund infrastructure growth in the United States without a hint of the risks involved.

Poor's purpose was to alert investors to the need to be informed about default risks involved in lending money. Many of the London-based investors lost vast amounts of money when railroad and canal companies that they financed went bankrupt - as any investor today loses on average 65% of the face value of a bond when it defaults. Henry Poor went on to say that:

what is wanted is a work which shall embody ... a statement of the organization and condition of all our companies, and at the same time present a history of their operations from year to year which would necessarily reflect the character of their management, the extent and value of their business, and supply abundant illustrations with which to compare similar enterprises that might be made the subject of investigation and inquiry.

Three types of businesses emerged in the 19th century to publish reports that enabled investors to make better-educated investment decisions and to, directly or indirectly, pressure obligors to respect their obligations - the specialized financial press, credit reporting agencies, and investment bankers. One of the first specialized business publications on record was The American Railroad Journal, which was started in 1832. Henry Poor transformed it into a publication for investors in railroads when he became its editor in 1849. To fill the gap he had identified, Poor eventually created his own firm. It embarked upon collecting operating and financial statistics on US railroad companies. The company started publishing the results annually in 1868 as the Manual of the Railroads of the United States. One of the first credit reporting agencies, founded in 1841, was The Mercantile Agency. Through a network of agents, it gathered information on the business standing and creditworthiness of businesses all over the US, and sold its service to subscribers. The merchant banker was of course the consummate insider, insisting that securities issuers provide all relevant information related to company operations on an ongoing basis, sometimes insisting on being on the board for that purpose. One of their hallmarks was also that they 'vouched for the securities they sponsored', as had already happened in 1835-1845 when the debts of several American States had been restructured.

The foundations of these businesses lay in their grasp of the issuer's business in its competitive environment, so credit analysis originated as business analysis. It focused strongly on the quality of the portfolio of opportunities that companies were actually pursuing, on the success with which management was pursuing them, on the ability to respect the debt obligations that the companies had incurred to finance their development, and on the character of the management to be willing to honor them. These businesses formed the information infrastructure in which the bond markets expanded in the 19th century. The fact that business reporting and financial statements are vastly better today in many parts of the world than they were in 1860 is in no small part due to the activities of these 19th-century businesses, which predated the CRAs.

In 1909, John Moody initiated agency bond ratings in the US, marking the expansion of business analysis to include credit risk analysis for rating purposes. Originally, this only covered the bonded debt of the US railroad companies. The purpose of the analysis became more targeted toward rating an issuer's relative credit quality, but the foundations of the ratings continued to focus on the issuer's business fundamentals.

Rating actions in the automobile industry highlight the extent to which ratings continue to focus on business fundamentals. As an example, consider S&P's December 12, 2005, downgrade of General Motors (GM) corporate credit to B, affecting $285 billion. Exhibit 1.1 reproduces the action announcement in extenso. Summing it up, note how S&P refers at length to GM's business position as the key driver of the downgrade. S&P emphasizes the point by going out of its way to remind investors that GM's liquidity position and borrowing capacity give it substantial staying power. But that power is limited by GM's ability to generate positive free cash flow (FCF), and that ability is currently impaired due to the difficulties in turning around the performance of GM's North American automotive operations. S&P explains that GM suffers from meaningful market share erosion related to a marked deterioration of its product mix, despite concerted efforts to improve the appeal of its product offerings. S&P also refers to the aging of GM's SUV models. Credit rating is, and remains, thus deeply rooted in business analysis. No spreadsheet ratings can replace this.

Exhibit 1.1 S&P Research Update: General Motors Corp. Corporate Credit Rating cut to 'B'; Off Credit Watch; Outlook Negative (December 12, 2005)

Credit Rating: B/Negative/B-3

Rationale

On December 12, 2005, Standard & Poor's Ratings Services lowered its corporate credit rating on General Motors Corp. (GM) to 'B' from 'BB-' and its short-term rating to 'B-3' from 'B-2' and removed them from Credit Watch, where they were placed on October 3, 2005, with negative implications. The outlook is negative. (The 'BB/B-1' ratings on General Motors Acceptance Corp. [GMAC] and the 'BBB-/A-3' ratings on Residential Capital Corp. [ResCap] remain on Credit Watch with developing implications, reflecting the potential that GM could sell a controlling interest in GMAC to a highly rated financial institution.) Consolidated debt outstanding totaled $285 billion at September 30, 2005.

The downgrade reflects our increased skepticism about GM's ability to turn around the performance of its North American automotive operations. If recent trends persist, GM could ultimately need to restructure its obligations (including its debt and contractual obligations), despite its currently substantial liquidity and management's statements that it has no...