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Peter Browne is the editor of Inside Story, where the following article first appeared. Webdiary thanks Peter and Inside Story for permission to republish.
John Moody, who began publishing investment ratings exactly a hundred years ago, would have been surprised to learn that the company bearing his name, Moody’s, has copped some of the blame – and from some commentators a lot of the blame – for the global financial crisis. Moody started out on Wall Street as a “stamp licker” in 1890, earning $20 a month. After working his way through the ranks he went out on his own, publishing industry guides and a monthly magazine for investors. But it was only after the downturn of 1907, which forced him to sell his company and start again, that he came up with the idea of rating and analysing the riskiness of the investment opportunities offered by individual companies – an activity that has come to have so much influence not only over business but also over economic policy.
As the dust settles on a dramatic eighteen months for the international economy, the credit rating agencies continue to attract criticism from the likeliest and unlikeliest of quarters. In his new book, The 86 Biggest Lies on Wall Street, the former investment banker John R. Talbott writes: “Of all the criminal behaviour conducted by all the criminal participants in the schemes and scams that created the global credit crisis, I believe the most egregious was that conducted for profit by the rating agencies.” Last month in the
For people outside the finance industry, the growing reach and power of agencies that put a rating – from AAA to D, with D conveniently standing for default – on the bonds issued by borrowers can be puzzling. A century after Moody’s first set of ratings, the industry is dominated by three companies – Moody’s, Standard & Poor’s and, to a much lesser extent, the French-owned Fitch Ratings – with a combined annual turnover of around $US6 billion. These three big players, along with a larger group of much smaller agencies, rate the risk associated with lending not only to companies but also to governments and public agencies, from
The turning point came in the 1970s. For the previous four decades the agencies had been a semi-formal part of the regulatory system in the
Meanwhile, the finance industry was developing increasingly complex financial instruments – derivatives and structured financings, for example – which gave the agencies a much more important role in helping investors decide between alternative options. Companies were less likely to seek funding from banks, and banks were facing stiffer competition for depositors’ funds. Not surprisingly, the banks themselves started seeking financial holdings that could increase their profits, and they sought them in a globalised financial world.
The impact of these factors on the size and profitability of the agencies could hardly have been greater. In the mid 1960s, according to one writer, S&P’s sole office, in
The other important factor driving growth was a change in the way the agencies charge for their services. Once, they earned money mainly by selling detailed reports with sometimes very detailed titles (John Moody’s first report was called Moody’s Analyses of Railroad Investments Containing in Detailed Form an Expert Comparative Analysis of Each of the Railroad Systems of the United States, with Careful Deductions Enabling the Banker and Investor to Ascertain the True Values of Securities by a Method Based on Scientific Principles). But from the late 1960s, the agencies increasingly charged the issuer of the bonds – the borrower – for assessing their capacity to pay back a loan.
This sounds a lot like a recipe for a conflict of interest, and it has certainly been the most common criticism made of the agencies over the past year. The borrower, who pays the rating agency, naturally wants to attract lenders. The agency is working for the borrower, so surely it has an incentive to talk down the possibility that the borrower mightn’t be able to repay? But the agencies respond that they won’t last long in the business if they keep boosting the virtues of the companies paying them: a default will reflect very badly on whoever that gave them a high score, so there’s a built-in bias towards caution. This argument had some force – at least until the subprime crisis showed that the agencies could all get things very wrong, in a very incautious manner, for a long time without being called to account.
But there’s also evidence that the problem is not so much that the agencies are talking up their clients but that they are boosting a certain view of how business and the economy work, or should work. The agencies’ ratings reflect the mainstream of thinking among businesses, banking economists and the pundits who dominate the popular end of the business media. In this world, the long boom that began in the late 1980s, and was only briefly interrupted by the Asian economic meltdown and the dotcom crash, looked set to continue forever. This was a “weightless economy” in which the marginal cost of producing the newest and most exciting products – delivered by the internet – was close to zero, so the old constraints on growth no longer applied. Fuelled by innovation, low interest rates and interesting new types of finance, western economies would keep expanding. Debt could always be repaid; housing bubbles would never burst. Above all, governments should leave wealth creation to the markets.
Even when the subprime market began to deteriorate, the agencies clung to their optimistic ratings. Only when the writing was clearly on the wall did they dramatically downgrade the funds, and by then it was far too late.
The flipside of the agencies’ enthusiasm for an unbridled private sector is a distinct bias against the public sector – despite the fact that federal, state and local governments and public agencies, even in
The suspicion that the agencies don’t like government spending was given a boost in
Paradoxically, the agencies can – in one sense at least – be very conservative organisations. Their primary function is to judge a company (or a government) on the basis of its ability to repay bondholders in the relatively near future. But, as Sinclair describes in his book, the agencies are increasingly faced with grading projects and organisations – ambitious telecommunications projects, for example – that would once have been financed directly by government or predominantly by shareholders with a view to the longer term. On top of that, they are often attempting to attach a grade, at a single point in time, to businesses operating in a complex and fast-moving environment in which returns sometimes don’t materialise in the short to medium term. In that sense, they could have contributed to the short-term thinking that eventually produced the subprime crisis.
Unchastened by their recent failures, the agencies are still pressuring governments to toe the line. In May, the Wall Street Journal reported, “
It’s the agencies’ worldview that makes changing the system so difficult. They are quite happy to concede the need for more “transparency” and a degree of greater competition, but it’s hard to imagine any major shift in the weight of opinion they express. The British government has been a leading exponent of the need for governments to stimulate the ailing world economy – a strategy that has won fairly wide, though not universal, support – but the agencies still believe that their view of government debt is the right one. The agencies have been under intense scrutiny before – many mainstream economists now accept that they contributed to the depth and duration of the Asian economic crisis, for instance – and have largely escaped change. The intense criticism during the Enron scandal did force the Securities and Exchange Commission to open up the system a little by giving more agencies NRSRO status, but not surprisingly the big three, with their long head start, continued to dominate.
Over the past year more significant options for reform have been discussed in Europe, North America and
All that seems pretty clear, though whether it will shift the industry-wide worldview is another question. What’s nowhere near as clear is what the
President Obama’s proposals were not much tougher, according to Eric Dash, banking writer with the New York Times. “While the administration is proposing some modest changes, none addresses what many see as the central problem: Services like Moody’s and Standard & Poor’s are paid by the companies whose securities they are evaluating. It is as if
The White House proposals did include a call for regulators to stop relying so heavily on assessments by the agencies, and Congress – via a number of committees – is looking at a further move away from this quasi-regulatory role, together with other proposals for change. But the legislative process could be protracted and there’s a strong chance that the options will be diluted.
According to Timothy Sinclair, there’s no reason to think that rating agencies will be less important in future. Complex financial arrangements will inevitably be more widespread, and the agencies’ business model is unlikely to change, which means that issuers of bonds will still overwhelmingly foot the bill.
“If there is a substantive change to come out of the crisis,” he told me by email, “it may come in forcing the agencies to play the game they were initially founded to play: judge. The problem was that in working on securitised finance the agencies stopped playing this role and started helping financial players create financial instruments.”
The IOSCO code of conduct certainly stresses the need for agencies to be rigorous and independent in their judgements. As Sinclair puts it, “agencies must play a much more conservative game – like all market actors really. This might lead to the development of new institutions as securitised finance is a creature of ratings. It only exists because of the different categories of risk. So there may be an opportunity here for a lot of ex–rating agency officials to establish advisory firms.”
If the regulations eventually adopted by the
This means that people like Bill English,
Not everyone is in the thrall of the agencies. In February this year, a few days before she planned to announce the state election, the
John Moody lived to see his company prosper through almost half a century. He died in 1958, aged eighty-nine, having become a “strong advocate of Christian principles in business.” It’s interesting to speculate about what he would have thought of the role of his agency just a half-century later.