A powerful force in modern capitalism
A look at the history of credit rating agencies shows that regulating the regulators is easier said than done.
In 1909, John Moody became the first financial analyst to assign letter grades to railroad bonds, giving investors an easier way to evaluate the rail companies’ debt. It was the beginning of one of the most powerful forces in modern capitalism.
Today a small club of bond-rating agencies, led by Moody’s, Standard & Poor’s and Fitch, wields enormous power, sending investors scrambling simply by changing the ratings that the firms assign to everything from Greece’s sovereign debt to the IOUs issued by multinational companies.
A look at the history of these institutions, however, highlights the development these agencies underwent to become what they are today. As rating agencies gained more power, their structure morphed. This brought with it new conflicts of interest.
An easy target
“Ratings agencies, in particular Fitch, Moody’s and Standard & Poor’s, have been implicitly allowed by the government to fill a quasi-regulatory role …"
Credit rating agencies have long been a lightning rod for criticism when financial markets were perceived to have failed. Following the East Asian crisis of 1997, many observers suggested that ratings agencies had amplified business fluctuations through hasty downgrades.
Rating agencies once again came under scrutiny following the Enron debacle: some argued that the agencies had waited too long to voice doubt about the ailing conglomerate.
In the wake of large losses in the collateralized debt obligation market that occurred despite being assigned top ratings by the credit rating agencies, the wrath of the public is once again upon the likes of Moody’s, Standard & Poor’s and Fitch.
The rating agencies respond that their advice constitutes only a “point in time” analysis, that they never promise or guarantee a certain rating and that any change in circumstance regarding the risk factors of a particular product will invalidate their analysis and result in a different credit rating.
This argument stands in contrast to the quasi-governmental role these agencies currently hold. In 1975, the Securities and Exchange Commission (SEC) deemed certain firms “nationally recognized statistical ratings organizations”, making a sign-off from a ratings agency a necessity for anyone selling debt. Ratings agencies, in particular Fitch, Moody’s and Standard & Poor’s, have been implicitly allowed by the government to fill a quasi-regulatory role, but because they are for-profit entities their incentives may be misaligned. In addition, conflicts of interest often arise because the rating agencies are paid by the companies issuing the securities – an arrangement that has come under fire as a disincentive for the agencies to be vigilant on behalf of investors.
The debates of the past decade raise the question of how and why rating agencies came to be used as the basis of regulation in the first place. Given the recurring criticisms of agencies whenever financial markets fall into turmoil, such a decision may appear to have been ill advised. The irony, however, is that rating agencies were discovered by regulators precisely in a period of deep distrust towards the market mechanism.
Lessons from history
Bond ratings by independent agencies are an innovation of the 20th century that came along rather late. By the time of John Moody’s bond rating innovation
“In 1909, John Moody became the first financial analyst to assign letter grades to railroad bonds..."
in 1909, Dutch investors had been buying bonds for three centuries, English investors for two, and American investors for one century, all the time without the benefit of agency ratings. According to Richard Sylla, an economic historian from the Stern School of Business, the bond-rating agency innovated by Moody in 1909 did not represent an actual innovation; instead, it was a fusion of functions performed by other institutions that preceded it: the credit-reporting (not rating) agency, the specialized financial press and investment banks.
The collapse of stock and bond markets that followed the Great Crash of 1929 had led to accusations of “banksterism”. Banks, it was said, had failed to address the conflicts of interest between their role as gatekeepers and the fees they earned from selling securities to the public. In an article on ratings, performance and regulation during the Great Depression, Marc Flandreau, Norbert Gaillard and Frank Packer try to understand why rating agencies emerged from the Great Depression with a considerably enhanced status within the US financial system, securing regulatory licence from banking supervisors. Interestingly, they come to the conclusion that rating agencies do not appear to have performed particularly well relative to financial markets in seeing the incoming mess approaching or judging relative risks of borrowers. When they compare the predictive power of agency ratings with that of synthetic ratings based on market yields, they find little that suggests superior performance could have been a critical motive for the initial delegation of a regulatory licence to ratings.
During the 1920s, rating agencies operated in an environment that was radically different from that of today. While today’s incentives have, at least in the minds of some critics, tarnished the credibility of rating agencies as much as that of banks, the conflicts of interest they faced during the interwar era – when the rating industry was in its infancy – were perceived as very different from those of banks. When problems hit in the 1930s, banks came under ferocious public criticism. But rating firms earned revenues from selling their manuals instead of charging the concerns they rated.
The agencies’ new role in the 1930s did not result from the superior forecasting qualities of ratings. They became important because they were perceived as being free from conflicts of interest. While bankers were said to have manipulated prices, the agencies provided a certification of quality that was not tainted by the rampant mistrust in financial intermediaries, and their opinions were used as benchmarks in legal cases. The emergence of ratings as a regulatory instrument was a specific response to the specific financial problems faced during the Great Depression.
The emergence of conflicts of interest
If the credit rating agency itself was the key innovation of the earlier era, the key innovation underlying the recent era of agency growth is an innovation in the way agencies finance their operations. From 1909 to the 1970s, revenues came from selling agency reports to subscribers. Investors and other users of the information provided by the agencies essentially paid for it. Starting in the 1970s, the agencies shifted their main revenue source from investors and users to the issuers of securities.
Now nearly all of the leading agencies’ revenue comes from fees, usually a few basis points of the amount of the issue rated, charged to issuers. This raises the question of what those who pay for agency ratings receive in return.
Predicting the future?
This casts doubts on what we ought to expect from a revision of incentive frameworks. It may or may not be that some particularly ill-advised ratings were produced ahead of the latest crisis in part on account of defective incentive schemes plagued by conflicts of interest, but there is a long way to go between proving this claim and reaching the further conclusion that regulatory changes addressing such conflicts of interest ought to cure most of our modern problems and somehow make credit ratings more “perfect”.
If anything, a world where agency conflicts of interest are less pronounced is neither one where crises are absent, nor one where they are more predictable.
Article by Adam Lockstein
Comments on this entry are closed.