Fico and Rating Agencies

FICO is a public company that was found in the year 1956 with the aim to help financial services companies by measuring credit risk in a score which is called the FICO score. This stands for Fair Isaac Corporation mainly used in the United States and Canada by lenders and others to assess the credit risks of prospective borrowers or existing customers. Here a three digit number between 300 and 850 is being given to each person that wants a review and a summary of their credit risk. After having calculated this through using several personal files concerning the particular individual, the personal data is collected and this information is split into five categories: 1.Payment history

2.Length of credit history
3.Amounts owned
4.New credit
5.Types of credit used
These five parts concern payment history; how much credit you have used, how long you have had using credit, the type of credit that you had and the most recent applications for a credit. The FICO score of a person can improve if it has been paid on time, but can be a major impediment in acquiring a loan if payments if in the past they have not made payments on time. This part counts for around 35% of the total score and is one of the most important ones in allowing the person to obtain a loan. Around 30% percent of the FICO score is determined by how much credit you have used as well as the type of credit you have had. A person that has applied for several credit cards in a short period of time will be perceived as less reliable and the score will be negatively affected. The period of how ownership of a credit account counts for around 15% percent of the FICO score. Here the longer you have been a customer for the same company, for example a credit card firm, the better the score will be.

Along with this, the type of credit you have used has an influence of around 10% percent of the score. If a person has borrowed in the past for home equity, this gives him a much better credit worthiness than someone that has open a credit card right before Christmas with the intention of buying presents. The most recent credit applications count for 10%, so if someone had applied for several credit cards in short period he or she will have a lower score in this part of rating. In short it be said that, the outcome is linked to the change of information in the personal report of the individual. When this fluctuates, it also changes the importance of factors affecting the results as well, because of that, it is almost impossible to measure the exact impact of any one factor in how a particular credit score is calculated without looking at the individual’s complete report. Additionally, it is important to say that FICO scores are mostly being used while applying for a private loan, mortgage, home equity and even for opening a cell phone contract.

Criticism
As we have just stated, FICO credit scores are necessary to provide information related to all loan takers for supporting the running of whole business of financial loan system. Despite this, there are some very significant critical issues about it which are valuable enough for us to take into consider. On the one hand, the formula of calculating FICO is kept a secret! For instance, one day you are planning to have a house mortgage which is a big step in your life. At this moment, you are excited and go to communicate with those bankers to figure out if you can take the loan, payment terms and also the level of interest rate over it. Therefore, it is easily to notice that it will have a severe effect on an individual and even a household. After that, you are informed that your FICO is slightly lower than 600 therefore you need to pay a relatively high interest rate! It is obvious that numerous question marks will occur in your head and you will feel really bad at the same time. So how can an individual affected so severally by the FICO credit scores and no one know how it comes to be calculated? Of course, we can think up some ideas logically such as bankruptcy, it will sure hurt some ones score immensely.

The thing is we have no idea if we lose points for doing something responsible which could be considered as unprofitable for banks, such as paying off credit cards in full every month or applying for new cards to get rewards. On the other hand, FICO is a risk analysis which is not fair enough. It is generally thought that it looks back over around 7 years of credit history to evaluate risk in payment of debt, and it does not cover the overall credit health. Those factors such as income, debt to income, age, marital status, and employment history… all of these are significant indicators of credit stability. Unfortunately, FICO does not include or consider those factors. FICO is more a measure of the past track record of individuals in actually paying their obligations.

It doesn’t consider anything about how much they have in the bank or what their paycheck is each month. In one sentence, FICO is not balanced so that some individuals profit from better interest rate whereas the others are paying more for those risks which might not even exist. To sum up, FICO is imperative for banks to notice those risky clients efficiently and enable the whole business run smoothly. But overall, it is convinced that it is not perfect since a vast number of important factors which FICO doesn’t take into consideration. This shows that the way FICO calculates the score should not be kept a secret. It would be better to open the formula for the public, collect different opinions and finally improve the credit scores system. However, it is clear to be seen that the financial crisis was not caused by the faults of FICO since numerous subprime mortgages were accepted by the banks to satisfying their greedy stomachs.

Rating agencies history
The Credit Rating Agencies have come a long way to become the financial giants that played a decisive role in the financial crisis. The history of rating agencies goes back to when John Moody first started to rate railroad bonds in 1909. Other companies soon followed including, but not restricted to, Poor’s (1916), Standard Statistics (1922) and Fitch Publishing (1924). Later Standard Statistics and Poor’s would merge into Standard & Poor’s and the “Big Three” would emerge. These companies would sell their ratings to various other companies including federal regulators and the popularity began to grow. Bank regulators set in 1936 a decree that would prohibit banks from investing in bonds that weren’t considered “investment grade” (BBB or better by S&P) by rating agencies. The bank regulators had outsourced the work of regulating banks to the assertions that rating agencies deemed a company possessed. Other sectors followed suit in years to come including regulators from insurance companies and federal pension regulators. This gave more and more weight to the assumptions made by credit rating companies, and less on the regulators set to look over the markets.

The growth slowed down after World War II when bond defaults simmered down, but picked up again after the 1970’s due to the economic turmoil that took place during the era. This uncertainty caused consumers to once again get consultation for their investments and business began booming. The Securities and Exchange Commission (SEC) finalized the authenticity of rating agencies in 1975 when it created the Nationally Recognized Statistical Rating Organization (NRSRO) in order to weed out agencies that might give false information to companies for personal gain. It gave special status to Moody’s, S&P, and Fitch which were deemed reliable and later a few others were added to the list.

The SEC didn’t allow too many other entrants and the few that did manage to get the official status merged with the original three. This barrier gave more power to the “Big Three” and more freedom to expand. Whereas before the agencies stood to protect the consumer, there started to be a shift where the companies they were critiquing starting paying for better ratings. The subjectivity of the ratings allows for such payoffs since it is extremely hard to rate thecompanies based on a set formula. This has led to a conflict of interest since there is a  lot riding on the ratings the companies provide, and these ratings are now being skewed by companies with deeper pockets than those that truly need the numbers to make informative decisions. Quick reminder of the financial crisis

In 2008, numerous shares dropped sharply in many major countries. The super huge company Lehman Brothers bankrupted, the price of house declined from the U.S. to Hong Kong. A vast number of people lost their jobs in U.S., Europe… A terrible crisis took place and destroyed the economies of the U.S. and Europe, and the rest of world suffered from it as a result of globalization. Everyone is paying for the debts to feed those bankers’ greedy mouths. In September 2008, devastating effects were felt on many “too big to fall” financial companies all over the world. After that, the negative effects began spreading to all other sectors of the economy. The crisis originated in the U.S.A. and Western Europe, and it was spread everywhere very soon, from banks, financial companies, investors, loan takers, etc. Most parties everywhere suffered heavily from it. U.S. stocks went down 50% from their peak in 2007. Paper losses for shareholder of major financial institution have been up to 70%. Of course, some of them even lost everything when the company went into bankruptcy. The stock market had dropped 50-70% in major countries and pension funds had large monetary losses. Along with all this was the drop in the overall prices of U.S. houses declining twenty percent.

Then, companies of other sectors were affected and they could not borrow money for any expansion or even for daily operations. These companies needed to cut back and some of them simply went extinct. On the other hand, as is always the case during a recession, consumer spending dropped while unemployment rose significantly, and then the tax income plunged as a result. Finally, the U.S. and Western Europe suffered deeply from it. Furthermore, these countries and the rest of world “are paying” for the events that transpired up until this moment. From what we know from the news, one of the biggest problems which caused the financial crisis to take place was companies owned numerous “toxic” securities, which came from U.S. sub-prime mortgages put into CODs. No one would like to purchase them since everyone knew the bomb would be detonated very soon. $800 billion rescue plan was announced in the U.S. October 3, but it did not seem to be very effective. By this time, the economic crisis was deteriorating in Europe, as trillions of dollars in losses occurred there and in Russia, China, India and in many developing countries. International Monetary Fund arranged emergency bailouts for medium-sized countries, like Pakistan and Ukraine. Policies of U.S. government

Rescue AIG: The Federal government feared the company would not be able to pay off on all the insurance policies that it had sold. The failure of AIG would cause losses for banks (and others) which had purchased this insurance, adding more losses to those banks which had already suffered strongly from financial crisis. So the Fed decided that it had to bail out AIG in order to save the financial system. Economic Stimulus: In February 2008, Congress passed a bill of a $168 billion stimulus quickly that included tax rebates for households and tax cuts for businesses. After that the incoming Obama administration and Democrats in Congress were working on much larger stimulus package of $850 billion, which emphasized on aid to states, education, unemployment benefits, and public works infrastructure projects and one-third tax cuts.

Anti-foreclosure measure: In July 2008, Congress passed this measure which allows for the refinancing of existing mortgages, they are in default with new mortgages that would have a value of around 85 percent of the current market value of the houses, and would be guaranteed by the Federal Housing Administration. Pay for toxic securities: Treasury Secretary Paulson requested, and Congress later approved $700 billion to purchase high-risk, mortgage-based securities (“toxic waste”) from U.S. banks. In a conclusion, numerous countries suffered from financial crisis heavily in 2008, it started from U.S. & Western Europe and then spread out to the rest of the world. Even though, U.S. government announced numerous new policies, they did not solve the fundamental problems of too much household debt, declining housing prices and rising foreclosure rates. These problems have not been solved until nowadays. Role of the rating agencies

Credit rating agencies are the main authority to assign rate of credit for the companies who issue debt. Any investor can measure the risk of bad debt after analyzing these credit rates. These credit rates are fixed on the basis of ability to pay back the loan. Credit rating agencies also assist in portfolio monitoring. In portfolio monitoring, they provide information about which investment is most secure and provide high return of interest. The role of credit rating agencies is to provide investors (individuals, corporations and institutions) and debtors with crucial information regarding the creditworthiness of an individual, corporation, agency or even a government institution. They provide a wide array of financial data and information on bonds, equities and mutual funds, bridging the information gap between issuers and investors and a source of credit surveillance for investors by monitoring and disseminating credit opinions in a timely and efficient manner. Credit rating agencies help to measure the quantitative and qualitative risks of these entities and allow investors to make wise and accurate decisions.

The quantitative risk analysis carried out by credit rating agencies include the comparison of certain financial ratios with chosen benchmarks and the qualitative analysis focuses on the management character, legal, political and economic environment in a jurisdiction. Investors will benefit from the professional risk assessment that will be carried out by these credit rating agencies. One of their most important role is to serve as an unbiased, independent “second opinion” that an investor can use to confirm or refute his or her own analysis. Credit rating agencies are also helpful in rebuilding investor confidence, which is vital to the global capital markets. Furthermore, these agencies help in reducing information asymmetry and improve the capital market function and efficiency. There are laws in place to ensure that these credit rating agencies make accurate ratings on investments. Rating agencies will run credit checks on companies, countries and financial products. They track and monitor performance of economy or countries as well as their default statistics and provide ratings on the basis of their history of borrowing and repayment.

They rate on the basis of country’s borrowing and repaying capability considering other macroeconomic indicators. If the country is under debt for a prolonged time and not able to manage its high debt situation, rating agencies may downgrade their credit rating. Companies and the various financial products will be rated in a similar way as well. In relation to the recent subprime crisis, credit rating agencies played a very important role at various stages in the subprime crisis. They have been highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO). The Financial Crisis Inquiry Commission reported in January 2011 that: “The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Their impact

The credit rating agency’s (CRA’s) play an important role on the financial market as many investors take their ratings in consideration when making investments. Share prices and risk premiums are partly based on the ratings given by CRA’s. Therefore it is logical that the financial system will be negatively affected when CRA’s lose their credibility. Banks who had a triple A status like Fannie Mae and Lehman Brothers collapsed, showing investors that they cannot rely on the best rating a CRA can give. As a result, CRA’s suddenly began to downgrade the ratings of financial institutions and countries. In the CRA’s effort to remain credible they created more unrest among investors. Their poor ratings were not only applicable to just a couple of banks but to the whole financial market. Investors realized that their investments were not as safe as they thought. For many companies that suddenly got a lower rating this meant that their share price dropped significantly. For many countries that got a lower rating, this meant that it became more expensive for them to borrow money.

Even wealthier countries in the world like the US and France lost their precious triple A rating. When we look at France in particular we see that after their rating was downgraded from AAA to AA+ their borrowing cost rose from 3.03% to 3.07%. Although this is a relatively small change, it contributes to the economic problems in Europe. For instance, it makes it more difficult to borrow enough money to provide rescue loans by the EFSF. Therefore the chance of a financial collapse is more likely as EU member states that need financial aid – like Greece -might not get all the funds they need. The higher borrowing costs can be explained by the higher premium investors demanded as a result of CRA’s lowering credit ratings signaling that some investment are riskier than first thought. Moreover, institutions that solely invested in very secure assets like government bonds realized that their portfolio was riskier that they thought and moved away from these investments. Therefore the demand of certain government bonds decreased which negatively affected the financial market. So in general the CRA’s, whose role was to prevent investors that were unsure about their investments, actually contributed to pushing the financial system to the verge of collapse. All parties were negatively affected leading to more demand to increase government regulations on rating agencies. Perspectives

“I think we’re basically back to business as usual,” said Peter Hagan, director at Berkeley Research Group in Princeton, New Jersey. In effect, only a few changes have been made since the financial crisis of 2008. One of the reasons the situation stayed the same is the fact that despite the SEC opening up competition in the market, financial institutions are still requiring companies to rate their debt using one of the big three. Given the costs associated with having debt rated, experts agree that companies would be hard pressed to pay twice when one rating will suffice. However, Companies can technically issue debt without the help of the rating agencies, but ratings will be required by the financial institutions. Consequently, if companies really need this funding from the investors, the rating becomes necessary “Do [debt issuers] place a lot of faith in those ratings? Not really,” said Jeffrey Glenzer, managing director at the Association for Financial Professionals (AFP). “But do they still have to pay for them in order to issue their debt?

Yes. So deeply embedded in the banks are the NRSRO-designated rating agencies.” Now agencies must file annual reports detailing internal controls and disclosure of performance statistics, in addition to adhering to stricter conflict-of-interest rules around their sales and marketing practices. Fines and penalties have been shored up, and agencies must disclose performance statistics along with data and assumptions underlying their credit ratings. Part of the problem is that ratings agencies are funded by the very companies they rate. The price to be rated is from $1,500 to $2,500,000, depending on the size of your company. In theory, this creates a conflict of interest, because it gives the agency an incentive to give the companies the rating they want. Rating agencies rely on audited statements. Meaning companies can show whatever they want.

Could we change this model? One idea would consist on this method: on trade debt issued in the secondary market, both issuers and investors are paying for those ratings as part of the sale or purchase of the security. “That way you take the economic power of either party out of the equation” according Jeffrey Glenzer. Banks follow the KYC (Know Your Client/Customer, depending on the banks) method to manage their risks. Unfortunately, risk department who maintain these standards procedures might be under overpressure and don’t have time to deal with the changes themselves; consequently, they would rely on the ratings from the big three.

This phenomenon has been underlined a lot of times in the news. Then, that’s not a surprise Hagan said “rating agencies do a good job in rating debt — so good, in fact, that complacency can set in. Credit departments began depending on ratings rather than doing their own analysis”. Because of the criticism against the big three and consorts, the Bertelsmann Foundation will lead a group of international experts to develop a model for a non-profit institution that uses transparent criteria to rate sovereign debt. Despite this, the group is not supposed to replace the big three; its role is to propose an alternative to them.

The EU has approached legislative reform of CRAs and has been faster than the US. In the end of 2009 the European Parliament and Council approved the Credit Rating Agencies Regulation. This legislation became immediately effective and implied:

1. Establishment of a registration and certification system for CRAs
2. Restriction of conflicts of interest
3. Provision of justifiable and clear ratings
4. Increased transparency

In summary, FICO is a well known rating tool that provides lenders to obtain in the blink of an eye insight into the reliability of the future borrower. FICO credit score systems are vital for enabling bank system to run smoothly, but it is not perfect and the formula should be open for public. This causes imbalances that could be fixed to help the regular Joe more than the corporate executive. In 2008, financial crisis took place and expanded from the US and Europe to the world; house prices, stock prices, unemployment rates, and everything else suffered significantly from it. The credit rating agencies played a big part in the Crisis given the freedom without having to show strict backing for their assumptions.

The role and responsibility of the credit rating agencies are to act as an unbiased, independent and trustworthy source that an investor can use to judge his own analysis when undertaking any form of investment. It is clear that rating agencies had a negative effect on the financial world. By adjusting their ratings they’ve created unrest in the financial markets. This has put companies and countries in serious problems. Rating agencies undoubtedly played a key role in the drop in share prices of companies and the rise of borrowing costs of countries. To conclude even though the rating agencies have been under a lot of scrutiny, there is still a lot to do to make sure their power is not too strong. Measures are being taken and we hope that they will be efficient enough to avoid this kind of situation from happening again.

References:

[ 1 ]. http://www.FICO.com/en/Company/Pages/history.aspx
[ 2 ]. http://www.moneycrashers.com/credit-rating-agencies-history/ [ 3 ]. http://www.time.com/time/magazine/article/0,9171,1886559,00.html [ 4 ]. http://www.ftc.gov/be/seminardocs/091112crediratingagencies.pdf [ 5 ]. http://www.ftc.gov/be/seminardocs/091112crediratingagencies.pdf [ 6 ]. http://www.conservapedia.com/Financial_Crisis_of_2008 [ 7 ]. http://www.isreview.org/issues/64/feat-moseley.shtml

[ 8 ]. http://www.nytimes.com/2008/02/08/business/worldbusiness/08iht-stimulus.2.9870969.html?_r=0 [ 9 ]. http://www.svtuition.org/2010/06/role-of-credit-rating-agencies.html [ 10 ]. http://www.goodreturns.in/classroom/2011/08/role-credit-rating-agencies.html [ 11 ]. http://www.ehow.com/about_6723240_importance-credit-rating-agencies.html [ 12 ]. http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245333793833 [ 13 ].