Moody's Corporation: What It Does and How Its Credit Ratings Work

What Is Moody's?

Moody's Corporation (MCO) is a New York-based company that owns Moody's Investors Service, which rates the creditworthiness of companies, governments, and fixed income debt securities, and Moody's Analytics, which provides software and research for economic analysis and risk management. It also owns a number of other companies in full or in part.

What Does Moody's Investors Service Do?

Investors worldwide pay close attention to the ratings that Moody's assigns to corporate and government securities. Moody's ratings of long-term corporate obligations, for example, go from Aaa, which is the highest grade for top-quality issuers believed to pose the lowest risk, down to C, a grade usually given to securities that are already in default with little chance of recovery of principal or interest.

Moody's History

Moody's Corporation dates back to 1900, when company founder John Moody published "Moody's Manual of Industrial and Miscellaneous Securities." The manual provided general information and statistics about the stocks and bonds of financial institutions and government agencies, along with companies in manufacturing, mining, and certain other industries. While Moody's manual was a successful venture for the company, it did not have the financial resources to survive the Bank Panic of 1907, and Moody eventually sold the publication.

In 1909, John Moody returned to financial publishing with "Moody's Analyses of Railroad Investments." This time, however, instead of just publishing general information and statistics, Moody offered investors his analysis of a railroad's operations and finances. He included letter rating symbols, which he adopted from the rating system used in the mercantile industry.

Moody's Investors Service was established in 1914 and built on the company's foundation by offering ratings for industrial companies, utilities, and government bonds issued by U.S. cities and other municipalities. Moody's Investors Service was bought by credit reporting company Dun & Bradstreet (D&B) in 1962 but was spun off in 2000 and has been an independent company ever since.

In 1975, the U.S. Securities and Exchange Commission (SEC) made Moody's a nationally recognized statistical rating organization (NRSRO), along with Standard & Poor's (now S&P Global), and Fitch Ratings. Many financial institutions require that debt issuers have a certain level of credit rating from an NRSRO entity before they will purchase their bonds or other debt. The ratings are also taken into consideration in the capital requirements that the Federal Reserve Board sets for banks in the United States.

Today the various subsidiaries and affiliates in what the company refers to as "the Moody's family" employ more than 14,000 people in more than 40 countries. According to Moody's, their most recent acquisitions have broadly focused on real estate, cyber security, and ESG expertise.

Moody's and the 2007-2008 Financial Crisis

Moody's, S&P, and Fitch were all heavily criticized for their role in the worldwide financial crisis of 2007-2008. Much of the criticism centered around the high credit ratings these companies gave to mortgage-backed securities that in many cases were made up of risky subprime loans. The ratings agencies' highly complex models failed to take into account the possibility of a broad nationwide decline in housing prices and how that would affect the performance of the bonds.

In 2007, as housing prices started to fall, Moody's downgraded 83% of the mortgage securities it had rated Aaa just one year earlier. Because a bond's issuers typically pay the ratings agencies to rate their bonds, some observers have blamed that seeming conflict of interest for inflated ratings. Moody's competitor S&P paid $1.5 billion to the Justice Department, 19 states, and the District of Columbia to resolve allegations that it knowingly misled investors.

Moody's, also with the other two major credit rating agencies, was criticized for helping exacerbate the Eurozone sovereign debt crisis of 2008-2012 by aggressively downgrading sovereign credit ratings of countries like France and Austria.

In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in the aftermath of the 2008 crisis, established the Office of Credit Ratings (OCR) within the SEC and gave the SEC broad supervisory powers over the three NRSROs. The OCR's mission includes "promoting accuracy in credit ratings issued by NRSROs" and "working to ensure that credit ratings are not unduly influenced by conflicts of interest."

How Moody's Credit Ratings Work

Moody's analysts conduct in-depth evaluations of the financial health, management practices, industry trends, and economic conditions of the entity being rated. They analyze various quantitative and qualitative factors to form an understanding of the entity's credit risk.

After obtaining a sufficient understanding of an entity, Moody's assigns credit ratings using a standardized scale that indicates the likelihood of default or failure to meet financial obligations. The scale consists of both letter grades and numerical modifiers. As mentioned earlier, the main letter grades, from highest to lowest credit quality, are:

• Aaa
• Aa1, Aa2, Aa3
• A1, A2, A3
• Baa1, Baa2, Baa3
• Ba1, Ba2, Ba3
• B1, B2, B3
• Caa1, Caa2, Caa3 (speculative)
• Ca (highly speculative)
• C (lowest rated, indicating default is likely)

Moody's considers various factors when assigning credit ratings. These factors may include financial ratios, cash flow, debt levels, market position, industry trends, regulatory environment, geopolitical factors, and management quality. Moody's also compares the entity being rated to its peers within the same industry or sector to provide context for the rating and allows investors to understand how the entity's credit risk compares to others in a similar position.

How Moody's Ratings Are Used

Moody's ratings are used by a variety of institutions, individuals, or entities. These include mutual funds, pension funds, insurance companies, and hedge funds. Institutional investors manage large portfolios and use credit ratings to assess the risk associated with corporate bonds and other debt securities. Ratings help them make informed decisions about portfolio diversification and risk management. Similarly, individual investors such as retail investors who buy stocks and bonds, use credit ratings as a simplified indicator of the risk associated with investing in a particular company's debt.

Banks and lenders use credit ratings to evaluate the creditworthiness of corporations seeking loans or credit facilities. Ratings influence the terms and interest rates offered to borrowers. Alternatively, when companies plan to issue debt securities like bonds, they consult credit ratings to understand the credit risk assessment of potential investors as higher credit ratings can lead to lower borrowing costs for the issuing company.

Last, regulatory bodies and government agencies such as central banks or financial regulators may use credit ratings to assess the financial stability and risk profile of institutions under their supervision. This information can aid in setting regulatory requirements and monitoring systemic risk.

The Bottom Line

Moody's is a large corporation dating back to the earliest days of the 20th century and a pioneer in the rating of companies, governments, and the bonds and other debt they issue. Today it is one of the three major credit rating agencies and its ratings are highly important in the financial markets and in the regulation of the banking industry.