Sunday, 21 May 2017

Article Preview: Considering the Historic Culture of the Credit Rating Industry

Today’s extended post will be the first of a number of article previews this week concerning the credit rating industry. Throughout the week we will look at a number of issues, ranging from current regulatory proposals in the U.S. concerning the industry, to the role of the agencies in the emerging motor-finance bubble. In today’s post, the focus will be upon a work in progress that aims to chart the history of the ratings industry, but does so with a ‘cultural’ lens; the thesis of the piece is that the current agencies act in a manner which they have always acted – ruthlessly in their own self-interest – and that we must have that at the forefront of our minds if we are to regulate the industry for the protection of the public.

The article, which can be found here in its current form, primarily seeks to recount the major instances within the industry’s history and analyse them to see if a pattern emerges. Before the article analyses the first ‘phase’ of the industry as we know it today, the scene is set by discussing the origins of the industry before it became a commercialised force. In the burgeoning and antebellum United States, the problems facing the largest financiers and merchants were focused upon how to increase the likelihood of a debtor repaying the credit that was afforded to them (a thorough analysis of this time can be found in Olegario’s book here). Whilst this problem was limited when most trade was localised, the introduction of the expansive railroad network introduced the aspect of nationalised trade where reputation could not be relied upon. The article, to emphasise this point, focuses upon one of the largest financiers of the time – Baring Brothers – and their ingenious resolution to the intermediation problem. In acquiring the services of a retired and respected merchant from Boston, Thomas Wren Ward, the firm began compiling the creditworthiness of traders and merchants by way of Ward’s extensive knowledge and diligence in the area (Ward would create a system that ‘ranked’ merchants). In the article, an important point is raised – because the Baring Brothers’ capital was at risk, the firm used the system to protect themselves, and acting in a diligent and considered manner; they were not speculators in the manner with which we know speculators as today.

However, the explosion of the railroad network did encourage speculation and a commercialisation that the United States had not witnessed before. As most merchants did not have the resources that large financiers like Baring Brothers could call upon, a New York law firm called Griffen, Cleaveland, and Campbell stepped into the vacuum in 1835, establishing a network of lawyers that would rank and attest to people’s creditworthiness, which would then be compiled and the information then sold for a fee – it was the first ‘investor-pays’ rating entity. However, the firm collapsed because, up until that point in the U.S., there were no major economic shocks that would inspire the diligence that such a system introduced. That all changed in the late 1830s with the Panic of 1837, that led to the enactment of the National Bankruptcy Act of 1841 (more on this period in American bankruptcy law can be found here) – yet, many feared that the Act would encourage a ‘jubilee’ or a ‘universal pardoning of all debt’, which initiated an intense need for creditors to select those to whom they would lend ex ante (translation: before the event), and into that vacuum stepped the first commercially successful credit (reporting) agency: The Mercantile Agency.

The Mercantile Agency was set up by Lewis Tappan, an Evangelical businessman and philanthropist, just two days after the enactment of the Act – the fact that the Act was repealed just months later was irrelevant; there was now an accepted understanding that one needed to have information on a debtor before extending credit – fear of loss had become engrained in the American economy. There is much to be discussed about the first successful agency, but for our purposes the focus is on the actions of the agency. Although Tappan was well known for his religiously-inspired endeavours – like his legal representation for the rebellious slaves on board the infamous La Amistad schooner – this ‘piousness’ did not extend to his business, with Tappan hiring a notably pro-slavery man to succeed him in business, leading one academic to deduce that Tappan was ‘seldom sentimental’. Additionally, Tappan would go on to deceptively divide his business so that his anti-slavery stance would be concealed when the business expanded to the pro-slavery south, something which would seem to confirm the importance of survival over ethical considerations. Tappan would recognise this before his death, stating that the ‘eagerness to amass property… robs a man and his family of rational enjoyment… [and] tempts him to doubtful and disreputable acts’, although it was too late – this ‘at all costs’ culture had now been cemented within the ever-growing firm. The men chosen to take the firm forward, Benjamin Douglass and later R.G. Dun, would embark upon a campaign of intimidation and disreputable legal and illegal acts to protect their products from being deemed as contravening libel laws – the firm would create fake lawyers, drag cases on so that poorer victims could not compete (strangulation), and usually play the system (venue shopping) so that people who were wronged by the agency could not seek recompense – the Beardsley v Tappan case represents the best example of the agency ruthlessly destroying someone to protect themselves (an excellent account of this can be found here).

So, the culture was developed towards the end of the 19th Century. In picking up the mantle, new entrants to the field – Poor’s Railroad Manual Company would merge with Standard Statistics in 1941 to create Standard & Poor’s, John Moody would set up Moody & Co. in 1900 which would, after a number of issues, become Moody’s in 1910, and finally the two oldest firms, R.G. Dun and Co. (the Mercantile Agency rebranded) and Bradstreet Ratings Co. would merge to form Dun and Bradstreet, that still exists today as a credit reporting firm – would attempt to develop the rating industry throughout the 20th Century, although they had little success. Rating agencies were required during this time, but an amnesia that we are more than familiar with today gripped society before the Wall St. Crash of 1929 (and subsequently The Great Depression of the 1930s), with the Second World War initiating an economically so-called’ Quiet Period thereafter; as a result, rating agencies were facing extinction as late as the 1960s. However, a strange set of events would dramatically alter their collective fortunes and the agencies’ culture would see them cemented within the economy from then on – the real threat to their survival would encourage the absolute commitment to the ‘by any means necessary’ culture.

In 1970, the conglomerate Penn Central spectacularly collapsed, setting the then-record for the largest bankruptcy at $82 million. Whilst some researchers have suggested that the investing public simply invested in large conglomerates like Penn Central through reputation alone – this apparently being the reason for the agencies’ lack of success – the actual reason was that Dun & Bradstreet has been providing top-notch recommendations (akin to the AAA rating we know today) via its ‘National Credit Office’ (NCO), which meant that investors saw no need to consult S&P and Moody’s as they relied upon the NCO for their information. The collapse led to a panic amongst the investing public, with the resulting fear being who they could turn to regarding solving the disintermediation (information asymmetry) problem that is inherent within the capital markets – i.e. understanding the creditworthiness of people and institutions without revealing sensitive data to the marketplace. Rather strangely – but this author argues emblematic of the issues regarding the perception of this industry – the investors turned to the rating agencies to provide the information. This is strange because, quite simply, Dun & Bradstreet, S&P, and Moody’s are, in essence, one and the same. The rating agencies (S&P and Moody’s) were delighted at this potential reprieve because, as their existence was being actively threatened by the public introduction of photocopying machines through a concept known as ‘free-riding, this would have seen their ‘investor-pays’ business model destroyed as one investor could have easily disseminated the information to other investors with the agency being compensated fully for their output. Yet, in a clear demonstration of their culture prevailing, as investors turned en masse towards the agencies for independent and accurate ratings, the two leading agencies altered their business models so that now the issuers of debt were forced to pay for ratings – issuers were inclined to do so to demonstrate to investors that their creditworthiness could be relied upon, unlike that of Penn Central and the like. Hopefully not unsurprisingly to anyone who has an interest in the industry, researchers have found that the two agencies’ ratings rose substantially if an issuer was paying for the privilege, which clearly indicates the understanding that agencies act in their own interest, not that of investors. The cementation of this culture was confirmed in 1973 and later 1975, when the Securities and Exchange Commission would designate Nationally Recognised Statistical Rating Organisation (NRSRO) status to S&P and Moody’s, thus protecting them from competition and confirming the power of the oligopoly.

The article goes on to discuss the fact that the agencies remained unregulated until 2005/6 which, as we now know emphatically, was far too late to see the agencies directly facilitate the pilfering of the economy, pilfering which we are all still continuing to be negatively affected by. The underlying theme of the article is this existence of a culture that is overwhelmingly concerned with survival. It is accepted that private institutions must be concerned with their survival, but it is declared here that the rating agencies do this to an extreme level. Whilst we cannot dictate how a private institution is run, we can alter our perception of these institutions so that we can predict their actions. There continues, to this day, an incredible lack of awareness as to the actualities of the ratings industry, which is confirmed by some deregulatory tones emanating from the U.S. at the minute and the insistence that rating agencies act for investors. It is clear that they do not, and when we analyse the history of the agencies and line up all of the instances together, we can see, undoubtedly, that these agencies will consciously and actively act against investors – it is vital, for societal development, that investors, regulators, and the public moreover realise this.

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