Five Things You Need to Know About Corporate Credit Ratings
What you need to know (and what it means)!
Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
This morning Standard & Poor's cut the credit-rating outlook for Bear Stearns (BSC) to negative from stable. S&P said the decision to cut the rating outlook was due to concerns that declining prices for mortgage-backed securities would hurt earnings. OK, so what does all this mean in real-person talk? Below we take a look at what this means and why it's important.
1. Who Is Standard & Poor's and Why Do They Care?
Standard & Poor's is one of many agencies that evaluate the credit risk of certain companies, financial instruments and even entire countries. The other ratings agencies you may have heard of are Fitch's and Moody's, but there are quite a few others.
2. How Do They Rate?
The credit agencies use a ratings system to indicate the credit-worthiness of the companies or instruments they rate. That credit rating helps determine the interest rate applied to the specific loans and instruments. Wall Street uses those ratings for comparative purposes and to help determine available capital options for borrowers.
3. What do the Ratings Mean?
The ratings agencies use a system of letters to rate credit quality. For example, S&P uses AAA to denote the highest credit quality rating. On the low end, D is used to indicate the highest risk and lowest quality debt. Below are S&P's ratings categories:
Investment Grade Ratings
AAA - Highest quality companies
AA - Quality companies, but a bit higher risk than AAA
A - Certain economic situations could impact financing
BBB - Medium credit-quality companies
Non-Investment Grade Ratings or "Junk" Ratings
BB - Very dependent on stability of economy
B - Company's financial situation fluctuates very quickly
CCC - Presently vulnerable to, and dependent on, positive economic conditions to meet credit obligations
CC - Highly speculative bonds
C - Vulnerable company, potentially in bankruptcy, but still continuing to pay out on obligations
CI - Past due on interest payments
R - Under regulatory supervision due to financial situation
SD - Selectively defaulted on some obligations
D - Defaulted on obligations and S&P believes company will default on most or all obligations
4. You Lost Me
Ok, let's stop right here.
Whenever "Wall Street" as a concept is introduced into anything that is being explained, the explanation usually begins to descend into something arcane and impenetrable. Why? Because that is how Wall Street makes money. You know all these people out here selling things you don't understand? They wouldn't be employed for long if you understood what they were selling, because then you wouldn't need them to tell you what you should buy and why you are buying it in language you can't understand. Make sense? Of course not. So let's look at what is really going on here in terms that we can understand.
Like you and me, companies need money to operate. In our case, we sell something (our labor, services) to someone (our employer) and then use that income to live our lives. Similarly, companies sell something to someone and use that income to live their corporate existence.
If we want to expand our operations beyond living on a cash-only basis - for example, if we want to buy a car so that we can get around more easily, or if we want to stop renting an apartment and buy a home - then we must find someone to loan us the money to expand.
Now, it would be great (for us) if a nice person who has a lot of money simply gave us some of their unused money and said, "Just return it when you can," but life doesn't work that way. So instead, we have to buy a loan from someone. But this raises some interesting questions. How does the person who is selling loans know how much to charge for them? And why do loans vary in price in the first place? Why aren't they more like shoes? Shoes cost what they cost... for everybody.
The first difference is obvious; once we buy our shoes the transaction has concluded and the shoe seller won't be affected in the least by what we do with our shoes. The seller of a loan, however, has a much longer relationship with us since our transaction won't be concluded until we finish paying for the loan.
Now, how does the person selling the loan know how much to charge us for it? That person uses a credit agency and that credit agency gives us a rating similar to the S&P ratings. The higher the rating, the lower the credit risk, the less expensive the price of the loan.
Alright, but what happens if an event occurs - loss of our job, reduction in earnings, illness - that reduces our ability to pay for the loan we bought? Well, potentially, our credit rating could be downgraded. So, we already bought our loan, why should we care if our rating is downgraded now? Because a downgrade in our credit rating means we could be forced to pay more for any loans we buy later. It raises the cost of our lives. Similarly Bear Stearns, if S&P downgrades their credit rating, could be forced to pay more for their future loans.
5. The Ripple Effect
Where things begin to get complex is when other interested parties are interjected into the mix. In the case of our lives, those other interested parties are usually a spouse, girlfriend, boyfriend, or child. In the case of companies, those interested parties are investors and other lenders. A ratings downgrade for a company can have a ripple effect. How does this ripple effect work? Let's return to our favorite topic (ourselves) for a moment.
Ok, let's say that the person we bought our loan from has loans of their own. Perhaps they too wanted to buy a house, or maybe because they have a better credit rating than us, loans they buy cost less than the loans we buy, and so they figured they could make a nice living by pocketing the difference between the amount they paid for their loan and the higher amount they charged us for our loan.
Now, if an event makes it impossible for us to continue to pay out loan, think about what happens to the person who sold it to us if they have loans of their own - it potentially reduces their ability to pay for their loans... and on, and on, and on in the food chain of loan sellers.
That chain of events is pretty close to what has been happening in the world of subprime mortgages. First, something happened to cause the original purchaser of the subprime loan (the homebuyer) to default - the economy in general in some cases, or the fact that the loan turned out to be way more expensive than they thought. Next, as those buyers began to stop paying, the lenders began to stop being able to pay for their own loans.
And then, in the case of the Bear Stearns potential credit-rating downgrade, there's the "guilt-by-association" effect. Other companies in the same sector (broker-dealers such as Lehman (LEH), JP Morgan (JPM), Goldman Sachs (GS) and Merrill Lynch (MER)) and companies with similar exposure could also be "infected" by the downgrade and potentially find their financing costs rising as well. Hmm, wait a second, infected? Isn't that something that happens in a "contagion"?
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