Credit ratings grade repayment ability from AAA to D, with 'BBB-' as the investment-grade cutoff; SEC records tie issuer-pays incentives to the collapse of subprime AAA grades before 2008.
What Is a Credit Rating, and How Does the AAA-to-D Scale Work?
A credit rating is an assessment of an entity's ability to pay its financial obligations, as stated by the U.S. Securities and Exchange Commission's (SEC) investor-education office, Investor.govCITE:E1. Investor.gov, in a bulletin published October 12, 2017, describes a typical credit rating scale that runs from a top rating of 'AAA' down to a lowest rating of 'D', which indicates defaultCITE:E2. That single scale is what allows any two debt issuers to be compared on the same terms: from the strongest capacity to pay, at 'AAA', down to an entity that has already failed to pay, at 'D'.
Where Is the Line Between Investment Grade and Non-Investment Grade?
Investor.gov draws the investment-grade line between the 'BBB' and 'BB' rating categories, meaning a rating of 'BBB-' or higher is investment grade, while anything lower than 'BBB-' is non-investment gradeCITE:E3. The Federal Reserve sharpened this standard in a revised rule issued November 15, 2012: a security meets the 'investment grade' test only if the issuer has an adequate capacity to meet its financial commitments under that security for the security's entire projected lifeCITE:E4. Read together, the two agencies define investment grade not just as a letter-grade cutoff but as a forward-looking capacity test that must hold for as long as the security is outstanding.
How Does the Issuer-Pays Model Affect Rating Independence?
Under the issuer-pays model, the entity being rated — not the investors relying on the rating — pays the rating agency, and the SEC says this business model encourages ratings shopping by issuers and the investment banks selling the securitiesCITE:E5. In a statement dated May 14, 2013, the SEC said the arrangement results in undue pressure for Nationally Recognized Statistical Rating Organizations (NRSROs) to give favorable ratings in order to attract businessCITE:E5. That structure means the agency assigning the letter grade is compensated by the same party whose securities it is grading.
How Did Rating Agencies' Grades on Subprime Mortgage Securities Fail Ahead of the 2008 Crisis?
In the same May 14, 2013 statement, the SEC said more than 90% of the 'AAA' ratings given to subprime residential mortgage-backed securities (RMBS) that originated in 2006 and 2007 were later downgraded by the NRSROs to junk statusCITE:E6. Securities that had carried the highest possible rating on the AAA-to-D scaleCITE:E2 were, in the vast majority of cases, subsequently reclassified below the 'BBB-' investment-grade lineCITE:E3 that Investor.gov and the Federal Reserve use to separate investment grade from non-investment gradeCITE:E4.
| Rating / Threshold | Classification | Source |
|---|
| AAA | Top of a typical credit rating scale | CITE:E2 |
| BBB- or higher | Investment grade | CITE:E3 |
| Below BBB- | Non-investment grade | CITE:E3 |
| D | Lowest rating; indicates default | CITE:E2 |
| >90% of 2006–2007 subprime RMBS 'AAA' ratings | Later downgraded to junk status | CITE:E6 |
What this means: The AAA-to-D scale placed subprime RMBS issued in 2006 and 2007 at the top tier at the time of issuanceCITE:E2, the issuer-pays structure that produced those ratings was already drawing SEC scrutiny for encouraging ratings shopping and pressure to favor paying clientsCITE:E5, and more than 90% of those same top-tier grades were later cut to junk statusCITE:E6. Because the Federal Reserve's 'investment grade' test requires an issuer to have adequate capacity to meet its commitments for a security's entire projected lifeCITE:E4, and Investor.gov sets the investment-grade cutoff at 'BBB-'CITE:E3, the pre-crisis downgrades did not just adjust a number — they moved a large share of subprime RMBS across the line separating investment grade from junk.