Thomas L. Friedman stated, “we live again in a two-superpower world. There is the U.S. and there is Moody’s. The U.S. can destroy a country by levelling it with bombs: Moody’s can destroy a country by downgrading its bonds.”[i] In order to fully explain the role of the rating agencies in the current state of affairs, it is first necessary to provide a brief history of these companies and elucidate why they have so much power[ii].
A credit rating agency (hereinafter rating agency) is a company that reviews a set of factors[iii] for certain types of debt obligations (such as a loan) and the underlying instrument itself. On many occasions a rating agency will also rate the issuer of the underlying debt as well. In theory, a rating agency exists to allow an objective third party to assess the credit worthiness of another person, entity or debt obligation.
The concept of judging and weighing factors is nothing new. We, as individuals, make judgments about every aspect of our lives, down to the simplest of matters. The traditional concept of creditworthiness is, in essence, the same idea. An early form of rating agencies emerged in the nineteenth century when investors were dealing with failed railroads and skeptical land schemes.[iv] In 1868 Henry V. Poor released the first Manual of the Railroads of the United States, which reached five thousand subscribers by the early 1880s.[v] John Moody saw an opportunity[vi] because at that time, “A high percentage of corporation securities had to be bought on faith rather than knowledge.”[vii] Moody then went on to begin publishing his Manual of Industrial Statistics in 1900.
It wasn’t until 1909, that Moody began assessing creditworthiness, which was partially based “on the mercantile credit rating of retail businesses and wholesalers by companies like R.G. Dun and Company.”[viii]Materials on the history and development of rating agencies suggest that there were three phases of growth in both reputation and authority. The first phase, was in the early 1930s, when rating agencies became a requirement for selling any issue in the United States. From the 1930s to the 1980s, rating agencies became more prominent as a result of the U.S. bond market prevailing over a series of defaults by major sovereign borrowers.[ix]Rating agencies gained more power and influence as the high-yield junk bond market developed in the 1980s.
After this last phase, companies like Moody’s and Standard and Poor’s, became household names, and investors throughout the world came to rely on their judgments with increasing regularity. Rating agencies became a source of knowledge where investors could turn for information regarding an issue or the issuer in the form of a grade. The grades are based on risk to the investor and range from AAA (or “triple A”) to D (for some rating agencies). Those that are considered “investment grade” range from triple A to BBB- (or “triple B minus”) with triple A being of the best quality and lowest risk. Bonds and preferred stock that are speculative are graded anywhere from BB+ to D and carry greater risks. [x][xi][xii]
During the second phase, legislation was passed that gave the rating agencies broader power and authority over the investments that were made. “In 1975, the SEC further pulled ratings into the regulatory system through Rule 15c3-1, the net-capital rule…the rule gave ‘preferential treatment’ to bonds rated investment-grade by at least two ‘nationally recognized statistical rating organizations’ (NRSROs)…The SEC did not define the substance of an NRSRO in any detail.”[xiii] This act by the SEC helped to solidify the presence of rating agencies and made it incredibly difficult for other rating agencies to emerge in a meaningful way.
One of the prevailing views of rating agencies is the “reputational capital” model. According to this framework, rating agencies are considered to be an essential function of the financial system. They serve as “reputational intermediaries” who monitor issuers and issues periodically to ensure that the grade is correct and accurate at a given point in time. This view can be applied in a general sense to individuals.
“Individuals acquire reputations over time based on their behavior. If an individual’s reputation improves, and other members of society begin to hold that individual in higher esteem, that individual acquires a stock of reputational capital, a reserve of good will, on which other parties rely in transacting with that individual. Reputational capital leads parties to include ‘trust’ as a factor in their decision-making; trust enables parties to reduce the costs of reaching agreement. Reputational capital is especially valuable when a small number of actors interact repeatedly. In such situations, cooperation among individuals can prevail even without a government authority, as players learn information about other players’ strategies (i.e. their reputations).”[xiv]
However, an accountability gap exists in rating as a result of rating agencies not being heavily regulated. While the rating agencies do have a prominent interest in preserving their reputational capital (which creates an incentive to provide the best possible information to investors), the barriers to entry for competition allow them to continue with the oligopoly unopposed. What is most important to the rating agencies is the ability to continue their reign. As long as people continue to act collectively based on their beliefs about an agency, their job is done.
Rating agencies have worked hard to establish a reputation for impartiality as “the success and function of a credit rating agency…depends on trust and credibility”[xv] and “credibility is fragile. [A rating agency] operates with no governmental mandate, subpoena powers, or any other official authority. It simply has a right, as part of the media, to express its opinions in the form of letter symbols.”[xvi]However, if this view is correct, a rating agency’s grade is nothing more than an opinion, and they can only survive in the business of rating if investors view them as being accurate and reliable.[xvii]
Their integral role within the capital markets gives them significant knowledge and resources. Furthermore, even if some investors or individuals become skeptical about rating agency credibility, they cannot assume others in the markets have also become skeptical. The risk of that situation gives those that are skeptical more of an incentive to act based on this assumption that others are still reliant, and continue to “trust” the rating agencies. “Rating agencies should be understood therefore as a crucial nerve center in the world order, as a nexus of neoliberal control. They are agents of convergence who, along with other institutions, try to enforce “best practice” or “transparency” around the globe.” [xviii]
So why then, is there a problem? The problem first arose, when rating agencies began to charge those that issue these securities for their rating. There is an undeniably inherent conflict of interest in the current overall process of rating. In most scenarios, the individual who is primarily receiving the benefit or the service is the person who pays. With rating agencies, the investor is the person who is benefiting (for the most part) from the service of rating, but they bear none of the upfront costs (some argue that they bear the cost in the price of the issue). Rather, in this situation, the very entity issuing the item is the same entity that bears the cost, thereby increasing the potential for issuers to influence the judgment of these “impartial” rating agencies and consequently creates difficulty in allowing a rating to be an accurate resource of information.
In the past, rating agencies issued a rating to the individual investor for a fee[xix]. However, with the advances in technology that were made, and the vast increase in readily available information, rating agencies had a large free-rider problem. “Ratings are like the news-public goods. Once a rating is released, there is no way for the agency to prevent investors or intermediaries like banks, which have not paid for the rating, from free riding on the rating. The dilemma for the agencies is to reconcile the public-good aspect of ratings with the need to earn revenue and make an appropriate return.”[xx]The solution for this free-rider problem then, was to charge the issuer of the item.[xxi]
These changes in the rating process have caused a shift from the reputational capital view of rating agencies to a “regulatory license” view. “The regulatory license view is quite simple. Absent regulation incorporating ratings, the regulatory license view agrees with the reputational capital view: rating agencies sell information and survive based on their ability to accumulate and retain reputational capital. However, once regulation is passed that incorporates ratings, rating agencies begin to sell not only information but also the valuable property rights associated with compliance with that regulation.”[xxii]
The act on the part of the SEC to create this fiction of NRSROs, has in effect, created a situation where issuers are not only buying the individual investor’s trust, but also the right to issue an item on the open market in a lucrative or meaningful way. Many, if not all regulations require at least one of the NRSROs to rate the issue investment-grade for it to be sold at all.[xxiii] Moreover, the potential for conflicts of interest to arise is heightened by the fact that rating agencies obtain their “valuable” information from the issuers themselves. So how then, is the rating truly independent, when the agencies themselves admit they haven’t always been?[xxiv]
Additionally, rating agencies do not conduct any of their own audits, but rather fully rely on the issuer’s “books”. Therefore, it is unclear as to whether the information that they receive from an issuer is even accurate.
[i] Thomas L. Friedman, New York Times, 1995
[ii] “As the free capital flowing through debt markets reaches new heights, the American rating agencies’ lever of upgrading, downgrading or putting on the “watch list” seems to have more weight than most international actions by the American government. But even the IMF [International Monetary Fund], as the only global institution with the power to infringe upon the sovereignty of even the biggest nations by carrying out its regular surveillance, looks weak compared with Wall Street’s mighty rating twins.” Klaus C. Engelen, International Economy, 1994.
[iii] “No complaint is more frequently voiced than the lack of clarity about what the ratings actually measure. While ratings are intended by the agencies to gauge the relative degrees of credit quality…how such factors are weighted-and-why-in making the final rating decision remains unclear.” John E. Petersen, The Rating Game: Report of the Twentieth Century Fund Task Force on Municipal Bond Credit Rating, 1974.
[iv] Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and The Politics of Creditworthiness. (Ithaca, NY: Cornell University Press).
[v] Ibid., at 23.
[vi] “somebody, sooner or later, will bring out an industrial statistical manual, and when it comes, it will be a gold mine.” Moody, John. (1933) The Long Road Home: An Autobiography . New York: Macmillan.
[vii] Moody, 1933, at 90.
[viii] Sinclair, 2005, at 24.
[ix] Sinclair, 2005, at 26.
[x] For Moody’s Definitions, please see: http://www.bankersalmanac.com/addcon/infobank/credit_ratings/bnkmood.aspx .
[xi] For Standard and Poor’s, please see: http://www.bankersalmanac.com/addcon/infobank/credit_ratings/bnksap.aspx .
[xii] For Fitch’s, please see: http://www.bankersalmanac.com/addcon/infobank/credit_ratings/bnkibca.aspx .
[xiii] Sinclair, 2005, at 42.
[xiv]Partnoy, 1999, at 629. Internal citations are omitted.
[xv] Partnoy, 1999, at 630.
[xvi] Standard & Poor’s Debt Ratings Criteria: Industrial Overview iii (1986) at 3.
[xvii] “According to this view, if S&P and Moody’s had not continued to generate quality information and their ratings had therefore become less accurate or reliable, they would have suffered a loss in reputation. Over time the agencies would have lost revenue, and perhaps been forced out of the rating industry. Assuming few barriers to entry in the credit rating business, new entrants would have displaced any agency suffering a loss of reputational capital. Such market forces would have acted continuously on credit rating agencies, especially given the technological innovation in financial markets in recent decades, so that the playing field would have shifted constantly if agencies had not out-innovated and out-improved the competition. Therefore, the argument goes, Moody’s and S&P must have survived because of the quality of their ratings.” Partnoy, 1999, at 634-635.
[xviii] Sinclair, 2005.
[xix] “Rating agencies continued to accumulate reputational capital during the 1920s because they were able to gather and synthesize valuable information. During this time, ratings were financed entirely by subscription fees paid by investors, and the rating agencies competed to acquire their respective reputations for independence, integrity, and reliability. In a market with low barriers to entry, a rating agency issued inaccurate ratings at its peril. Every time an agency assigned a rating, that agency’s name, integrity, and credibility were subject to inspection and critique by the entire investment community.” Partnoy, 1999, at 640.
[xx] Ibid.
[xxi] “Perhaps the most important change in the credit rating agencies’ approach since the mid-1970s has been their means of generating revenue. Today, issuers, not investors, pay fees to the rating agencies…an agency publishing a rating to one or more individuals, for a fee, will find it difficult to exclude other non-paying individuals from access to that rating. Consequently, the agency should be able to collect higher fees. The agency also can solve the free-rider problem associated with the provision of a public good by having the issuer pay for the rating on behalf of all investors in the issue.” Partnoy, 1999, at 652.
[xxii] Partnoy, 1999, at 682.
[xxiii] “pursuant to the Secondary Mortgage Market Enhancement Act of 1984 (“SMMEA”) a security must, among other requirements, be rated in one of the two highest rating categories by at least one nationally-recognized rating organization to qualify as a ‘mortgage related security.’” Kenneth G. Lore & Cameron L. Cowan. Mortgage-Backed Securities Database on Westlaw.
[xxiv] Morgenson, Gretchen. (2008). “Credit Rating Agency Heads Grilled by Lawmakers” at http://www.nytimes.com/2008/10/23/business/economy/23rating.html?_r=1&pagewanted=print
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