Nationally Recognized Statistical Rating Organization
Encyclopedia
A Nationally Recognized Statistical Rating Organization (NRSRO) is a credit rating agency
(CRA) that issues credit ratings
that the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes. Originally, seven rating agencies were recognized as NRSROs, a number that dwindled as a result of mergers to six by the mid-1990s and then to three by 2003. As of November 2011, nine organizations were designated as NRSROs.
Ratings by NRSROs are used for a variety of regulatory purposes in the United States
. In addition to net capital requirements (described in more detail below), the SEC permits certain bond issuers to use a shorter prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimic the safety and liquidity of a bank savings deposit, but without Federal Deposit Insurance Corporation
insurance) comprise only securities with a very high rating from an NRSRO. Likewise, insurance regulators use credit ratings from NRSROs to ascertain the strength of the reserves held by insurance companies.
from very stable companies. The safety of these securities, under this approach, is reflected in their credit ratings, as determined by certain highly respected CRAs. In the early 1980s, there were seven NRSROs, but, due to mergers, this number dropped to three during the 1990s. Recently, the SEC, arguably as a result of political pressure and/or concern about concentration in the industry, added to this number, first with Dominion Bond Rating Service
(DBRS, a Canadian CRA) in 2003, and A.M. Best (highly regarded in particular for its ratings of insurance firms) in 2005. In 2007, the SEC added two Japanese rating agencies, Japan Credit Rating Agency, Ltd.
and Ratings and Investment Information, Inc. and a Philadelphia area based firm Egan-Jones Rating Company
(EJR).
Originally, NRSRO recognition was granted by the SEC through a "No Action Letter" sent by the SEC staff. Under this approach, if a CRA (or investment bank or broker-dealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determined that this was the case, it would send a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff would not recommend enforcement action against that entity. These "No Action" letters were made public and could be relied upon by other regulated entities, not just the entity making the original request. The SEC later sought to further define the criteria it uses when making this assessment, and in March 2005 published a proposed regulation to this effect.
Until recently, the SEC staff used several criteria when determining whether a CRA publishes ratings that the market considers reliable and credible. According to the SEC's Concept Release:
In June 2007, the SEC promulgated new rules that implemented the provisions of the Credit Rating Agency Reform Act.
, and now, Egan-Jones
). If true, this, of course, raises the question of whether this is something the government should do, and whether the NRSRO recognition process is the best mechanism to achieve this goal.
The larger NRSROs have also been criticized for their reliance on an "issuer-pays" business model, in which the bulk of their revenue comes from the issuers of the bonds being rated. While this is recognized by regulators as a potential conflict of interest (since the bond issuer paying for the rating has an incentive to seek out the CRA most likely to give it a high rating, possibly creating a "race-to-the-bottom" in terms of rating quality), the larger NRSROs claim that the issuer-pays model is the only feasible model for them. This is because, in an age of email and faxes, the ratings of the larger CRAs are so widely and so quickly shared that a subscription-based model would not be profitable.
Furthermore, the larger CRAs often receive non-public information from issuers and, under the SEC's Regulation FD, a CRA may only use such information if their ratings are made available to the public for free.
However, some smaller CRAs, including Egan-Jones (the only NRSRO to do so), rely on a subscription-based business model where the ratings are not made public but are available only to subscribers. These firms argue that such a business model makes them less reliant on the good will of the issuers they rate, thereby eliminating one major potential conflict of interest.
. The agencies made massive profits from rating Collateralized debt obligation
s, Residential Mortgage Backed Securities, and other creatures of structured finance
intimately connected to the subprime industry. The ratings on these products were essential to the way the banks marketed the products. Buyers, like pension funds, university endowments, and cities (a classic example being the city of Narvik
, Norway), relied on these ratings in their decisions to purchase CDOs and other structured finance products. The activities of the ratings agencies have been detailed in many books, including The Big Short
, by Michael Lewis
, Confidence Game by Christine S. Richard, All The Devils are Here
by Bethany McClean and Joe Nocera, and in many other accounts of the financial crisis. Janet Tavakoli
, author of Structured Finance and Collateralized Debt Obligations, has suggested that these agencies lose their NRSRO status in relation to certain financial products. In 2011, the US Senate released the Levin-Coburn report on "Wall Street and the Financial Crisis"; it did a case study of the behavior of some of the credit ratings agencies during the crisis.
Credit rating agency
A Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
(CRA) that issues credit ratings
Bond credit rating
In investment, the bond credit rating assesses the credit worthiness of a corporation's or government debt issues. It is analogous to credit ratings for individuals.-Table:...
that the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes. Originally, seven rating agencies were recognized as NRSROs, a number that dwindled as a result of mergers to six by the mid-1990s and then to three by 2003. As of November 2011, nine organizations were designated as NRSROs.
Ratings by NRSROs are used for a variety of regulatory purposes in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
. In addition to net capital requirements (described in more detail below), the SEC permits certain bond issuers to use a shorter prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimic the safety and liquidity of a bank savings deposit, but without Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
insurance) comprise only securities with a very high rating from an NRSRO. Likewise, insurance regulators use credit ratings from NRSROs to ascertain the strength of the reserves held by insurance companies.
History
The use of the term NRSRO began in 1975 when the SEC promulgated rules regarding bank and broker-dealer net capital requirements. The idea is that banks and other financial institutions should not need to keep in reserve the same amount of capital to protect the institution (against, for example, a run on the bank) if the financial institution is heavily invested in highly liquid and very "safe" securities, such as U.S. government bonds or commercial paperCommercial paper
In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...
from very stable companies. The safety of these securities, under this approach, is reflected in their credit ratings, as determined by certain highly respected CRAs. In the early 1980s, there were seven NRSROs, but, due to mergers, this number dropped to three during the 1990s. Recently, the SEC, arguably as a result of political pressure and/or concern about concentration in the industry, added to this number, first with Dominion Bond Rating Service
Dominion Bond Rating Service
DBRS is a credit rating agency headquartered in Toronto, Ontario. Founded in 1976 by its current owner and president, Walter Schroeder, it is the largest rating agency in Canada....
(DBRS, a Canadian CRA) in 2003, and A.M. Best (highly regarded in particular for its ratings of insurance firms) in 2005. In 2007, the SEC added two Japanese rating agencies, Japan Credit Rating Agency, Ltd.
Japan Credit Rating Agency, Ltd.
The Japan Credit Rating Agency is a Japanese financial services company which publishes credit ratings to Japanese companies, local governments, and other interested parties. The company is one of the Japanese credit rating agencies which the Japanese financial service agency has approved as...
and Ratings and Investment Information, Inc. and a Philadelphia area based firm Egan-Jones Rating Company
Egan-Jones Rating Company
Egan-Jones Rating Company, also known as EJR, was founded in 1995 and actively rates the credit worthiness of approximately 2000+ high yield and high grade U.S. corporate debt issuers. Egan-Jones is wholly supported by investors to minimize the potential for conflicts of interest in accessing...
(EJR).
Originally, NRSRO recognition was granted by the SEC through a "No Action Letter" sent by the SEC staff. Under this approach, if a CRA (or investment bank or broker-dealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determined that this was the case, it would send a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff would not recommend enforcement action against that entity. These "No Action" letters were made public and could be relied upon by other regulated entities, not just the entity making the original request. The SEC later sought to further define the criteria it uses when making this assessment, and in March 2005 published a proposed regulation to this effect.
Until recently, the SEC staff used several criteria when determining whether a CRA publishes ratings that the market considers reliable and credible. According to the SEC's Concept Release:
- The single most important factor in the Commission staff’s assessment of NRSRO status is whether the rating agency is “nationally recognized” in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings. The staff also reviews the operational capability and reliability of each rating organization. Included within this assessment are: (1) the organizational structure of the rating organization; (2) the rating organization’s financial resources (to determine, among other things, whether it is able to operate independently of economic pressures or control from the companies it rates); (3) the size and quality of the rating organization’s staff (to determine if the entity is capable of thoroughly and competently evaluating an issuer’s credit); (4) the rating organization’s independence from the companies it rates; (5) the rating organization’s rating procedures (to determine whether it has systematic procedures designed to produce credible and accurate ratings); and (6) whether the rating organization has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed. The staff also recommends that the agency become registered as an investment adviser.
Credit Rating Agency Reform Act of 2006
In 2006, following criticism that the SEC's "No Action letter" approach was simultaneously too opaque and provided the SEC with too little regulatory oversight of NRSROs, the U.S. Congress passed the Credit Rating Agency Reform Act. This law required the SEC to establish clear guidelines for determining which credit rating agencies qualify as NRSROs. It also gives the SEC the power to regulate NRSRO internal processes regarding record-keeping and how they guard against conflicts of interest, and makes the NRSRO determination subject to a Commission vote (rather than an SEC staff determination). Notably, however, the law specifically prohibits the SEC from regulating an NRSRO's rating methodologies.In June 2007, the SEC promulgated new rules that implemented the provisions of the Credit Rating Agency Reform Act.
Controversies
Many private users (pension funds, banks) of ratings data now demand that ratings be from an NRSRO. Consequently, there is some debate that, by "recognizing" certain CRAs, the SEC has bestowed a competitive advantage on them. This view is supported by the vigor by which many non-NRSRO CRAs seek NRSRO recognition. On the other hand, historically, many private users of ratings data have "defaulted" to Standard and Poor's and Moody's when specifying which ratings must be used for their own purposes. (S&P and Moody's are the oldest, most widely respected, and by far the largest of the CRAs.) Accordingly, it is conceivable that the NRSRO designation has actually increased competition in the industry by providing an unintended government "seal of approval" on certain smaller CRAs (such as Fitch Ratings, DBRS, A.M. BestA.M. Best
A.M. Best Company, Inc., headquartered in Oldwick, New Jersey, is a rating agency designated as a Nationally Recognized Statistical Rating Organization by the United States Securities and Exchange Commission....
, and now, Egan-Jones
Egan-Jones Rating Company
Egan-Jones Rating Company, also known as EJR, was founded in 1995 and actively rates the credit worthiness of approximately 2000+ high yield and high grade U.S. corporate debt issuers. Egan-Jones is wholly supported by investors to minimize the potential for conflicts of interest in accessing...
). If true, this, of course, raises the question of whether this is something the government should do, and whether the NRSRO recognition process is the best mechanism to achieve this goal.
The larger NRSROs have also been criticized for their reliance on an "issuer-pays" business model, in which the bulk of their revenue comes from the issuers of the bonds being rated. While this is recognized by regulators as a potential conflict of interest (since the bond issuer paying for the rating has an incentive to seek out the CRA most likely to give it a high rating, possibly creating a "race-to-the-bottom" in terms of rating quality), the larger NRSROs claim that the issuer-pays model is the only feasible model for them. This is because, in an age of email and faxes, the ratings of the larger CRAs are so widely and so quickly shared that a subscription-based model would not be profitable.
Furthermore, the larger CRAs often receive non-public information from issuers and, under the SEC's Regulation FD, a CRA may only use such information if their ratings are made available to the public for free.
However, some smaller CRAs, including Egan-Jones (the only NRSRO to do so), rely on a subscription-based business model where the ratings are not made public but are available only to subscribers. These firms argue that such a business model makes them less reliant on the good will of the issuers they rate, thereby eliminating one major potential conflict of interest.
Subprime mortgages, CDOs, and the financial crisis
The ratings agencies were heavily involved in the markets that enabled the subprime credit bubble of 2000-2008 and the subsequent financial crisisFinancial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
. The agencies made massive profits from rating Collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
s, Residential Mortgage Backed Securities, and other creatures of structured finance
Structured finance
Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid lawsStructured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws...
intimately connected to the subprime industry. The ratings on these products were essential to the way the banks marketed the products. Buyers, like pension funds, university endowments, and cities (a classic example being the city of Narvik
Narvik
is the third largest city and municipality in Nordland county, Norway by population. Narvik is located on the shores of the Narvik Fjord . The municipality is part of the Ofoten traditional region of North Norway, inside the arctic circle...
, Norway), relied on these ratings in their decisions to purchase CDOs and other structured finance products. The activities of the ratings agencies have been detailed in many books, including The Big Short
The Big Short
The Big Short: Inside the Doomsday Machine is a 2010 non-fiction book by Michael Lewis about the build-up of the housing and credit bubble during the 2000s...
, by Michael Lewis
Michael Lewis
Michael Lewis may refer to:*Michael Lewis , American non-fiction author and financial journalist*Michael Lewis , Bishop of the Anglican Diocese of Cyprus and the Gulf*Michael Lewis , Belizean racing cyclist...
, Confidence Game by Christine S. Richard, All The Devils are Here
All the Devils Are Here
All the Devils Are Here: The Hidden History of the Financial Crisis is a nonfiction book by authors Bethany McLean and Joseph Nocera the 2008 financial crisis. It details account of how the financial crisis bubbled up from a volatile, and bipartisan, mixture of government meddling and laissez-faire...
by Bethany McClean and Joe Nocera, and in many other accounts of the financial crisis. Janet Tavakoli
Janet Tavakoli
Janet Tavakoli is an American author and structured finance expert based in Chicago. She has had three books published on credit derivatives, structured finance, and the 2008 global financial crisis.-Education and background:...
, author of Structured Finance and Collateralized Debt Obligations, has suggested that these agencies lose their NRSRO status in relation to certain financial products. In 2011, the US Senate released the Levin-Coburn report on "Wall Street and the Financial Crisis"; it did a case study of the behavior of some of the credit ratings agencies during the crisis.
List of NRSROs
As of April 2011, ten organizations were designated as NRSROs:. This number was reduced to nine in October 2011 after the Japanese firm Ratings and Investment Information, Inc. withdrew its registration with the SEC.- Kroll Bond Rating Agency
- Moody's Investor ServiceMoody'sMoody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...
- Standard & Poor'sStandard & Poor'sStandard & Poor's is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock-market indices, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian...
- Fitch RatingsFitch RatingsThe Fitch Group is a majority-owned subsidiary of FIMALAC, headquartered in Paris. Fitch Ratings, Fitch Solutions and Algorithmics, are part of the Fitch Group....
- A. M. Best Company
- Dominion Bond Rating Service, Ltd
- Japan Credit Rating Agency, Ltd.Japan Credit Rating Agency, Ltd.The Japan Credit Rating Agency is a Japanese financial services company which publishes credit ratings to Japanese companies, local governments, and other interested parties. The company is one of the Japanese credit rating agencies which the Japanese financial service agency has approved as...
- Egan-Jones Rating CompanyEgan-Jones Rating CompanyEgan-Jones Rating Company, also known as EJR, was founded in 1995 and actively rates the credit worthiness of approximately 2000+ high yield and high grade U.S. corporate debt issuers. Egan-Jones is wholly supported by investors to minimize the potential for conflicts of interest in accessing...
- Morningstar, Inc.Morningstar, Inc.Morningstar, Inc. is an independent investment research company based in Chicago, Illinois, USA.-Businesses:Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for...