Sheel's Project on Credit Rating

A PROJECT REPORT ON SIGNIFICANCE OF CREDIT RATING IN INDIA BY SHEEL KUMAR HANS (MBA-Applied Management) EN.NO.4740800891 SUBMITTED TO

NIS ACADEMY,INDORE (A division of NIS Sparta, a Reliance ADA Group company)

PROJECT REPORT ON SIGNIFICANCE OF CREDIT RATING IN INDIA

CERTIFICATE OF PROJECT COMPLETION

This to certify that Mr. Sheel Kumar Hans a Bonafide student of Nis Academy Institute of Management, Indore has completed the project title

SINGNIFICANCE OF CREDIT RATING IN INDIA. The Project was undertaken in degree of Master in Applied Management under University of Annamalai during the academic year 2008-2010. He has carried out this project under my guidance and supervision. His work is found to be satisfactory in all respects. He duly acknowledged the source of information and data used for the purpose of completion of the project report.

We wish him all the best for his future endeavors.

Mr. Feroz Banglowala (Director)

Prof. Abhishek Kumar Jain (Project guide)2|Page


ACKNOWLEDGEMENT

I take this opportunity to pay my sincere thanks to all the people who have helped me directly or indirectly to complete my project successfully. First of all, I would like to express my sincere gratitude to Mr. Abhishek Kumar Jain senior faculty of NIS Academy, who gave me the opportunity to carry out this project. I am equally grateful to Ms. Neha Chawala, Faculty of Nis Academy, who in spite of her busy schedule provided her valuable guidance and sufficient material needed for the completion of my project. In fact, she has been my guide throughout my project. I am also grateful to Mr. Feroz Banglowala, Director (NIS Academy), for granting me an approval to undertake this project, my sincere thanks to Mr. Gajendra Rathor, for their invaluable guidance and support. Date: Place: Indore Sheel Kumar Hans MBA 2nd year Financial Management

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DECLARATION

I hereby declare that the project entitled Significance of Credit Rating in India submitted for the degree of business administration in Applied Management is my original work and the project has not formed the basis for the award of any degree, diploma, associate ship, fellowship or similar other titles. It has not been submitted to any other university or Institution for the award of any degree or diploma.

Date: Place:

Signature of the Student Name: Enrolment no: 4740800891

INDEX

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INTRODUCTION

07

Concept of credit rating and features ORIGIN OF CREDIT RATING

11 13 15 18

THE CREDIT RATING SYSTEM CRDIT SCORE

CREDIT RATING AGENCY Reasons for the origin of the credit rating agencies Functions and the way of working.

GROWTH OF CREDIT RATING AGENCIESG CRITISISM FOR CREDIT RATING AGENCIES CREDIT RATING IN INDIA Credit rating agencies in India and working procedures.

22 30 39

USES OF RATING TAXABLE EVENTS AND SCOPE OF SERVICES Value of Taxable Service, Exemption and ExclusionLIST OF DATA REQUIREMENTS FOR CREDIT RATING FUTURE OF CRIDIT RATING IN INDIA

49 59

64 685|Page


BENIFITS AND DRAWBACKS OF CREDIT RATING NEED AND IMPORTANCE OF CREDIT RATING PRACTICAL PROBLEMS WITH CREDIT RATING INDIVIDUAL CREDIT RATING RAGULATORY FRAMEWORKS

69 74 80 84 96

SEBI GuidelinesIPO RATING

154 162 175 182 191 192 196

BOND RATING

SME RATINGS BY NSIC CRISIL

FINDINGS

CONCLUSION

QUESTIONARIES

BIBLIOGRAPHY

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INTRODUCTION In a market, financial markets play the role of efficient intermediary. They act as a link between savers and investors, mobilizing capital on one hand, and efficiently allocating them between competing users to the other hand. In addition to this an investor can also base the investment decision on the grading offered by credit rating agencies.

Concept of Credit ratings A credit rating is a measure used by creditors to determine how much they can trust a certain borrower, whether the borrower is an individual, a corporation, or a country. The credit rating is derived using past financial data or the borrowers credit history. There are several factors that can affect the credit rating of an individual including: the persons ability to pay a loan Reflected by the persons salary and other assets

the amount of credit in existence This is what credit limits are for. If the person is near his credit limit or has reached it is harder to get a loan. This also reflects whether the person is in the habit of going into debt7|Page


credit history Shows whether the person makes payments on time. This also reflects the persons spending and saving patterns.

Definition The process of assigning a symbol with specific reference to the instrument being rated, that acts as an indicator of the Current opinion on relative capability on the issuer to service its debt obligation in a timely fashion, is known as credit rating. According to the Moodys, A rating on the future ability and legal obligation of the issuer to make timely payments of Principal and interest on a specific fixed income security. The rating measures the probability that the issuer will default on the security over its life, which depending on the instrument of the expected monetary loss, should a default occur. Acc to Standard & poors, it helps investors by providing An easily recognizable, simple tool that couples a possibly Unknown issuer with an informative and meaningful symbol of credit quality. According to ICRA, Credit ratings are opinions on the relative capability of timely servicing of corporate debt and obligations.8|Page


These are not recommendations to buy or sell.neither the accuracy nor are completeness of the information guaranteed. Features of Credit ratings Specificity. Relativity. Guidance. Not a Recommendation. Broad Parameters. No Guarantee. Quantitative and Qualitative.

Function of credit ratings Superior Information Low cost information Basis for proper risk- return trade off Healthy discipline on corporate borrowers Formulation of public policy guidelines on institutional investment

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Exercising responsibility Credit is a part of everyday life. It enables people to buy everything from necessities to luxuries. However, if you do not exercise responsibility in managing your finances you will find that the concept of credit will cripple you instead of empower you. To make sure you exercise responsibilities always keep track of your purchases, loans, and overall expenses. Keep yourself informed and do not fall for the buy now pay later mentality. Buy only what you need and if buying for luxuries makes sure that it is planned and not a spontaneous buy. Pay your bills on time and do not allow yourself to go in debt. In the end being responsible will not only yield in an excellent credit history but will also ensure that you will have more options for finding money fast in case you need it in the future.

ORIGIN OF CREDIT RATING Origin in 1840 following the crisis in 183710 | P a g e


The First Merchantile Credit Agency was set up in New York by Louis Tappan in 1841. First rating guide was published in 1859 John Broad Street set up the similar agency in 1849 which published its rating books in 1857 In 1900 John Moody founded Moodys Investors Services and in 1909 Published his manual of Rail Road Services

History of Credit Rating The initial rating exercise was started by Henry Poor who published financial statistics of Railroad companies in 1860. In addition to his publishing business, John Moody (Moodys Investors Services) started publishing ratings for railroad bonds from the year1909. The rating activity got a boost post Great Depression of 1933 when US Government Controller of Currency directed the banks in USA to purchase bonds rated BBB/Baa and above and the rest came to be known as junk bonds. At present in US markets all commercial bonds are invariably rated.

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IMPETUS The credit rating system originated in the USA in seventies. The high levels of default, which occurred after Great Depression, in the US capital markets, gave the impetus for the growth of credit rating. The default of $82 million of commercial paper by Penn Central in the year 1970. and the consequent panic of investor in commercial papers, resulted in massive defaults and liquidity crisis. US made rating Mandatory for institutions such as Govt Pension funds, and Insurance companies.

THE CREDIT RATING SYSTEM

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Credit rating has facilitated authorities around the world to issue mandatory rating requirements. For instance, specific rules restrict the of new issues that are rated below a particular grade. Growth Factors Credibility and Independence. Capital Market Mechanism. Disclosure requirements. Credit Education. Creation of Debt Market. Major issues Investment Vs speculative Grades. Continuous Monitoring. Grade Surveillance. Rating Ceiling. Evaluation of Line. Ownership Consideration. Investment Grade Ratings S&P and Others13 | P a g e


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CRDIT SCORE

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Credit score is a number which lenders use to assess the risk of extending credit to you. PROJECT REPORT ON SIGNIFICANCE OF CREDIT RATING IN INDIA In other words, credit score is an estimate of the risk that a bank will take to lend you money. It is also a snapshot of your credit file at a certain point in time. The FICO score is developed by Fair Isaac Corporation and based on credit files maintained by consumer credit reporting agencies. It is widely used by banks, credit unions, insurance agencies, financing companies and other lenders. However, it is not the only factor determining your ability to obtain credit. Other important factors include: income, employment history, previous and current relationships with a lender, to name a few. Each lender decides on its own what will be taken into account when it considers lending money to you. Credit score is a mathematical formula which takes into account many different pieces of information and compares it with hundreds of thousands of other credit reports from the past, to create patterns, which identify statistical possibility of future credit risk. Every person with a credit file has three credit scores based on information from three credit bureaus. They are not exactly the same, but for most people they will be only slightly different. If your credit report does not contain enough information, your score cannot be calculated as there aren't enough items to be compared with generated patterns.16 | P a g e

In that case, a different formula is used to provide your credit rating to a lender. It is important to remember that while most lenders use FICO score, they decide


Tips to improve and maintain a good credit score 1. Collect credit report from Experian, TransUnion and Equifax. Review the report for any error or mistake. 2. Try to reduce the debt of those with high interest. 3. If not in full, try to make payment of minimum balance due of credit cards. 4. Pay all you bills on time. Late payment can do a serious damage to your report. 5. Avoid credit from financial companies. It can negatively affect your score. 6. Don't apply for too many credit accounts.Credit score determine your financial status, so one should always try to keep it as good as possible and avoid any such actions that can affect it and result a low score.

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CREDIT RATING AGENCY A credit ratings agency is a company that assigns credit ratings to institutions that issue debt obligations (i.e. assets backed by receivables on loans, such as mortgage-backed securities. These institutions can be companies, cities, non-profit organizations, or national governments, and the securities they issue can be traded on a secondary market. A credit rating measures credit worthiness, or the ability to pay back a loan. It affects the interest rate applied to loans - interest rates vary depending on the risk of the investment. A low-rated security has a high interest rate, in order to attract buyers to this high-risk investment. Conversely, a highly-rated security (carrying a AAA rating, like a municipal bond which is backed by stable government agencies) has a lower interest rate, because it is a low-risk investment. These lowrisk bonds are available to a wide range of investors, whereas high-risk bonds cater to a narrow investing demographic. Companies that issue credit scores for individuals are usually called credit bureaus and are distinct from corporate ratings agencies.

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Definition "Credit Rating Agency" means any commercial concern engaged in the business of credit rating of any debt obligation or of any project or programme requiring finance, whether in the form of debt or otherwise, and includes credit rating of any financial obligation, instrument or security, which has the purpose of providing a potential investor or any other person any information pertaining to the relative safety of timely payment of interest or principal; (Section 65(21) of Finance Act, 1994 as amended)

Big Three The top three credit ratings agencies in the United States are:

Moody's Standard & Poor's Fitch Ratings

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In the wake of recent credit-market turmoil, some niche agencies are picking up market share or at least additional visibility. Among the niche agencies are DBRS and Egan-Jones.

Credit rating agencies Agencies that assign credit ratings for corporations include:

M. Best (U.S.) Bay corp. Advantage (Australia) Dominion Bond Rating Service (Canada) China Credit Information Service (China) Fitch Ratings (U.S.) Japan Credit Rating Agency (Japan) Moody's Investors Service (U.S.) Standard & Poor's (U.S.)

Rating Agency Malaysia (Malaysia)

Egan-Jones Rating Company (U.S.)

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Reasons for the origin of credit rating agencies

the increasing role of capital and money markets consequent to disintermediation.

Increased securitization of borrowing and lending disintermediation.

consequent to

Globalization of the credit market. The continuing growth of information technology. The growth of confidence in the efficiency of the market mechanism. the withdrawal of Govt safety nets and the trend towards privatization

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GROWTH OF CRDIT RATING AGENCIES 1841- Merchantile Credit Agency (USA) 1900- Moodys Investors Services (USA) 1916- Poor Publishing Company (USA) 1922- Standard Statistics Company (USA) 1924- Pitch Publishing Company (USA) 1941- Standard and Poor (USA) 1074- Thomson Bank Watch (USA) 1975- Japanese Bond Rating Institution (JAPAN) 1987- CRISIL by ICICI (INDIA) 1991- ICRA by IFCI (INDIA) 1994- CARE by IDBI (INDIA)

Rating Grades

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Each rating agency has developed its own system of rating grades for sovereign and corporate borrowers. Fitch Ratings developed a rating grade system in 1924 that was adopted by Standard & Poor's. Moody's grading is slightly different. Moody's sometimes argues that their ratings embed a conceptually superior approach that directly considers not only the likelihood of default but also the severity of loss in the event of default.

Long Term Credit Rankings Fitch Ratings and Standard & Poor's use a system of letter sliding from the best rating "AAA" to "D" for issuers already defaulting on payments. Investment Grade

AAA : best quality borrowers, reliable and stable without a foreseeable risk to future payments of interest and principal

AA : very strong borrowers; a bit higher risk than AAA A : upper medium grade; economic situation can affect finance BBB : medium grade borrowers, which are satisfactory at the moment

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Non-Investment Grade

BB : lower medium grade borrowers, more prone to changes in the economy, somewhat speculative

B : low grade, financial situation varies noticeably, speculative CCC : poor quality, currently vulnerable and may default CC : highly vulnerable, most speculative bonds C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations

CI : past due on interest R : under regulatory supervision due to its financial situation SD : has selectively defaulted on some obligations D : has defaulted on obligations and S&P believes that it will generally default on most or all obligations

NR : not rated

Moody's grading follows a different system

Investment Grade

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Aaa: Obligations rated Aaa are judged to be of the highest quality, with the "smallest degree of risk"

Aa1, Aa2, Aa3: Obligations rated Aa are judged to be of high quality and are subject to very low credit risk, but "their susceptibility to long-term risks appears somewhat greater".

A1, A2, A3: Obligations rated A are considered upper-medium grade and are subject to low credit risk, but that have elements "present that suggest a susceptibility to impairment over the long term".

Baa1, Baa2, Baa3: Obligations rated Baa are subject to moderate credit risk. They are considered medium-grade and as such "protective elements may be lacking or may be characteristically unreliable".

Non-Investment Grade

Ba1, Ba2, Ba3: Obligations rated Ba are judged to have "questionable credit quality."

B1, B2, B3: Obligations rated B are considered speculative and are subject to high credit risk, and have "generally poor credit quality."

Caa1, Caa2, Caa3: Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk, and have "extremely poor credit quality. Such banks may be in default..."25 | P a g e


Ca: Obligations rated Ca are highly speculative and are "usually in default on their deposit obligations".

C: Obligations rated C are the lowest rated class of bonds and are typically in default, and "potential recovery values are low".

Others

WR: Withdrawn Rating NR: Not Rated P: Provisional

Recent developments Since the beginning of the credit crunch in early 2007 rating agencies have come under fire for their high ratings of mortgage backed securities (MBS) that did not reflect the financial stability of the borrowers. This has also reopened a discussion whether rating agencies, which get paid by borrowers for their rating, are not in a conflict of interest.26 | P a g e


Description Maximum Safety High grade High grade High grade Higher medium Grade Higher medium Grade

Moody\'s Aaa Aa1 Aa2 Aa3 A1 A2

S&P AAA AA+ AA AAA+ A

Fitch AAA AA+ AA AAA+ A27 | P a g e


Higher medium Grade Lower medium Grade Lower medium Grade Lower medium Grade Speculative Speculative Speculative Highly Speculative Highly Speculative Highly Speculative Substantially risky Substantially risky May be in default Extremely Speculative Income bonds - not paying interest Default Default Default

A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3

ABBB+ BBB BBBBB+ BB BB-

ABBB+ BBB BBBBB+ BB BBB+

B

B B-

CCC+ Caa Ca C CCC CC C CI

CCC+ CCC CC C

DDD DD D D

CRITISISM FOR CREDIT RATING AGENCIES Credit rating agencies have been subject to the following criticisms:28 | P a g e


Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months.[5][6] Some empirical studies have documented that yield spreads of corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that the market often leads a downgrade and questioning the informational value of credit ratings.[7] This has led to suggestions that, rather than rely on CRA ratings in financial regulation, financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spreads when calculating the risk in their portfolio.

Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled.[8] These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. Furthermore, because information about ratings changes from the larger29 | P a g e


CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings. This has led to accusations that these CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. At the same time, more generally, the largest agencies (Moody's and Standard & Poor's) are often seen as agents of globalization and/or "Anglo-American" market forces, that drive companies to consider how a proposed activity might affect their credit rating, possibly at the expense of employees, the environment, or long-term research and development. These accusations are not entirely consistent: on one hand, the larger CRAs are accused of being too cozy with the companies they rate, and on the other hand they are accused of being too focused on a company's "bottom line" and unwilling to listen to a company's explanations for its actions.

The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. In some cases, large loans to companies contain a clause that makes the loan due in full if the30 | P a g e


companies' credit rating is lowered beyond a certain point (usually a "speculative" or "junk bond" rating). The purpose of these "ratings triggers" is to ensure that the bank is able to lay claim to a weak company's assets before the company declares bankruptcy and a receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called "death spiral"). These rating triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting these triggers and discouraging their use, and the U.S. Securities and Exchange Commission requires that public companies in the United States disclose their existence.

Agencies are sometimes accused of being oligopolists, [9] because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings31 | P a g e


businesses, and its high profit margins (which at times have been greater than 50 percent of gross margin) can be construed as consistent with the type of returns one might expect in an industry which has high barriers to entry.

Credit Rating Agencies have made errors of judgment in rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. The actual method by which Moody's rates CDOs has also come under scrutiny. If default models are biased to include arbitrary default data and "Ratings Factors are biased low compared to the true level of expected defaults, the Moodys [method] will not generate an appropriate level of average defaults in its default distribution process. As a result, the perceived default probability of rated tranches from a high yield CDO will be incorrectly biased downward, providing a false sense of confidence to rating agencies and investors."[10]. Little has been done by rating agencies to address these shortcomings indicating a lack of incentive for quality ratings of credit in the modern CRA industry. This has led to problems for several banks whose capital requirements depend on the rating of the structured assets they hold, as well as large losses in the banking industry.[11][12][13] AAA32 | P a g e


rated mortgage securities trading at only 80 cents on the dollar, implying a greater than 20% chance of default, and 8.9% of AAA rated structured CDOs are being considered for downgrade by Fitch, which expects most to downgrade to an average of BBB to BB-. These levels of reassessment are surprising for AAA rated bonds, which have the same rating class as US government bonds.[14][15]

. Most rating agencies do not draw a distinction

between AAA on structured finance and AAA on corporate or government bonds (though their ratings releases typically describe the type of security being rated). Many banks, such as AIG, made the mistake of not holding enough capital in reserve in the event of downgrades to their CDO portfolio. The structure of the Basel II agreements meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios vulnerable to multiple downgrades, essentially precipitating a large margin call. For example under Basel II, a AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB (-) securitization requires a 52% allocation. For a number of reasons (frequently having to do with inadequate staff expertise and the costs that risk management programs entail), many institutional investors relied solely on the ratings agencies rather than conducting their own analysis of the risks these instruments posed. (As an example of the complexity involved in33 | P a g e


analyzing some CDOs, the Aquarius CDO structure has 51 issues behind the cash CDO component of the structure and another 129 issues that serve as reference entities for $1.4 billion in CDS contracts for a total of 180. In a sample of just 40 of these, they had on average 6500 loans at origination. Projecting that number to all 180 issues implies that the Aquarius CDO has exposure to about 1.2 million loans.)

Ratings agencies, in particular Fitch, Moody's and Standard and Poors have been implicitly allowed by the government to fill a quasi-regulatory role, but because they are for-profit entities their incentives may be misaligned. Conflicts of interest often arise because the rating agencies are paid by the companies issuing the securities an arrangement that has come under fire as a disincentive for the agencies to be vigilant on behalf of investors. Many market participants no longer rely on the credit agencies ratings systems, even before the economic crisis of 2007-8, preferring instead to use credit spreads to benchmarks like Treasuries or an index. However, since the Federal Reserve requires that structured financial entities be rated by at least two of the three credit agencies, they have a continued obligation.

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Many of the structured financial products that they were responsible for rating, consisted of lower quality 'BBB' rated loans, but were, when pooled together into CDOs, assigned an AAA rating. The strength of the CDO was not wholly dependent on the strength of the underlying loans, but in fact the structure assigned to the CDO in question. CDOs are usually paid out in a 'waterfall' style fashion, where income received gets paid out first to the highest tranches, with the remaining income flowing down to the lower quality tranches i.e.

Documents

Sheel's Project on Credit Rating