Credit ratings agencies (CRAs) are companies that issue letter grades to bonds, and they have a market-moving impact on whether or not investors trust any given company.

In this week's episode of Industry Focus: Financials, Motley Fool analyst Gaby Lapera is joined by contributor Jordan Wathen walk to listeners through the ins and outs of credit ratings agencies like Moody's (NYSE:MCO), S&P Global (NYSE:SPGI), and Fitch. Find out how and when they got started, how CRAs make their money today, some of the most important things that investors need to know about them before buying in, some of the biggest risks and biggest prospects in the industry, and more.

A full transcript follows the video.

This video was recorded on June 26, 2017.

Gaby Lapera: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, June 26, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, The Motley Fool's financial expert. Hey, Jordan! How's it going?

Jordan Wathen: It's going well! How are you, Gaby?

Lapera: Pretty good. I had a nice, long weekend. I went to a wedding, I got bit by a spider. [laughs] It's been a doozy of a weekend, so I'm definitely excited to be at work. How about you?

Wathen: I just got a fidget spinner in the mail today, so I'm feeling really good.

Lapera: [laughs] Yeah? That's what all the kids have, right?

Wathen: Something like that, I guess. I saw one on Amazon for $3, so I had to try it out.

Lapera: I would love to know how it goes for you. I have some friends who are teachers, and they all hate them, because they say the kids are constantly messing with them in class and fights break out, and it's like prison fights in the school because of the fidget spinners, it's really bad. For people of another generation, I think that would be Pokemon cards, and for the generation before that, it might be marbles.

Wathen: Tamagotchi, I think, yeah.

Lapera: So, talking about fights ... that was a pretty bad segue, it's OK. Talking about other stuff today on the show, the thing we're actually here to talk about is credit ratings agencies, which we might be referring to as CRAs throughout the show, so don't be surprised if an acronym just pops up. We've already defined it right here at the beginning. Anyway, today we're going to be talking about what credit agencies are, what they do, why we should care about them. Think about this as an intro to credit rating agencies 101. The thing about credit ratings agencies is they're really important to understand, and not just as a potential investor in Moody's or S&P, but also because of the effect that they can have on a company that's not them or on the market. We'll get into that later. Let's start with what ratings agencies are, and what they do.

Wathen: Yeah, let's start there. What CRAs do is give letter grades to bonds, just like a kindergarten teacher would give letter grades to kindergarteners. The whole goal of a credit rating agency is to sum up the risk that a company can't pay on its bonds or loans in a single letter or multiple letters, basically, to show how risky that borrower is. The U.S. government is, for instance, a very good credit. It's very unlikely that it will have difficulty paying you back, so it's rated AAA or AA, which is either the best or the second-best ratings you can possibly get.

Lapera: Yeah. And some background for super new listeners, bonds are one of the ways that companies raise money to do things. They're basically loans. You can buy the bond from the company, and the company pays you an interest rate back. And generally the returns on bonds aren't as high as they are on stocks because bonds are considered a much safer investment than stocks. But you're going to have a higher interest rate paid to you than, say, on your savings account, because a bond is riskier than just putting your money in a bank.

Wathen: Right. A long time ago, the whole idea that individuals actually own common stocks or stocks is really new. One hundred years ago, it would be really unlikely for your average American to own stocks. If anything, they would own bonds. In the early 1900s, stocks were seen as something very risky. So, most likely you were investing in something like a railroad bond or a loan to a railroad. But the problem with bonds is that one company could issue 10 or even 20 of them. So, understanding the differences between them is difficult. This guy by the name of John Moody basically pioneered the industry. In 1909, he decided he was going to make these letter grades for bonds, and make it easier for investors to understand the risks and the rewards with each one that came out. So, he created these manuals and these letter grades. And almost overnight, investors said, "This is a better mousetrap; this is a great thing and I need to subscribe to Moody's service so that I can understand how risky or a rewarding a potential bond could be based on this single letter grade that John Moody has decided for the bond."

Lapera: And Moody's isn't the only player in this space. There's also Standard & Poor's, which is pretty frequently just referred to as S&P, and Fitch, which is kind of the redheaded stepchild. I don't know why, I just feel like I never talk about Fitch's ratings. It's always Moody's and S&P for me.

Wathen: Right. Moody's and S&P are the two big ones. As a percentage of revenue, I think they have something like 80% of revenue roughly, and if you add in Fitch, you get close to 95% of the industry. So basically, three companies own this whole industry.

Lapera: Yeah. And to give listeners an idea of how effective these ratings generally are, I have this chart in front of me. If you would like me to send it to you, I'm super happy to do that. It has all the grades, AAA through CA-C, which is not good. If you're AAA, you have a 0.2% chance of defaulting on your bond over the course of 10 years, versus if you are a CA-C, you have an 85% chance of defaulting on your bond over the course of 10 years. That's a pretty big difference. And obviously, we have, like, 100 years' worth of data, so we can actually see whether or not Moody's and S&P are doing a good job doing these ratings. And generally, they are.

Wathen: Right. That's the big thing. A lot of people read about the crisis of 2008, and they leave with the opinion that the ratings agencies and the ratings are virtually worthless. But in reality, the truth is, if you go down the list of the grades by quality, you will find that defaults actually do increase as the quality of the rating goes down. So, a lower rated bond is more likely to default than a higher rated bond, which is exactly what these credit rating agencies want to happen. They want to see that their ratings are accurate. And over history, we've seen that they are accurate.

Lapera: Yeah. And the ratings scale kind of works the same as that kindergarten teacher's grades that you were referring to earlier. AAA is the best, then there's AA, then there's A, BAA, BA, B, CAA, CA-C for Moody's, but they vary. S&P just does A's and B's. But, the more letter something has, the better it is, and the higher it is in the alphabet, the better it is. So, use that to create your matrix, I suppose. Or, I'll send you this chart, if that was a super confusing verbal explanation of it. We know that companies really need these ratings in order to sell their bonds. But how do Moody's and S&P make their money? That's part of it?

Wathen: If we go back 100 years ago, the whole bond rating system was based on the idea that the company, let's say Moody's or S&P, which both published manuals, investors would pay for those manuals. Over time, that business has changed. What happens today is investors still pay, to a small degree, for these ratings. But by and large, what happens now is, when a company wants to issue a bond, it goes to Moody's or S&P, and it pays a fee based on the issuance, the size of the bond that the issue. It's basically a percentage, and it's maybe 10 basis points at the most, or 0.1% of the amount they wish to borrow. But, on a $10 billion bond, that becomes a rather significant amount.

Lapera: Yeah. They also charge for initial credit assessment fees and annual surveillance fees, so that they can maintain the rating.

Wathen: Right. Initially, they'll pay a small fee, maybe $50,000 or $100,000, to basically fly people out there to take a look at the books and start to understand the business. Then they pay the issuance fee, which is by far the biggest driver of revenue for Moody's, S&P, or Fitch. Then they also pay that ongoing surveillance fee to keep looking at the bond or the company each year, and what they'll do, if the rating doesn't change, they'll say, we reaffirm our initial rating on that bond.

Lapera: Which is, I think, part of the reason that people can't shake the idea that Moody's and S&P and CRAs in general are vulture-y, because they basically thrive with governments and companies issuing debt. So, it's kind of like they're profiting off of this company having to issue debt. Of course, issuing debt isn't necessarily a bad thing. They could be issuing debt for something positive like a merger and acquisition that will grow their business 100%. But, I don't know, there's always that feeling when you're dealing with debt. Same thing with banks. When you're dealing with debt, I think people are always a little bit more hesitant to invest.

Wathen: Right. I think that's one of the things that makes credit agencies so important, that they're so intertwined to the financial system that basically, their approval or disapproval over a particular company can really be market-moving. Going back as far as 1934, there was a law that was passed that said banks can only own securities that are investment-grade rated. So, basically, if Moody's, S&P or Fitch at that time did not give you the rubber stamp that says "you are investment grade," then a bank couldn't own your bonds. And by the 1970s, basically everyone was using these credit ratings to decide whether or not a bond is worth owning or even looking into. Actually, I found a quote and I really love it. It was written in 1996, but I think it still applies today. Someone wrote, "There are two superpowers in the world today. There's the United States, and there's Moody's bond rating services. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful." I think that really encapsulates just how important the ratings agencies are to companies that need a rating to issue debt.

Lapera: Yeah, definitely. It's a really interesting thing. And this is what I was referring to earlier at the beginning of the show when I was talking about how these CRAs can really affect the future of a company. Because you're right, it Moody's is like, "Your bonds are junk," which is a term, junk bonds, that I'm sure most listeners have heard, that means that the bonds are super risky and you have to pay a much higher interest rate on those bonds if you're the company trying to issue them, and people are a lot less likely to buy them, because they don't know that they're going to get paid.

Wathen: Right. This has become even more institutionalized today with the rise of funds, index funds, generally. If you read any bond ETF prospectus, it'll refer to the bond index they use, and the bond index will basically say, "We will only by investment-grade rated bonds that have the rating from Moody's, S&P or Fitch." Nobody else, even though there's more than 10 credit rating agencies. These are the only three that matter.

Lapera: Yeah. The other thing to think about with these credit rating agencies is that they have access to all of the information. They have to, so that they can make these decisions. So, that actually translates into some of their side businesses, like Moody's Analytics or S&P market and commodities intelligence, which are subscription services which are sold to banks, insurance companies, The Motley Fool, sometimes.

Wathen: Right. So, once you collect all this information, as S&P, Moody's, and Fitch have done, they have all this information and another way to monetize it is to repackage it. S&P, this is a good one for a banking show, S&P recently bought out SNL Financial, which is basically the go-to bank information service provider. If you want to know what, say, Wells Fargo's non-performing loans looks like in 1982 and how that compared to other banks in the neighborhood, in California neighborhoods, they have that information. So, basically, these side businesses that they have, which aren't as important, for S&P, it's roughly half of their income, for Moody's it's only about 15% of their operating income. But these side businesses allow them to basically reuse information they've collected and resell it in different ways. 

Lapera: Which is so smart. I have a coworker whose son is raising goats for a ritual that happens in Islam once a year. He's going to sell these goats to the local mosque. In the meantime, he's also hiring the goats out as lawn mowers, which is kind of the equivalent of the S&P and Moody's doing this with all the information they've collected. And congratulations to you, you're a very enterprising young man. The other thing that S&P does that I don't think Moody's does is the index funds.

Wathen: Right. Even if you don't know who Standard & Poor's is, you know S&P, and you probably just know it from the S&P 500, which is their premiere stock index. And because this has such a reputation, such a name as the large-cap index -- really there isn't a peer for it -- and because there's so much money willing to invest in the S&P 500 index, they've found it possible to license the S&P 500 name out to fund managers and charge a fee. It's usually 0.03% of assets under management, just to use the name and to use the index and the ETF name. So, every $100 that goes into an S&P 500 Index Fund, Standard & Poor's is collecting $0.03 on that, just for the rights to use its name. It's an amazing business. I would love to own that by itself, because it's truly incredible that they can basically collect royalties on index fund assets.

Lapera: Yeah, it's super cool to see all the ways that these companies are putting stuff together. And that's one of the reasons that CRAs is so interesting, is because they're using every part of the cow in order to make money. It's a very impressive business model.

Wathen: I wrote an article on this recently, it's really interesting, S&P really didn't realize, for a long time, just how valuable that brand is that it has, the S&P 500 brand. At one point, they actually gave Vanguard the license to use the S&P 500 name in one of its biggest funds for as little as $50,000 a year. It later turned out that they woefully underpriced that contract, and I think they've reworked it since. But this business of theirs is collecting over $100 million per quarter in pure operating income, just by skimming off the top of all these funds that are out there. It's truly incredible. If there's one business that I wish I could just own outright, it would be that, and I would just sit at home and check the mailbox every month for my next check. It's just an amazing business.

Lapera: We've talked a lot about why these businesses are awesome, how they really interesting, how they make their money. What are some potential risks to investing in a company like a CRA?

Wathen: When we think about the CRA businesses, only two are publicly traded, at least to close to pure plays. Moody's generates about 85% of its operating income from ratings. S&P generates just over half from ratings. Then there's the smaller players. There's Morningstar, but Morningstar's rating business is basically immaterial, it's a rounding error. And when we think about the money that these businesses make, it primarily comes from the issuance fees. When you buy a credit rating agency, or decide to invest in one, the single most important thing that drives revenue and profitability is how much debt companies are issuing. One of the biggest possible risks that you could face is that debt issuance simply goes down because one of the biggest drivers would be that rates go up. That's something that people are really worried about, is that as interest rates go up, the attractiveness of issuing debt won't be as big as it is today.

Lapera: Yeah. And that's certainly a valid concern, but I would urge those people to look at historic precedent. People still ask for debt issuance even when interest rates are high. That seems to me that it shouldn't be a huge factor in your concern about whether or not to buy these companies long-term.

Wathen: Right, over the long term, no, but shorter-term, it is. Because these are based on issuance fees, when that's the primary driver, because it's based on issuance fees over the last five to 10 years as rates have come down, these companies have basically earned more than maybe they would in a steady state environment because they're picking up those fees on every refinance. So, if a company issues a bond and rates go down two years from now, they'll refinance it and pay another issuance fee. But if rates are going up, they won't have that refinance activity built in. So, that's the give and take there.

Lapera: Yeah, fair enough. But like I said, if you're thinking long-term, probably not a huge deal for you. And you know us at The Motley Fool, we're all about that long-term investing. Another thing to think about is government tax policy, right?

Wathen: Yeah. There's been some talk in D.C. about eliminating the ability of companies to deduct interest as an expense on their taxes. I don't know if this will happen. Supposedly the GOP is going to come up with a proposal by September. They've talked about it, but companies last year, The Wall Street Journal said, they quoted I think it was $1.3 trillion in interest expense last year. If, for some reason, interest is no longer a tax-deductible expense, obviously that makes issuing debt much less attractive, too. So, that may be a long-term hurdle if it happens. I don't want to get into trying to predict what happens in D.C., but it's obviously a factor.

Lapera: Yeah, it's a bad business trying to predict what's going to happen here. [laughs] Sorry, that long-suffering chuckle is the sound of someone who's lived in this area for 28 years. Another potential threat, as is a threat in any industry, is that there's a potential for new entrants to enter the field. I don't think this one is a particularly big deal either, because if you think about how brand recognition plays such a huge role in soda, imagine how much brand recognition is important when you think about people who are in charge of saying whether a company is credit worthy or not.

Wathen: Right, that's a really good point. You have to look at it through the lens of someone who's using their ratings to make a decision. If you're an investment analyst, for example, and you work at a bond fund, and you say, "We should buy this bond because Jo Schmo's credit rating agency rates it AAA," there's some job risk there. If you come to it and say, "Moody's didn't see it and Fitch didn't see it and S&P didn't see it, so of course, they rated it AAA and I still bought it," you might actually keep your job. I think the brand value is important. But to the extent that maybe some smaller agencies pick off some of the more valuable business, it might happen, but it hasn't happened. So, I always like to ask the question: If it hasn't happened yet, will it happen? I don't know. I think, to some extent, the rise of index funds has made it a lot harder for the smaller shops to gain traction.

Lapera: Yeah. I think the smaller CRAs had their opportunity post-financial crisis when people were really questioning especially Moody's, because they played a role in rating some of these securities and bonds that companies had been selling with the housing bundles in them as better than they actually were. And both S&P and Moody's, ended up paying huge fines. If I recall, Moody's was around $850 million, and I think S&P paid...$1.5 billion?

Wathen: Yeah, it was a lot of money. And it's still coming through today. I think they've just finally in 2017 put most of this behind them. But we'll see. And that's a risk, too. That's worth mentioning. If these companies miss the mark again, there's going to be fines, and it opens the field for competition, if it's going to happen.

Lapera: If it's going to happen. Which, like I said, the smaller rating agencies had a chance earlier in 2008, but they didn't really take off, so who knows if it would really make a difference in the future. But, that would be a second strike, so who knows. That's one of those things with investing, it's looking into your crystal ball, and there's just clouds. We're just not very good clairvoyants here.

Wathen: It's hard to say. When you invest in a credit rating agency today, if you look at the multiples they're trading for, it's 25 times or more earnings. So, your return is not going to come from the current environment. It has to come from the, basically, assumption that they're going to do more business in the future. Your return is going to come primarily from growth. So, the question is, does that come through pricing? Does it come through volume of debt issued? Where does it come from? You basically priced in no downside, you haven't priced in many risks to the downsides. So, you need these things to work out really well.

Lapera: Yeah. I think that's something that you hit on, too. Have we hit peak debt issuance? If so, long-term...well, I don't think we've hit peak debt issuance, because I think the economy is going to continue to grow. Generally, that's just a belief that I have. But I also don't think that it's sustainable in the short term like it has been the last few years, which is what we were getting at with the first risk that we talked about.

Wathen: That's the thing. If you bought these CRAs in 2007, and you held them, you would have done fine, but you would have waited a really long time to see that outcome. That goes for any financial. You you buy a financial company at a peak multiple of earnings at a peak volume of business, you're not going to do very well when the cycle hits a trough, and now you have a low multiple on a low level of earnings. That doesn't work out well. But over time, if nothing changes to the credit rating agencies, this has to be one of the best businesses on Earth. If nothing changes, which is a huge factor. Everyone's looking at them. There's those conflicts of interest. The people who are issuing debt are basically paying the credit rating agencies, and a lot of people don't like that. Certainly, a lot of regulators don't like that. So, if that changes, too, that's a change in the revenue model, which, again, is very difficult to predict.

Lapera: I was going to ask you what your final thoughts on CRAs were, but you just said it was one of the best businesses on Earth, so I think that pretty much accurately sums it up.

Wathen: I feel that way about a lot of these service-oriented financial businesses, like Visa and Mastercard and the credit rating agencies. They're just terrific businesses. But you're always paying a peak multiple on them, and it's one of those things where if anything changes, the thesis falls apart. But as it stands today, if the trends continue, I think they're one of the greatest businesses on Earth. It's just whether or not you pay the right price for them.

Lapera: Fair enough. I hope that answers your question, listener who emailed this to me many moons ago. I say that because I want everyone who's listening to know that we do, in fact, answer listener questions on the show pretty regularly. If you want us to cover a particular topic, go ahead and shoot us an email at industryfocus@fool.com. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks so much for joining us, Jordan. Thank you, Austin, our magnificent producer who has had very little sleep because of the puppy. I posted a picture of the puppy on our Twitter, you guys should totally go check it out. Everyone, thanks for listening and have a great week!

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Mastercard, Moody's, Twitter, and Visa. The Motley Fool has a disclosure policy.