In the film The Big Short, Mark and Vinny from FrontPoint Partners confront one of the credit ratings agencies as the housing bubble is on the cusp of imploding. ­

The discussion between these investors holding RMBS credit default swaps and the agency is a vivid reminder that credit ratings agencies are not insurers and their products are specific and perform important but limited and defined functions. Following the global financial crisis, it is still important to keep this in mind.

The term ‘shadow ratings’ is regularly misused and often confusing. It is important to understand exactly what a credit rating is, rather than a different product provided by the rating agencies. Without knowing the difference, investors run the risk of being wrong-footed or making investment decisions from incorrect assumptions. At Sidley Austin, we generally do not to use ‘shadow rating’ without a clear understanding of how it is being used.

Credit ratings provide needed transparency as well as a simple and identifiable code. This is to, among other things, facilitate trading in rated securities or conduct business with issuers that are rated.

Unlike credit ratings, non-credit rating opinion products (eg, estimates) were created to address distinct market needs and are limited in both scope and time. They are not credit ratings, nor are they a shadow of a credit rating.

Sophisticated market participants appreciate that deciding to extend loans, buy securities and conduct business with entities based solely on one of these products is distinct from relying on a credit rating. “An investment in knowledge pays the best interest,” wrote US founding father Benjamin Franklin. With that in mind, it is worth exploring the key features of credit ratings and non-rating opinions.

Credit ratings

As insurance agency AM Best notes, credit ratings are comprehensive analyses of creditworthiness based on “balance sheet strength, operating performance, business profile and enterprise risk management, or the specific nature and details of a security”. Most importantly, they are helpful to investors when assessing a rated entity’s credit health.

Credit ratings are also the rating agencies’ bread-and-butter, tested and trusted tools that rely on a rigorous data collection, review and monitoring process. For example, beyond extensive qualitative and quantitative information gathering, rating agencies will often conduct sit-down meetings with key executives to clarify the information and ask questions about the industry, the entity and the transaction.

Based on this, ratings analysts recommend an overall credit rating, which is reviewed through a rigorous committee process. Rating agencies commonly continue to monitor their initial ratings. If significant changes occur, they will adjust the ratings on an ongoing basis.

Non-ratings opinions or estimates

In contrast, non-rating opinions or estimates are limited, unpublished, point-in-time products. The agencies expressly do not conduct the same level of research and analysis. Examples include:

  • Preliminary estimate – an opinion on what an entity could receive as a credit rating if it requested one. Considered a rough estimate of an actual rating, it may be expressed descriptively, in a broad rating or range of categories, typically on a confidential basis to unrated entities. It allows firms wary of the cost and management time involved in a full analysis to test the waters with limited effort.
  • Third-party estimate – an opinion on an entity’s likely credit rating at the request of a third party. This is a second opinion supplementing the third party’s assessment of an unrated counterparty. Third-party businesses and financial institutions often use such estimates to supplement their credit analysis on unrated counterparties.
  • Hypothetical estimate – an opinion on the possible credit impact of a hypothetical transaction or scenario. This is an analytical or decision-making tool to evaluate various financial and strategic changes that might affect an entity’s overall creditworthiness. Considered a snapshot of a current credit situation overlaid with a hypothetical, it does not consider future material changes

Joshua Thompson is a partner in law firm Sidley Austin’s global finance practice