In the aftermath of the sub-prime mortgage crisis and last year’s global financial problems, the credit rating agencies have come in for a lot of criticism regarding the initial ratings that they assigned to various securities and the significant downgrades which followed as the financial crisis developed. However, despite the serious errors that were revealed in their ratings of some of the more complicated mortgage-backed securities, the rating agencies do have a ratings system that is quite rational and the rating scale that they use is quite easy to understand, at least at the very high level. There are a number of rating agencies and each one has their own rating scale, but the one that we will examine in some detail is that of Standard and Poor’s (S & P), since it is the most easily understood from an intuitive point of view.

S&P uses a rating scale which is very similar to the grading system that is used in many schools whereby A is the highest grade, C is the lowest passing grade and D represents a failure. Their system is enhanced by adding letters to each of the passing grades to indicate different levels within those grades. Hence AAA is the highest possible credit rating, followed by AA and A. A similar pattern is followed for the B and C rating categories. The rating system is further refined by the use of ‘+’ and ‘-‘ indicators for all the rating scales below AAA so that for example, an entity may be rated A+, A or A- to indicate its relative position within the A rating scale. To get a better understanding of what the ratings mean, we set out below, the brief definitions that S&P attaches to some of it ratings.

AAA

An obligation rated AAA has the highest rating assigned by S&P. The entity’s capacity to meet its financial commitment on the obligation is very strong.

AA

An obligation rated AA differs from the highest-rated obligations only to a small degree. The entity’s capacity to meet its financial commitment on the obligation is very strong.

A

An obligation rated A is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However the entity’s capacity to meet its financial commitment on the obligation is still strong.

BBB

An obligation rated BBB exhibits adequate protection parameters. However adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. This is the lowest investment grade rating category.

BB, B, CCC, CC, and C

Obligations rated BB, B, CCC, CC, and C are regarded as having significant speculative characteristics. BB indicates the least degree of speculation and C the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposure to adverse conditions.

D

An obligation rated D is in payment default.

The AAA credit rating is not to be taken lightly as while there are very few entities that are assigned this rating. While some people may be able to identify the United States, Great Britain and Germany as being countries that are rated AAA, how many can identify companies that carry a AAA rating? No, none of the banks operating here in Jamaica carry that designation, not Citibank, nor Bank of Nova Scotia, nor Royal Bank of Canada. Neither do any of the large American of Canadian banks that most of us would be familiar with such as CIBC, Bank of America, JP Morgan or Goldman Sachs. Have you ever heard of Kreditanstalt fuer Wiederaufbau or KFW for short? Well it is a German banking group which is rated AAA. There are no prizes for anyone who identified the US government agencies Freddie Mac, Fannie Mae or the Federal Home Loan Banks as being rated AAA.

The bottom line is that it is only the strongest of the strong that are rated AAA by the credit rating agencies and the debt obligations of these few entities are the safest of the safe. In another article we will look at the implications of some of the other rating categories and what they mean for the current and future safety of their debt obligations.

Charles Ross is Managing Director of Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor.

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