Credit ratings agencies got their start in the early 1900s, when one man decided to start handing out grades to bonds in the same way teachers hand out grades to students. It was an almost overnight hit, as investors were happy to pay a small fee to effectively outsource some of the due diligence to Moody's (NYSE:MCO), the first player in the space.
But a rising business attracted competition. The predecessors to Fitch and S&P (NYSE:SPGI) soon entered the business, and together with Moody's, these three companies effectively control virtually all of the ratings business today.
In this segment of Industry Focus: Financials, join host Gaby Lapera and Jordan Wathen as they discuss how the ratings industry rose from humble roots more than 100 years ago.
A full transcript follows the video.
This video was recorded on June 26, 2017.
Gaby Lapera: 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.
Jordan 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.
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 Moody's. The Motley Fool has a disclosure policy.