Preface and Chapter 1 Introduction

THE NEW MASTERS OF CAPITAL

Preface

Global finance is big business. Really big business. The bond rating agencies that are the subject of this book maintain ratings on $30 trillion worth of debt issued in American and international markets. These markets are surely too big for us to ignore if we want to understand how our world works.

Not only is global finance big, but it touches us all. The fortunes of currencies— and of banks and the markets for securities -affect our lives every day. They affect the interest rates we pay for our credit card debt, those for our house mortgage, and the return on our pension fund.

A lot of people are confused by how finance works. It appears very technical. Because finance has this image, many prefer to leave it to "the experts." But we must not allow ourselves to do so. Like war, the institutions and processes of global finance are too important to leave to professionals to figure out. This book is an effort to cross the boundary into expert territory and identify the broader political signifi­cance of these seemingly areane technical institutions.

Sir Robert Muldoon, prime minister and minister of finance of New Zealand, 1975—84, may not be a frequent beneficiary of scholarly thanks, but this book would not exist at all had it not been for him. Although I never met the man, his relations with the bond rating agencies first made me think that understanding these institu­tions might be important in the post-Bretton Woods era. Muldoon, short of stature and wide of girth, was energetic, intelligent, and truculent. Very little cowed him. Noted exceptions were the rating agencies, which Muldoon seemed to think were very important. He left an impression on rating officials that was still evident several years after his tenure ended, as I discovered during interviews on Wall Street. Muldoon's views had an impact on me as well.

I was very fortunate in the intellectual and institutional support that came my way as this book developed. Robert Cox, Stephen Gill, and David Leyton-Brown (DLB) all had a major influence. I could not have asked for more challenging schol­arly training or better mentoring. I also thank DLB for the generous financial sup­port he provided in connection with researeh funded by the Social Sciences and Humanities Researeh Council of Canada, without which my fieldwork in Japan would not have been possible. At York University in Toronto, the faculty and staff of the Department of Political Science, the Faculty of Graduate Studies, Stong Col­lege, and the York Centre for International and Security Studies supported this researeh in many ways, providing office space, fieldwork grants, and conference funding to test my initial ideas.

At the University of Warwick in England, where I have worked since 1995,1 am thankful for two researeh development grants, which allowed me to undertake sup­plemental fieldwork. I also appreciate the financial support for conference partici­pation generously provided by the Department of Politics and International Studies. The Warwick Center for the Study of Globalisation and Regionalisation provided support for attendance at a conference on rating agencies held at New York Univer­sity's Stern School in 2001. At Warwick, I have been fortunate to teach a graduate class on the politics of global finance for some years. Many students have offered valuable insights while reading and discussing my journal articles on rating. Joe Horneck and Belkys Lopez are notable among their colleagues for bringing useful doc­umentary sources to my attention. Paola Robotti, a Warwick doctoral candidate, applied her considerable skill to improve my primitive efforts at drawing figures.

During the closing stages of this project, I was fortunate to spend a sabbatical year at Harvard University, as a visiting scholar at the Weatherhead Center for Inter­national Affairs. Jeffry A. Frieden and James A. Cooney were instrumental in mak­ing this happen and helped make it a most valuable experience. While at Harvard, I was resident at Winthrop House, where Karen Reiber, Martine van Ittersum, David Simms, and Enoch Kyerematen made a big difference to my experience.

Many people in the global academic community helped with this book in one way or another. In Canada, Eric Helleiner, Louis W. Pauly, Chris Robinson, A. Claire Cutler, and Ricardo Grinspun were key. In the United States, I greatly benefited from the interest of James N. Rosenau, Raymond D. "Bud" Duvall, Craig N. Murphy, Rawi E. Abdelal, James H. Mittelman, Timothy J. McKeown, Kenneth P Thomas, Jeffry A. Frieden, Peter Gourevitch, Richard W. Mansbach, Yale H. Ferguson, Michael Schwartz, Mark Amen, Virginia Haufler, Kathryn Lavelle, and "Skip" McGoun. In Europe, I learned much from Ronen Palan, Jan Aart Scholte, Susan Strange, Dieter Kerwer, Torsten Strulik, Helmut Willke, Oliver Kessler, Philip G. Cerny, Donald MacKenzie, Tony Payne, Marieke de Goede, Peter Burnham, Henk Overbeek, and Kees van der Pijl. Frank and Patrick McCann pro­vided expert photographic input.

I have many debts to acknowledge for the help I received during my field researeh. Particularly kind were Leo C. O'Neill and Cathy Daicoff of Standard & Poor's, and David Stimpson of Moody's Investors Service. I met Mr. O'Neill, pres­ident of Standard & Poor's, near the start and the end of the project, and at each meeting he was forthcoming and incisive. Most helpful in the final years of my researeh was David Levey of Moody's. David is a great source of knowledge and good judgment about the rating business and its challenges, as well as a scholar and political economist himself. I learned a great deal from him. Chris Mahoney, also of Moody's, provided important aid. Takehiko Kamo, before his early death a profes­sor in the Faculty of Law at the University of Tokyo, assisted my researeh in Japan, sponsoring my stay at the International House of Japan. Donald J. Daly, Hiroharu Seki, and Seiji Endo helped with contacts in Japan.

In addition to anonymous reviewers, several scholars read the entire manuscript. I am greatly indebted to Benjamin J. Cohen, Tony Porter, Richard Higgott, Randall Germain, and Edward Cohen for their useful comments. They influenced me in many ways.

Friends and associates also supported me during the researeh and writing of this work. Especially important were Steve Patten, Graham Todd, Edward Comor, Robert O'Brien, J. Magnus Ryner, Martin Hewson, Liliana Pop, Randall Germain, Peter Burnham, Shirin Rai, and my IPMS Mercia friends in Warwickshire.

Peter J. Katzenstein and Roger Haydon made a major contribution to my think­ing about how this book should be organized. Their belief in the project and their practical impact cannot be underestimated.

Finally, my deep thanks go to the Wilson sisters. Delphine, Helen, Nancy, and Frances pushed me to defend my early ideas about politics, most memorably around the gas lamps and dinner tables at Mataikona. They inspired me, although it has taken me thirty years to appreciate fully their significance.

Timothy J. Sinclair

Kenihvorth, Warwickshire

Chapter 1 Introduction

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.

Thomas L. Friedman, New York Times, 1995

Contemporary American power is obvious to the casual observer. If you want concrete evidence of U.S. superpower status, take a trip to southern Ari­zona. Outside the city of Tucson is AMARE, the USAF "boneyard," the greatest collection of mothballed warplanes on Earth.¹ If an airplane was a part of the Amer­ican war machine during the past thirty years you will probably find it here, patiently awaiting its fate in the blazing Sonoran desert sun, together with some three thou­sand others. In this place, B-52 Stratofortresses, like those that dropped bombs on Vietnam, Afghanistan, and Iraq, and which were held in readiness for nuclear retal­iation during the Cold War, are broken up, their shattered fuselages and wings dis­played for the benefit of Russian spy satellites documenting the fulfillment of Strategic Arms Reduction Treaty (START) obligations. A-10 Thunderbolt IIs, the venerable "Warthog" tank-busters of Gulf Wars I and II, now expected to be in the USAF inventory until 2028, stand row upon row in the searing desert heat, quietly awaiting redeployment. Other "hogs,”based at nearby Davis-Monthan Air Force Base, fly low overhead, silently circling the University of Arizona campus. In this arsenal, the embodiment of a Tom Clancy or Don DeLillo novel, the basis of Amer­ica's superpower status could not be clearer.

But things are different when it comes to the "second superpowers," the major bond rating agencies—Moody's Investors Service (Moody's), its competitor, Stan­dard & Poor's (S&P), the smaller and less important Fitch Ratings (Fitch), and the multitude of minor domestic rating agencies around the globe. They operate in a very different world. Their arsenal is an occult one, largely invisible to all but a few most of the time.² Financial stress expands the size of the group aware of the agen­cies: in 2002, Europe had its highest-ever level of defaults, up to $15 billion from $4 billion in 2001. To the people directly concerned with matters of financial health— chief financial officers, budget directors, Treasury officials, and increasingly even politicians—rating agencies are well known.³ In this book the world of these second superpowers is explored: the basis of their power, the nature of their authority in financial markets, and implications of their judgments for corporations, municipal governments, and sovereign states.

In examining this world, I argue that rating agency activities reflect not the "cor­rectness" or otherwise of rating analyses but instead the store of expertise and intel­lectual authority the agencies possess. Market and government actors take account of rating agencies not because the agencies are right but because they are thought to be an authoritative source of judgments, thereby making the agencies key organiza­tions controlling access to capital markets. It is the esteem enjoyed by rating agen­cies—a characteristic distributed unevenly in modern capitalism—that this book explores, rather than whether agency ratings are actually valid.

A further claim made here is that this consequential speech has semantic content or meaning. That content, developed within the framework of rating orthodoxy delineated in chapter 3, is not purely technical but is linked to social and political interests. Although it is tempting to suggest that those interests are not related to location, the American origins of the rating agencies are relevant.

Changes on Wall Street and in other global financial centers increased the signif­icance of Moody's and S&P during the 1990s. The destruction of the World Trade Center in 2001 did not reverse this trend.⁴ Since the terrorist attacks, international trade and financial transactions have increased.⁵The broad context for the increased role of rating is the process of financial globalization that began in the 1970s.

Financial globalization encompasses worldwide change in how financial markets are organized, increases in financial transaction volume, and alterations in govern­ment regulation. As discussed here, the concept is more comprehensive than Armijo's specification of financial globalization as "the international integration of previously segmented national credit and capital markets."⁶ In financial globaliza­tion, markets are increasingly organized in an "arms length" way. Institutions that once dominated finance and were politically consequential, as a result, now have other roles.

Cross-border transactions have, of course, massively increased since capital con­trols were liberalized in most rich countries during the late 1970s and 1980s. The regulation of financial markets has also changed form since then. Though increas­ingly detailed, regulation is typically implemented by market actors. Government agencies create and adjust the self-regulatory framework as circumstances merit. In this environment, new financial products and strategies emerge frequently. Market volatility is associated with these developments, as is a sense that governments them­selves are increasingly subject to the judgments of speculators and investors.

The changes in market organization have been significant. Commercial banks used to be the institutions that corporations, municipalities, and national govern­ments sought out in order to borrow money. Today, in a process known as disinter- mediation, bonds and notes sold on capital markets are displacing traditional bank loans as the primary means of borrowing money. In a related process, securitization, mortgages, credit card receivables, and even bank loans are being transformed into tradeable securities that can be bought and sold in capital markets. This does not mean banks are of little importance in global financial markets. It means that judg­ments about who receives credit and who does not are no longer centralized in banks, as was the case in the past.

Over the past decade, the liberalization of financial markets has made rating increasingly important as a form of private regulation.⁷ States have had to take account of private sector judgments much more than in the heavily controlled post­war era.⁸ Liberalization of the financial markets have also increased exposure to risk and therefore the importance of information, investigation, and analysis mecha­nisms. Outside the rich countries, liberalization has been pursued by developing- country governments in Asia and Latin America that have sought to create local capital markets to finance investment in new infrastructure and industrial produc­tion. The importance of these new markets is that their operatives want information about the creditworthiness of the corporations and governments that seek to borrow their money. As things stand, market operatives get some of this information, in the form of bond ratings, from Moody's and S&P.

The two major U.S. rating agencies pass judgment on around $30 trillion worth of securities each year.⁹ Of this $30 trillion, around $107 billion worth of debt issued by 196 bond issuers was in default in 2001—a figure up sharply from 2000, when 117 issuers defaulted on $42 billion.^1,1 Ratings, which vary from the best (AAA or "triple A") to the worst (D, for default), affect the interest rate or cost of borrowing for businesses, municipalities, national governments, and, ultimately, individual cit­izens and consumers. The higher the rating, the less risk of default on repayment to the lender and, therefore, other things being equal, the lower the cost to the bor­rower. Rating scales are described in more detail in chapter 2.

The phenomenon investigated here is usually thought of as a technical matter. But this is largely a nontechnical book. An accurate, meaningful understanding of bond rating requires a broader view than the technical, just as an understanding of war cannot be limited to the analysis of military maneuvers or logistics. Hence, this book considers not just how ratings are done but also the purposes attributable to the rating process, the power and authority of the agencies, the implications of rat­ing judgments, and the problems that may bring change to the world of ratings.

Widespread misunderstandings exist about the way capital markets and their institutions work and shape the world. These markets are complex and seemingly areane. The amount of money involved is titanic and likely awesome to all but the richest inhabitants of the planet. Many think these markets shape economic and political choices in an objective way, much as the laws of physics shape the universe.¹¹ But the unqualified influence of markets and market institutions in recent years has not always been evident. For a time, during the New Deal era of the 1930s and the years of postwar prosperity in the West, a greater degree of public control tempered these global forces. U.S. and other Western governments developed welfare pro­grams and policy measures to insulate their populaces from the vagaries of capital markets. But the constraints, so the story goes, were artificial and, since the 1970s, have been challenged. Financial markets have again opposed the dictates of elected authorities and voters, to assume their "rightful place" in the scheme of things. Now, we are told by the popular and the scholarly press, there is no escaping these imper­sonal forces.

As an explanation of financial globalization, this sort of mechanistic view is not adequate. A technical understanding of the forces that constrain our economic and political choices is necessarily limited. This view assumes markets develop in ways beyond the influence of citizens, that people should simply allow things to take their "natural" course—financial globalization is inevitable. This is a key point. Much that is written about financial markets, even by people who recognize the political consequences of these markets, misses the fundamentally social character of what happens inside the markets and their institutions.¹²

The assumption in established texts is that markets reflect fundamental economic forces, which are not subject to human manipulation. But this view does not take account of the fact that people make decisions in financial markets in anticipa­tion of and in response to the decisions of others.¹³ In this book, the social nature of global finance gets particular emphasis. The social view of finance suggests that in situations of increased uncertainty and risk, the institutions that work to facilitate transactions between buyers and sellers have a central role in organizing markets and, consequently, in governing the world.¹⁴ Financial markets are more social—and less spontaneous, individual, or "natural"—than we tend to believe.

The role of rating agencies is not mechanistically determined, either. Many financial markets survived and flourished in the past without them. Typically, banks assumed the credit risk in the relationship between those with money to invest and those wishing to borrow. Alongside banks, traditional capital markets relied on bor­rowers who were well known and trusted names in their communities. But rating has increasingly become the norm as capital markets have displaced bank lending and as the trust implicit in these older systems has broken down. Rating serves a purpose in less socially embedded capital markets, where fund managers are under pressure to demonstrate they are not basing their understanding of the creditworthiness of investment alternatives on implicit trust in names but use a recognized, accepted mechanism.

At least three other ways of doing the existing work of the rating agencies can be imagined. The first is self-regulation by debtors. Much like the professional bodies for physicians, architects, and lawyers, a debtor-based system of credit information could provide data to the markets. Although this system might not be independent, collective self-interest would mitigate the tendency to self-serving outputs, much as is the case with professional self-regulation. Second, nonprofit industry associations could undertake or coordinate creditworthiness work. Good precedents already exist in countries where nonprofits enforce some national laws, such as in the case of animal welfare. The nonprofit model offers to eliminate some conflict of interest tensions implicit in charging debtors for their ratings. Third, governments could collectively take on the job, perhaps in the form of a new international agency. The International Organization of Securities Commissions (IOSCO) is already involved in discussions about rating standards and codes of conduct.'¹ The World Bank, the International Monetary Fund (IMF), and regional development banks could encourage local rating agencies in emerging markets to issue ratings. Such an arrangement would be independent of particular debtors and less subject to conflict of interest concerns, especially if not funded by rating fees.

John Moody, a muckraking journalist, Catholic convert, and credit analyst, pub­lished The Masters of Capital in 1919. In this volume he chronicled the construction of the railroad and steel trusts in the United States, and the links between these interests and Wall Street during the "robber baron" years, the era between the end of the Civil War and 1914.¹⁶ Moody investigated the capitalism of his day by look­ing at great entrepreneurs. Here, twenty-first-century capitalism is examined through analysis of institutions rather than the actions of "great men," an ontology more appropriate to present conditions.¹⁷

Within contemporary capitalism, rating agencies do not represent the only insti­tutionalization of power, nor are they all-seeing, all-knowing, all-powerful. This vol­ume is not an account of a conspiracy. The issue of power and authority inside capitalism today is its focus, just as Moody sought insight into the business power of his time. Ironically, however, the watchdogs of his day are the subject here.

Characteristics of the Rating Agencics

Rating agencies are some of the most obscure institutions in the world of global finance. Everyone knows what a bank is. Most people can explain what an insurance company does or offer a rough outline of an accountant's activities. But rating agen­cies are specialist organizations whose purpose and operations are little known out­side their immediate environment.

The discussion is not concerned with the merits of the agencies from an economic or policy perspective, to determine whether they are "good" or "had." The purpose, based on the agencies' growing impact, is to evaluate their role in financial globalization. The agencies are influential mechanisms of financial globalization, shaping what governments (at all levels) do and corporate behavior, too. Hence, an understanding of the motivations, objectives, and constraints on these institutions is worthwhile.

Although they are often confused with Moody's and S&P, institutions such as Dun and Bradstreet, which undertake the mercantile rating of retailers for suppli­ers, are excluded from the analysis. Also excluded are corporations that issue credit ratings on individual consumers, such as Experian.¹⁸ Many of the broader processes identified here are evident in these institutions, but these other raters are not cen­tral to the organization of capital markets. Rating agencies are examined in the con­text of their work with institutions in the capital markets, including municipalities, corporations and sovereign states, because that is where rating has the most impact.

What do the raters actually do? The agencies claim to make judgments on the "future ability and willingness of an issuer to make timely payments of principal and interest on a security over the life of the instrument."¹⁹ Ostensibly, this is a narrow remit. The more likely it is that "the borrower will repay both the principal and inter­est, in accordance with the time schedule in the borrowing agreement, the higher will be the rating assigned to the debt security."²⁰ The agencies are adamant about what a debt rating is not. According to Standard & Poor's, a rating is "not a recom­mendation to purchase, sell, or hold a security, inasmuch as it does not comment as to market price or suitability for a particular investor," because investors' willing­ness to take risks varies.²¹ In other words, a credit rating should form just part of the information investors use to make decisions. Rating agencies themselves do not claim to provide more than some of the information investors need.

As noted, financial globalization has widened the scope of the agencies' work. The prevailing objective, for both major agencies, is to achieve globally comparable ratings. If an AA on a steel company in South Korea is equivalent in credit-risk terms to AA on a pulp mill in British Columbia or to a similar rating on a software producer in California, investors can make global choices. In recent years, the agen­cies have also sought to provide ratings that are comparable within specific national contexts. New York, however, very much remains the analytical center, where rating expertise is defined and reinforced internally through the agencies' established training cadres and standard operating procedures.

The agencies produce ratings on corporations, financial institutions, municipal­ities, and sovereign governments in terms of long-term obligations, such as bonds, or short-term ones like commercial paper.

Once issued, rating officials maintain surveillance over issuers and their securi­ties. They warn investors when developments affecting issuers—their tax base, say, or their market—might lead to a rating revision, either upward or downward. As will be seen, this surveillance aspect of rating work is a key one, just as Pauly has shown in the context of International Monetary Fund monitoring.²² Rating agency surveil­lance shapes the thinking and action of debt issuers. It also shapes the expectations of investors, who want the agencies to forensically scrutinize issuers and who com­plain vociferously when this scrutiny seems less than they think it ought to be. Investors seem to expect rating agencies to play the role of the prison guards in Bentham's perfect penitentiary, the panopticon.²³

What product do the agencies sell? They purvey both professional, expert knowl­edge in the form of analytical capacities and local knowledge of a vast number of debt security issuers. The disinter mediation process heightens the role of bond rating agencies. It increases their analytical and local specialization absolutely, because they now rate more issues in more locations, and relatively, because with the growth of capital markets, comparable specialists (bank credit analysts are the obvious exam­ple) have become less important as gatekeepers.²⁴

Both Moody's and S&P are headquartered in New York. Both global agencies have numerous branches in the United States, Europe, and emerging markets. A dis­tant third in the market is Fitch Ratings, a unit of Fimalac SA of Paris. Domesti­cally focused agencies have developed in OECD countries and in emerging markets since the mid-1990s.²⁵

Public panics or crises about rating miscalls are the most significant challenge the agencies face. Crises erode and even threaten to shatter the reputational assets the agencies have built up since the interwar period. The 1990s and the first years of the new millennium saw more of these events, when volatility grew along with financial globalization. Threatening events included Mexico's financial crisis of 1994-95, Asia's financial crises of 1997-98, and Russia's default in 1998. Derivatives and other innovations stimulated corporate and municipal scandals and financial collapses in the United States, including the bankruptcy of Enron Corporation in late 2001. The new millennium was marked by the $141 billion sovereign debt default of Argentina in 2001-02.²⁶

Two main strategies characterize the agencies' responses to these legitimacy crises. Like other financial industry institutions, the agencies try to keep up with financial innovation, spending large sums on staff training and hiring. They push development of their own products. The agencies have created new symbols to indi­cate when, for example, ratings are based on public information only and do not reflect confidential data (in the case of Standard & Poor's). The agencies, especially Moody's, have sought to change their cloistered, secretive corporate cultures and, since 1997, have become more willing to set out a clear rationale for their ratings. That strategy may have much to do with managing public expectations of the agencies.

How do the agencies relate to governments? Despite assumptions to the contrary, the work of rating agencies, in terms of their criteria and decision-making, is not regulated seriously anywhere in the developed world. Indeed, tight regulation would potentially destroy the key thing agencies have to sell: their independent opinion on market matters. However, some process by capital market regulatory agencies of "recognizing" rating agencies' activities is customary around the world.²⁷ This recognition is especially significant in the United States, where many states have laws governing the prudential behavior of public pension funds.²⁸ In these cases, the agencies' outputs are recognized as benchmarks limiting what bonds a pension fund can buy.

A central feature of United States and other countries' processes of governmen­tal recognition is regulators' reliance on wide market acceptance of a firm's rating. In turn, the agencies resist recurrent efforts to develop more invasive forms of regulation and hold up the public standard of market acceptance as the best test of their quality. They also oppose deeper incorporation of their ratings as benchmarks in law. Developing country governments often make ratings of domestic debt issues compulsory as a way of promoting the development of liquid, transparent capital markets.

Increasingly, ratings are key elements in transnational financial regulation. In 2001, the Bank for International Settlements proposed replacing established capital adequacy standards with a new system in which ratings play a significant role in esti­mating the risk exposure of banks.²⁹

Rating and Politics

Nuances of power and authority heighten the significance of rating. Rating agencies do possess, via rating downgrades, the capacity at times to coerce borrowers eager to obtain scarce funds. But relations between rating agencies and other institutions are more often about changing world views and influence than "power wielding." On the one hand, the influence of the rating agencies grows as new borrowers look to raise funds in lower-cost capital markets rather than borrow from banks in the tra­ditional way. In this environment, the number of agency branches is expanding, and the role of Moody's and Standard & Poor's is more significant: the agencies put a price on the policy choices of governments and corporations seeking funds.

On the other hand, many government administrations, particularly in the devel­oping world and Japan, have encouraged the formation of national bond rating agen­cies. These initiatives are intriguing. They suggest that the loss of government policy autonomy implied in the establishment of rating has not been imposed on govern­ments but is actually something states have sought, even promoted. Hence, a view of rating simply as a coercive force does not capture the whole story Consideration also must be given to where rating shapes, limits, and controls—often in connection with the generation of authority—rather than the brute application of power. Elab­orating this consideration is a key focus of this book.

Analytical Approach

In this book specific institutions and associated "micropractices" at the core of con­temporary capitalism are examined, in particular the "reconfiguring" effect these institutions and practices have on global economic and political life within sovereign states.³⁰ Natural science seeks to establish universal laws and considers specific events in terms of these laws. The objective is always generalization, and many social scientists have followed this path. Here, the purpose is similar to "process tracing," the historical development of interpretive frames actors use to understand the world.³¹

Specific events, institutions, and ways of thinking are associated with rating agen­cies. The focus on particular aspects of rating agencies—rather than on the positing of universal laws about agencies "in general"—means that the research design of this book is "realistic" and inductive. The design does not aspire to the "hypo- thetico-deductive mode of theory construction" that dominates much of social sci­ence.³² One way of viewing this book is as an exploration or probe that may help to create the basis for future hypothesis testing.

Substantively, this investigation is concerned with the veracity of different approaches, or general theoretical orientations, to motivation and action that are the subject of contemporary debate in the field of international political economy (IPE). These general theoretical orientations offer heuristics, in the form of relevant vari­ables and causal patterns that provide guidelines for research.

IPE has been dominated by rationalist approaches such as realism and liberalism, informed by economics, in which the heuristic is the struggle of rational actors with fixed preferences around scarce resources. This heuristic can be applied to any num­ber of problems as a guiding set of assumptions about what likely motivates an action." Here, this dominant rationalist lens is compared and contrasted with a very different general theoretical orientation.

This second approach draws on economic and organizational sociology and on the social sciences, other than economics. Rationalist approaches adopt the assump­tion that there is a one-to-one match between imputed material interests and social action. The constructivist approach can complement the instrumental cause-effect focus of rationalism. The heuristic focuses on processes through which the prefer­ences and subsequent strategies of actors (such as corporations and states) are socially constructed, varying over time and space, and defining the identity or nature of the actors in relation to others.³⁴The norms, identity, knowledge, and culture that comprise intersubjective structures—things held constant in rationalism—are among the things that constitute or regulate actors in this general theoretical orientation.³⁵

Both rationalism and constructivism are, as it is seen in subsequent chapters, essential for understanding bond rating agencies. The constructivist lens has, how­ever, so far been neglected in IPE, to our detriment.³⁶ In part, this book is an effort to correct that omission and to demonstrate the analytical contribution construc­tivist social science can make to IPE research.

International political economy started as a study of foreign economic policy, mainly of the United States and the European powers. These origins have led to IPE being dominated by the view that markets are very different from the typical insti­tutionalized manifestations of politics, like political parties and government bodies such as houses of representatives. Unlike most economists, many IPE specialists have been interested in the interaction of the economic and political spheres (under­stood as different motivations), which scholars with diverse approaches have thought were neglected.

Only through an analysis of this interaction could an understanding of interna­tional economic relations be formed, one that included many more variables than those economists have focused on. This area of analysis has contributed much to our understanding of the developing global order since World War II, especially of the creation and decay of the Bretton Woods regime. But global markets have developed and states have changed in form and behavior during the three decades since the end of that regime. Consequently, the strict separation of IPE subject matter, into a "states" category on the one hand and "markets" on the other, has become problem­atic. Increasingly, IPE thinkers have been concerned with intermediary institutions that are neither states nor markets but interact with both.³⁷ Some scholars have also looked at the economic sphere, to reappraise inherited notions of what markets are and how they work.³⁸

Economic sociology offers an alternative theoretical source for analytical insight.³⁹ The prime benefit it offers in abstract terms is to ground the agentcentric understanding (of states, of companies, of individuals) implicit in traditional IPE in a structure emerging from social relations. Waltz and international relations Neorealism offered a sense of structure. But that structure did not encompass market rela­tions and tended to minimize the role of actors other than states, even if the formal account of the approach gave space to other agents.⁴⁰

By contrast with the Neorealist vision of an anarchy of self-regarding units, the notion of "embeddedness" Granovetter identified—a key concept in economic soci­ology—sought to link institutions to the social relations in which they existed.⁴¹ In this understanding, economic life was not separate from society like a free-standing machine but was linked to historical and cultural circumstances and, therefore, vari­able over time and space.⁴² However, despite embeddedness, economic and institu­tional sociology has produced "evidence of global cultural homogenization."⁴³ This process of change is linked to pervasive myths or mental frameworks, which legiti­mate specific organizational forms (and negate others).

Mental or intersubjective frameworks are just as consequential as other social structures. As W. I. Thomas noted in 1928, "If men [sic] define situations as real, they are real in their consequences." Thomas claimed that people respond not just to objective things, like mountains and automobile accidents, "but also, and often mainly," to their collective attribution of meaning to the situation. As Coser points out, if people think witches are real, "such beliefs have tangible consequences."⁴⁴

The importance of mental frameworks is reflected within institutions. Meyer and Rowan argue that organizations and how they are structured reflect not the efficient undertaking of their function but the myths or mental frameworks that depict a pub­lic story about the organization.⁴¹ Internal rules and organizational forms within institutions reflect "the prescriptions of myths." These rules and organizational forms demonstrate that the organization is acting "in a proper and adequate man­ner." By conforming to the myth, the organization protects itself from interroga­tion. The key process is identifying elements of the myth and then reconfiguring the organization around them. Organizations, Meyer and Rowan suggest, typically face dilemmas between the prescriptions of these elements and their internal, shared sense of what they are really supposed to be about, and also between diverse com­peting myths held by different parts of society, such as government, interest groups, and market associations.⁴⁶

Professional judgment and analysis—and public expectations about its develop­ment and standards—is a key, societally legitimated rationalized element of the rat­ing agencies' mental framework. One conception of how this framework can be understood in its wider social context is through what Peter Haas and his fellow con­tributors have called epistemic communities.⁴⁷ Haas defines epistemic communities as "networks of knowledge-based experts" that address complex, seemingly techni­cal problems. The "recognized expertise and competence" of these professionals give them an authoritative claim to offering good advice, and their control of expert­ise is "an important dimension of power."

Haas suggests four features of epistemic communities: a shared set of normative and principled beliefs, shared causal beliefs, shared notions of validity in the area of expertise, and a "common policy enterprise" connected to enhancing human wel­fare. Epistemic communities neither guess nor produce data but interpret phenom­ena. The major role of the communities lies in ostensibly "less politically motivated cases," where they introduce a range of policy alternatives.⁴⁸ The communities dif­fer from the concept of profession in that they share normative commitments but such commitments may develop within professions (for example, the subset of econ­omists concerned with economic inequalities).

A normative element also distinguishes epistemic communities from other con­cepts such as policy entrepreneur.⁴⁹Haas argues that the communities do not behave as rational choice or principal-agent theory would predict because of the central role attributed to their beliefs. Epistemic communities are important in themselves because they "convey new patterns of reasoning" to policymakers and "encourage them to pursue new paths of policymaking," with unpredictable outcomes.⁵⁰

The concept of epistemic communities is relevant to this book's focus on patterns of reasoning, on the politics of technical expertise, and on the power that emanates from knowledge. However, this book parts company with epistemic communities over the key concept of normative beliefs. A subset of raters may share a conscious commitment to such beliefs, but this commitment is a defining element of epistemic communities. The notion of epistemic communities may be useful to the analysis of particular elements within the rating world to be examined in future work. An alter­native concept—embedded knowledge networks—is elaborated below.

Embedded Knowledge Networks

Embedded knowledge networks are analytical and judgmental systems that, in prin­ciple, remain at arms length from market transactions. "Embedded" does not mean that the networks are locked in and, thus, simply resistant to change. "Embedded" should not convey the idea of inertia, path dependency, or vested interests. Instead, it is supposed to suggest that actors view embedded knowledge networks as endoge­nous rather than exogenous to financial globalization. The networks are, therefore, generally considered legitimate rather than imposed entities by market participants.

How the networks construct and reinforce this collective understanding of them­selves is of great interest. Where institutions that are embedded knowledge networks in one society attempt to transplant themselves into others, they risk losing their embedded knowledge network status, unless they recognize the necessity of getting the market actors in these other places to recognize their endogeneity. To return to the discussion of myth and mental frameworks, rating agencies must adapt them­selves to public expectations of what they should be doing, as they expand from their American home base. Achieving endogeneity and, hence, legitimacy has been easier in some places than others for the major U.S. bond rating agencies.

The role of knowledge in investment decision-making is at the heart of embed­ded knowledge network activity. Market actors are overwhelmed with data about prices, business activity, and political risk. A typical form of knowledge output is some sort of recommendation, ranking, or rating, which ostensibly condenses these forms of knowledge. This knowledge output becomes a benchmark around which market players subsequently organize their affairs. Market actors can and do depart from the benchmarks, but these still set the standard for the work of other actors, providing a measure of market success or failure. In this way, embedded knowledge network outputs play a crucial role in constructing markets in a context of less-than- perfect information and considerable uncertainty about the future.

Rating agencies, acting as embedded knowledge networks, can be thought to adjust the "ground rules" inside international capital markets, thereby shaping the internal organization and behavior of institutions seeking funds. The agencies' views on what is acceptable shape the actions of those seeking their positive response. This anticipation effect or structural power is reflected in capital market participants' understanding of the agencies' views and expectations. In turn, this understanding acts as a base point from which business and policy initiatives are developed. The coordination effect of rating agencies therefore narrows the expectations of credi­tors and debtors to a well-understood or transparent set of norms, shared among all parties. Thus, the agencies do not just constrain the capital markets but actually provide significant pressures on market participants, contributing to their internal constitution.

Counterfactual Method

How might rationalist and constructivist analytical lenses be deployed in this sub­stantive discussion of rating institutions? Since the objective is to understand the implications of the particular rather than establish general laws, we need a suitable method of thinking through the implications of rating. For the type of cases described in this book, counterfactual analysis is an appropriate approach.⁵¹ In coun­terfactual analysis, the factor or variable thought most likely to be causal is subse­quently excluded from an alternative scenario the researcher constructs.⁵² Given this modification of what Weber terms the "causal components," we have to think through whether, in these changed conditions, the "same effect" would be expected empirically.⁵³ If, in the imaginative construct established, the supposition is that the effect would probably be different, we have likely isolated an adequate cause in the initial scenario and can feel confident about the analysis. But, as Weber cautions, causal significance of this sort always suggests a range of degree of certainty about causation.⁵⁴

One objection to counterfactual scenarios is, as Ferguson notes, the notion that "there is no limit to the number which we can consider." But the reality is quite dif­ferent. "In practice," suggests Ferguson, "there is no real point in asking most of the possible counterfactual questions" that can be imagined. Plausibility is key, as in all analysis. We are interested in what happened or could have happened, not what could not have happened. Our focus should be on "possibilities which seemed prob­able." Accordingly, there is a plausible set of counterfactuals, not an infinite number of alternatives for any situation. Even if we grant that this plausible set is always open to critique, by requiring us to rethink our arguments, the posing of counterfactuals is, as Ferguson suggests, a useful "antidote to determinism."⁵⁶

In the substantive chapters of this book, a rationalist account of rating agency effects is constrasted with a constructivist one inspired by economic sociology. The purpose is to demonstrate the utility of a constructivist-economic sociology analy­sis of rating agencies and, thus, of IPE problems more generally. Since constructivist accounts are not always better than rationalist ones, the working assumption is that the constructivist-economic sociology heuristic complements the rationalist account. In some cases, the most plausible explanation may be rationalist rather than constructivist.

Central and Supporting Arguments

Economists have been keenly interested in the question whether bond ratings actu­ally add new information to markets and thus affect market behavior. The central argument of this book concerns the intersubjective effect of rating, that is, how rat­ing affects the social context in which corporate and government policy plans are made. Specific attention is given to the power and authority of the agencies, and the implications of rating for private and public life.

Rating agencies are not the neutral, technical, detached, objective arbitrators they are assumed to be among people who see them as merely transmitting market views to investors. Capital markets (and other markets) are actually organized, coor­dinated, or "made" by processes of information gathering and judgment forming the rating agencies exemplify. These processes reflect particular ways of thinking and reject or exclude other ways.⁵⁷ The judgments produced acquire the status of understood facts in the markets—even when analysis shows they are at times faulty—because of the authoritative status market participants and societies attrib­ute to the agencies. These particular ways of thinking, which are hegemonic in the Western world and which the agencies enforce increasingly internationally, are referred to here as the mental framework of rating orthodoxy.

Most broadly, it is argued, the work of the agencies integrates further elements of economic and political organization around the world, pushing these toward a prevailing institutional pattern. In this emerging order, norms are increasingly shared, and policy converges around characteristically American "best practice."⁵⁸ American ideas have become the most important transnational ones.⁵⁹ Rating agency judgments contribute to this process, as does the work of other institutions like the IMF and World Bank.⁶⁰

Three supporting or mid-range arguments about the increasing importance of rating agency judgments are developed.

Supporting Argument 1: Investment

The first argument is concerned with investment, a central feature of any modern society that produces an economic surplus. Many economists, in the tradition of Hayek, assume that investment happens automatically if certain basic conditions hold.⁶¹ But investment may also be understood as an implicitly coordinated social process. Investment has its own history and particular constraints. It is therefore necessary to understand the context in which investment choices are made.

In current circumstances, the increasing importance of capital markets alters the basis on which investment is undertaken. As banks are displaced as key investment sources, gatekeeper power is concentrated in the hands of the small number of rat­ing agencies. Rating judgments are more important today and this trend will con­tinue into the future, because less investment capital in the form of loans is being allocated by banks. This change in the character of investment has significant con­sequences for corporations and governments seeking access to resources. Rating has become a key means of transmitting the policy orthodoxy of managerial best prac­tice. Much more of the world is now open to the consequences of rating judgments than was the case during the Cold War.

Centralization of investment judgment is the essential element of the first mid- range argument. This argument is supported by evidence from the relationship between corporate ratings and the cost of debt, Michael Milken's activities, and the rating of the automobile industry. Municipal rating adds further evidence of gate­keeping. The spread of the U.S. agencies and the emergence of local agencies in new markets also supports this first mid-range argument.

Supporting Argument II: Knowledge

The second argument is about knowledge. Knowledge is usually thought of as some­thing that transcends particular situations or times. In fact, certain forms of knowl­edge are more typical of some eras and places than others. Like the investment process, knowledge is a social creation, an arena in which particular understandings of the world compete for control over what is accepted as a basis for action and pol­icy. Politically, the key thing about knowledge is the moment when an idea changes from being an individual idiosyncratic view to one widely or intersubjectively held and collectively consequential. Rating judgments are not objective.

A specific form of knowledge at the heart of the rating phenomenon has conse­quences for what we think of as legitimate knowledge elsewhere in the policy process. The knowledge form that dominates rating tends to be analytical, to focus on how things do or should function in our world, in a cause-effect fashion. What this analytical form excludes is an explanation of origins: how institutions develop and also their potential for future transformation. Rating reinforces knowledge based on the assumption of a fundamentally unchanging world, one in which eco­nomic markets, for example, are thought to perform the same function today as "always."

Where did this specific form of knowledge originate? Sorel suggested the static, unhistorical way of thinking about knowledge is a technique linked to monetary accumulation.⁶² It eschews reflection and puts a premium on instrumental under­standing in the here and now. Capitalism is premised on such a knowledge form. But a static form of knowledge, under the changing conditions created by financial glob­alization, makes the capacity to anticipate the events of September 11, 2001, for example, inconceivable. Bond rating certainly did not create the static knowledge form, but rating agencies are transmitting and reinforcing this type of knowledge globally—with consequences for public and private policy around the world and, therefore, the daily lives of billions.

In the corporate world, the growth of the rating advisory industry and the rating of telecommunication firms support these claims. Problems with quality of life vari­ables provide evidence from municipal rating. The creation of Japanese rating agen­cies, discussed in chapter 6, also supports the claims.

Supporting Argument III: Governance

Ironically, perhaps, rating forces change in how we govern our lives because it spreads the static, instrumental form of knowledge, thus challenging established ways of thinking and acting. Governance is about how institutions or processes are organized in hierarehies and how these structures shape our lives as citizens and consumers. Sometimes, the existence of these governance structures is obvious, such as in the case of representative democracy. Other governance structures are quite diffuse. They operate in society much as operating systems do in computers, beneath the surface of things. The third mid-range claim made in this book is that established, historically derived norms and practices regarding governance are chal­lenged by the judgments of rating agencies: the views of appropriate constitutional arrangements and corporate governance approaches that the agencies promote are often derived from U.S. experience. Rating agencies did not invent these governance structures but act as interpreters, advocates, and enforcers of them around the world. When put in place, these patterns shape the nature of working life and the limits of democracy, making the former more insecure and competitive and the lat­ter less inclusive and meaningful.

In chapter 4, the problems in Japanese banks support this mid-range argument. New York City's financial problems provide evidence from the municipal world. Additional evidence from controversies over sovereign ratings, for both rich coun­tries such as Japan, Australia, and Canada, and developing countries, is given in chapter 6.

Plan of the Book

The three supporting arguments are developed in the chapters where the implica­tions of rating processes in particular contexts are investigated. First, however, in chapters 2 and 3, the book looks at the agencies: their internal organization, impor­tant features of their processes for creating ratings, and the relation between rating and regulation. Next to be examined is the power and authority of rating agencies, which underpin the mid-range issues. The key question asked is from what is rating power derived, and what are its limits? The context is development of the arguments about investment, knowledge, and governance to be investigated in subsequent chapters.

In chapters 4, 5, and 6, the discussion concerns corporate rating, municipal rat­ing, the sovereign rating of national governments, and the growth of rating agencies outside the United States. These accounts are organized in terms of the arguments about investment, knowledge, and governance that are developed in chapter 3.

This book focuses on more than one level of analysis, such as sovereign states. The politics of rating pervades the world order, requiring that we consider the effects on municipal government and private corporations as well as national states. In chapter 7, recent rating "failures" are explored. Why did these failures happen, what marks them as failures, and to what degree have they undermined rating authority? Just how resilient are the reputational assets the agencies possess?

Ironically, the financial crises of the 1990s and of the early years of the new mil­lennium may have actually enhanced the power of rating agencies: capital market financing has come to be seen as less risky than traditional bank lending, especially in emerging markets. Underlying market trends may be rescuing the rating agencies from their critics, even as the increasing importance of rating motivates further criticism.

The concluding chapter examines the significance of the discussion, in particu­lar the degree to which authority and power take on new forms in globalized condi­tions and how the agencies affect people in their everyday lives. What are some ways of responding effectively to the heightened role of the new masters of capital?

Chapter 2 Good, Bad, or Indifferent: The Emergence of Rating

THE NEW MASTERS OF CAPITAL
Chapter 2 Good, Bad, or Indifferent: The Emergence of Rating


All mentally competent individuals are engaged in an almost continual course of judging, of weighing, of rating. The choice of food, of clothing, and of activity are made chiefly as the result of judgments ... All stimuli coming to the attention of the individual are being judged, either consciously or subconsciously, as good, bad, or indifferent. Such is the essential nature of rating.
GILBERT HAROLD, Bond Ratings as an Investment Guide, 1938

The increasing role of capital markets in global finance has given rating agencies power and authority that has important implications for both developed societies and emerging markets. These claims are historical and situational rather than universal. The historical development of rating agencies examined here highlights how the power and authority of the agencies came to be established. The subsequent investigation of the rating process specifies what rating is, how it works, and how its impact is experienced. This information serves as background to the conceptual exploration and substantive analysis in the following chapters. In the last part of this chapter, the focus is on the ways in which rating has become a feature of the post-Bretton Woods regulation of financial markets. The dynamic between rating agency outputs and governments suggests that state-rating agency relationships are not purely conflictual or dichotomous.

Emergence of the Agencies

The appraisal of creditworthiness is, in itself, nothing new. It is a key feature of borrowing and lending throughout history and a prime activity banks undertake as part of the loan business.

23
What is intriguing is how this financial function has come to be separated into distinct institutions, the significance and implications of this separation, and the growth of rating institutions beyond their U.S. home.
What do we know or need to know about the emergence of the rating agencies? Rather than a history of bond rating activity, this book considers how the agencies have changed over time, to help us understand the basis of their power and authority. Debt security rating had its beginnings in the early part of the last century, during the public controversy and market turbulence created by failed railroads, dubious Florida land schemes, and other property deals in the newly opened lands of the western United States.'
Rating agencies evolved from market surveillance mechanisms that had developed over many years. From around mid-century until World War I, American financial markets experienced an information explosion. Poor's American Railroad Journal appeared in the mid-1850s. This was followed by Henry V. Poor's History of the Railroads and Canals of the United States of America in 1860.? His book detailed the track length of railroads, enumerated investors' share capital, and provided a record of the railroads' profit and loss, among other things. Many of these highly detailed records gave a useful picture of investment in American infrastructure. As Poor noted, “The need of such a work” had long been felt:
There is not in this country as in most others, a central point at which the more important companies are either domiciled, or at which all are required to present annual statements of their affairs, for the reason that they derive their existence and powers from the legislatures of the several States.
In 1868, Poor's produced the first Manual of the Railroads of the United States. By the early 1880s, this publication had five thousand subscribers.
John Moody saw that while information on the railroads was available, there was a poverty of useful data on the emerging industrial combinations. At the time, “A high percentage of corporation securities had to be bought on faith rather than knowledge. "6 According to Moody, “One bright morning the thought flashed through my mind: “Somebody, sooner or later, will bring out an industrial statistical manual, and when it comes it will be a gold mine. Why not do it myself?" "7
24
The New Masters of Capital

Moody first began publishing his Manual of Industrial Statistics in 1900. His prediction turned out to be accurate. This publication did indeed prove to be a “gold mine. "8
The transition between issuing compendiums of information and actually making judgments about the creditworthiness of debtors occurred between the 1907 financial crisis and the Pujo hearings of 1912. The 1907 crisis was every bit as threatening as the Asian financial crisis. It changed attitudes toward financiers, destroyed public confidence in how American finance was regulated, expanded demand for information free from conflicts of interest, and helped to bring about the founding of the Federal Reserve system.
The crisis was so severe it forced Moody to sell his manual business, John Moody & Company. He returned with a business assessing creditworthiness in 1909, based in part on the mercantile credit rating of retail businesses and wholesalers by companies like R. G. Dun and Company. In a speech he made in 1950, Moody noted that the idea of securities ratings "was not entirely original with me” but “the idea of actually doing it was my own.”10 Elsewhere, Moody claimed to have been inspired by bond rating activities in Vienna and Berlin, codified in what he called the Austrian Manual of Statistics." Americans Roger Babson and Freeman Putney, Jr. separately invented debt ratings in 1901, but neither exploited the concept before Moody.!? Poor's, following Moody, issued their first rating in 1916, followed by the Standard Statistics Company in 1922.13 According to Harold, “Security ratings were first published on 'hunch.' ” Many traders were hostile to ratings at the time, as a factor potentially limiting future market fluctuations of bond prices. 14
Ratings developed in a haphazard way in the early years of the twentieth century. One of the things Moody's Investors Service had to attend to in the 1920s was the legacy of John Moody & Company. Roy W. Porter became editor of Moody's manuals after Moody lost control of the company in 1908.15 Porter bought the company in 1914 (a year after Moody's Analyses Publishing Company became Moody's Investors Service) and five years later merged it with Poor's Railroad Publishing Company, forming Poor's Publishing Company. Ironically, then, part of contemporary S&P was built on the basis of John Moody's original bond information company.


25
figure 1









The historical links between the two contemporary rivals are displayed in figure 1.
Strangely, as it seems now, after 1919, Poor's had the legal right to use the Moody's name. As Moody's observed in 1950, “For long years this was a matter of great confusion in our markets; people were always confusing Poor's publications as ours and naturally enough this was a factor in limiting our sales."16 In 1924, Moody's bought back the rights for $100,000, selling preferred stock to fund the purchase. Interestingly, the complicated lineage of what we know today as Moody's and S&P has rarely been mentioned in print and seems little known among rating agency staff.



26

Moody's effort to buy back his name seems to have eliminated the confusion he noted in 1950.
The growth of the bond rating industry subsequently occurred in several distinct phases. Up to the 1930s, before the separation of the banking and the securities businesses in the United States with passage of the Glass-Steagall Act of 1933, bond rating was a fledgling activity, carried out as a supplement to the data compendiums. Rating entered a period of rapid growth and consolidation with this legally enforced separation and institutionalization of the securities business after 1929. Rating became a standard requirement for selling any issue in the United States, after many state governments incorporated rating standards into their prudential rules for investment by pension funds in the early 1930s.
A series of defaults by major sovereign borrowers, including Germany, made the bond business largely a U.S. sphere from the 1930s to the 1980s, dominated by American blue chip industrial firms and municipalities.!? During this time, foreign borrowers usually had to obtain funds from U.S. or domestic banks at relatively higher interest rates.
The third period of rating development began in the 1980s, as a market in lowrated, high-yield (junk) bonds developed. This market-a feature of the newly released energies of financial globalization--saw many new entrants into capital markets.
The categories of issuers the agencies cover have changed over time. Initially, the focus of rating activity was railroads, industrial corporations and financial institutions in the United States. After World War I, U.S. municipalities and foreign governments sought ratings. As we have seen, with the defaults of the 1930s and the creation of the Bretton Woods system, rating firms retreated to U.S. municipalities and higher-rated U.S. industrial firms. In this era of rating conservatism, sovereign rating coverage was reduced to a handful of the most creditworthy countries. During the Bretton Woods era, the rating agencies did not significantly alter the way they did business, aside from introducing fees for issuers in the late 1960s and early 1970s. There were no competitors to a comfortable oligopoly, and the rating institutions took on a gravitas in keeping with the nature of their task. Significant barriers to entry existed for possible competitors, and events like the collapse of New York City's finances in the mid-1970s did not give rise to fundamental change.
With the end of the Bretton Woods system of capital controls and the liberalization of financial regulation in the 1970s and 1980s, the narrowness and exclusivity of the system that had prevailed since the 1930s was challenged by a vibrant junk bond market. For the first time, lower-rated companies were able to raise capital by selling bond debt.

27
In this new market, ratings helped to distinguish between issues and price debt, rather than simply exclude issuers from the market altogether, as had been the case in the era of rating conservatism.
The Contemporary Rating Industry
The most obvious feature of current rating growth is internationalization. As is discussed in chapter 3, cheaper, more efficient capital markets now challenge the role of banks in Europe and Asia. Ratings have been a standard feature of European bond issues since the mid-1990s, and the rating agencies are expanding to meet the demand for their services.
A second major feature is innovation in financial instruments. Derivatives and structured financings, among other things, have stressed existing analytical systems and outputs, and the agencies have been developing new rating scales and expertise in response. The demand for timely judgments is greater than ever, and agency resources reflect this demand. Compared to the hundreds of staff today, in the mid1960s, as Wilson notes, S&P had “three full-time analysts, one old-timer who worked on a part-time basis, a statistical assistant, and a secretary in the corporate bond rating department."18
A third feature is competition in the rating industry, developing for the first time since the inception of the industry. The basis for this competition lies in niche specialization (e.g., Fitch Ratings in municipalities and financial institutions) and in "better treatment" of issuers by smaller, newer rating firms in developing countries. The global rating agencies, especially Moody's, have been characterized as highhanded or, in other ways, unresponsive.' This perception has not yet produced any really significant change, but after the Asian financial crisis of 1997-98, Moody's corporate culture became less secretive. Enron's bankruptcy in 2001-2002 accelerated this switch at Moody's, prompting the previously guarded institution to “invite comment” from market stakeholders on proposed improvements in the rating process.20
Both Moody's and S&P are headquartered in lower Manhattan's financial district. Moody's was sold off in 1998 as a separate corporation by Dun and Bradstreet, the information concern that had owned Moody's since 1962. S&P remains a subsidiary of publishers McGraw-Hill, owners since 1966.21

28
Table 1




Source: Moody's Investors Service and Standard & Poor's web pages.


29
As table 1 shows, both agencies have numerous branches in the United States, other developed countries, and several emerging markets. S&P is well known for the S&P 500, the benchmark U.S. stock index listing around $1 trillion in assets.22 Unlike Moody's, S&P also offers stocks analysis.
Third in the market is the French-owned Fitch Ratings. It has forty branch, subsidiary, and affiliate offices worldwide. 23 IBCA (International Bank Credit Analysts) merged with Euronotation of France in 1995, in what was then rumored to be the first step toward the creation of a "true European rating agency."24 The subsequent merger of IBCA with Fitch creates the potential for a truly international agency. Fitch has a long way to go to achieve the eminence of Moody's and S&P, however.
Domestically focused agencies have developed in OECD countries (including Japan, after 1985, and in Germany during the late 1990s) and, especially since the mid-1990s, in emerging markets (including China, India, Malaysia, Indonesia, Thailand, Israel, Brazil, Mexico, Argentina, South Africa, and the Czech Republic).25
In the late 1960s and early 1970s, raters began to charge fees to bond issuers to pay for ratings. Today, at least 75 percent of the agencies' income is obtained from such fees.26 In Canada, the Dominion Bond Rating Service (DBRS) gets more than 80 percent of its revenue from rating fees. Before being purchased by Moody's in the late 1990s, the Canadian Bond Rating Service (CBRS) made 50 percent of its revenue this way. 27 It has been suggested that charging fees to bond issuers constitutes a conflict of interest. This may indeed be the case with some of the smaller, lower-profile firms desperate for business. With Moody's and S&P,"grade inflation" does not seem to be a significant issue. Both firms have fee incomes of several hundred million dollars a year, making it difficult for even the largest issuer to manipulate them through their revenues. Moody's Corporation (owner of Moody's Investors Service) reported revenue of $602 million in 2000, $796.7 million in 2001, and $1.02 billion in 2002.28 Revenue figures for S&P are not broken out from McGraw-Hill data but likely are similar. The real constraint is that any hint of corruption in ratings would diminish the reputation of the major agencies—and reputation is the very basis of the rating franchise.


30
The New Masters of Capital

In the case of rating agencies in Japan and the developing world, financing typically comes from ownership consortia, which often include financial institutions and government agencies. Within local financial communities, this arrangement casts some doubt on the independence of the agencies' work. It remains to be seen whether ownership of Moody's Corporation stock raises conflict of interest issues.

Rating Process

It's the same type of credit analysis that you would do if you were in a bank ... there's really no magic to it ... The differences come because there [is] clearly, after you get to your basic analysis, much qualitative interpretation
Brian I. NEYSMITH, Montréal, June 1992

How do raters do what they do? Debt rating is a process that begins with information inputs, both quantitative and qualitative. The next steps are the analytical determination itself, the output of the process, and the surveillance after a rating is done. The rating universe is treated here in an undifferentiated manner. In other words, the differences between the rating of, say, municipalities and corporations are left out of the picture, because the core judgment processes are sufficiently similar. The rating process in simplified terms is illustrated in Figure 2.

Information

The rating process in the United States may be initiated by either the issuer or the rating agency, after the filing of an SEC registration statement on the bonds for sale. Moody's has rated “without request,” to the irritation of many in the financial markets, attracting investigation by the U.S. Justice Department. 29
For first-time securities issuers, typically there is a meeting with rating officials on the agencies' information requirements.30 However, S&P and Moody's organize public seminars with the same intent.31


31
Figure 2. Outline of the rating process


Request rating
Assign analytical team Conduct basic research
Meet issuer
Rating committee
meeting
Issue rating
Surveillance
Appeals process
Source: Standard & Poor's Corporation, S6 P's Corporate Finance Criteria (New York: Standard & Poor's Corporation, 1992), p. 9.



Hawkins, Brown, and Campbell note that the rating process incorporates information on (a) quantitative data from the issuer about its financial position; (b) quantitative data the agency gathers on the industry, competitors, and the economy; (c) legal advice relating to the specific bond issue; (d) qualitative data from the issuer about management, policy, business outlook, and accounting practices; and (e) qualitative data the agency gathers on such matters as competitive position, quality of management, long-term industry prospects and economic environment."
The rating agencies indicate they are most interested in data on cash flow relative to debt service obligations.33 They want to know how liquid a company is and whether timing problems are likely to hinder repayment. So, fluctuations in the flow of cash into the entity are important, as are the timing of major obligations.34 Other information may include five-year financial projections, including income statements and balance sheets, analysis of capital spending plans, financing alternatives, and contingency plans.35 This information may not be publicly known. It is supplemented by agency research into the value of current outstanding obligations, stock valuation, and other publicly available data that allow for an inference of the corporation's quantitative basis for future debt repayment.


32
The New Masters of Capital

The major agencies have invested in up-to-date information resources to facilitate this research.36 As became evident with Enron, none of the rating agencies conduct independent audits themselves. 37
Social science can be important in rating decisions. An example is the calculation of the size of the future tax base of the city of Detroit. In 1992, Moody's formed a negative view of the future prospects of the city repaying its obligations based on, among other things, the expectation that the population is expected to shrink to less than half the current figure of around 1 million persons by 2012, had very high tax rates when compared to other U.S. cities, and an unemployment rate twice the U.S. average. 38
The rating agencies are also interested in legal information relevant to the status of the issue, to determine the degree of protection provided to the holder of the debt security, relative to unsecured creditors. Accordingly, agencies insist on being provided with the indenture or contract between issuer and bondholder. This contract must cover such considerations as (a) the type of bond for sale; (b) the amount of the issue; (c) what collateral or assets are pledged, if any; (d) the nature of protective covenants, including provisions for sinking funds in which the issuer deposits principal repayments prior to their final repayment to the holder; (e) the working capital or liquidity position of the issuer; and (f) redemption rights or call privileges on the bond. 39
This legal work is an underrated, vital activity of rating agencies. In the United States, because of SEC disclosure regulations, indentures tend to be voluminous, running to thousands of pages, and written in very specialized language. These documents are crucial in what are called “structured deals," where a particular asset or pool of assets acts as collateral for bonds. As a result, “Smaller purchasers typically rely not on the prospectus but on the rating supplied by the rating agency." Accordingly, in the legal literature, bond rating agencies have been recognized as gatekeepers (along with underwriting investment banks). Significant inaccuracies have been reported in the agencies' gatekeeping function for bond indentures, based on comparisons of published agency information in Moody's Industrial Manual and actual prospectuses. When comparing the actual terms of 171 bonds with Moody's version, Coffee found Moody's to be inaccurate in 36 out of the 171 cases, or 21 percent of the time.


33

Issuers provide to the agencies qualitative information about their policy choices and strategic plans. This information is taken very seriously by rating officials, as it informs their judgments about management capacities. 41 This information is usually provided as part of the issuer's formal presentation, which includes the quantitative information mentioned above. Typically, these meetings cover (a) background on the company or other government; (b)corporate strategy or philosophy; (c) operating position (competitive position, manufacturing capacity, distribution and marketing networks); (d) financial management and accounting policies (in the case of a non-U.S. issuer, their accounting standards and whether they use GAAP, Generally Accepted Accounting Principles); and (e) topics of concern, such as risk of additional government regulation, major investment plans, and litigation.42
The major agencies also gather qualitative information about the issuer and the issuer's business environment. In the case of non-U.S. issues in the “Yankee” market—the huge U.S. domestic market where bonds are issued in dollars—relevant information includes the foreign issuer's economic and political environment. Other things deemed pertinent are industry risk, or the viability of the issuer's industry.43 Many factors, the agencies suggest, might affect industry growth, stability, or decline: technological change, labor unrest, and regulatory shifts. * Like others in the financial markets, rating agency officials pay close attention to what the news services are carrying about the institutions the agencies rate.

Analytical Determination

How is an analysis undertaken and ratings determined? The agencies assemble analytical teams that undertake research, meet with issuers, and prepare a report containing a rating recommendation and rationale. The teams present their view to a rating committee of senior agency officials, which makes the final determination in private. These decisions are usually subject to appeal by the issuer.
Next to the confidential information flows, the most secretive aspect of the rating business is the analytical process for producing bond rating judgments. 45 Historically, there was some variation between the major agencies on this issue. Moody's, true to its history of a more conservative and secretive corporate culture, tended to be much less revealing about its ratings criteria than its major rival.
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The New Masters of Capital

 The reason, according to one Moody's representative, is that publishing rating criteria that indicate, for example, acceptable financial ratios for particular industries, were thought potentially to distort expectations among issuers. Criteria based on quantitative information tend to "confuse people” when their issue does not achieve the expected rating for qualitative reasons.46 Moody's gradually abandoned this position during the 1990s. Moody's Rating Methodology Handbook, issued in February 2000, contains financial ratio appendices. 47
S&P publishes a great number of criteria books that contain guidelines on appropriate financial ratios for different types of credits. What are these ratios? In the case of sovereign credits (a country and its national government), a typical assessment of the debt-bearing capacity of the country begins with the evaluation of the current debt burden.
SOP's Corporute Finance Criteria contains a section that links ratios with specific ratings. For example, a utility company distributing gas and seeking an AA rating needs to ensure that “funds flow interest coverage,”--the number of times cash flow into the business covers in terest payments out-equals 4.25 or better. For a BBB rating, the company needs to ensure coverage is in the range of 2.25 to 3.5. To issue junk bonds in the upper ranges, anything under 2.5 was considered adequate by S&P at the time. 48
Ratios are important in analytical determination. Certainly, rating officials referred to them at length in interviews. However, as a Moody's analyst commented, “Ratios really are a starting point. ... All a ratio gives you is a historical look at a company. Where a company has been. And by the time an account comes out, it is old anyway."19 Raters' comments support the idea that rating mixes qualitative and quantitative data, producing a fundamentally qualitative result-a judgments" But they are quick to use the objectifying cloak of economic and financial analysis and, as it were, hide behind the numbers when it is easier than justifying what may, in fact, be a difficult judgment to a potentially hostile issuer.
The Detroit case again provides an example. Although he acknowledged that the rating process for a municipality includes so-called quality of life factors, such as crime and homelessness, the leader of the Moody's rating team claimed that his report to the rating committee (where the rating determination was actually made) “was based on the kinds of objective numbers the agency had always used to provide information to investors." 51


35


The rating agencies know that public views of the ratings process tend to revolve almost exclusively around the numbers. The prevailing assumption seems to be that quantitative indicators are the form of data incorporated into the rating determination and that the process is therefore technical rather than judgmental. This view certainly seems to be behind Detroit city officials' frustration with bond raters. The officials insisted that Moody's ought to have considered whether Detroit paid its debts and controlled its budget, rather than make judgments about the future population base or quality of life in the jurisdiction. Such matters would usually be subjects for political judgment, social science, or speculation. 52 The intersubjective belief that quantitative data is the only criterion of credit rating, or that it should be, has fostered research into variables that would help an issuer secure a higher rating and therefore access to cheaper credit. 53

Outputs

Typically, at the end of the rating committee meeting, a rating is established. A variety of rating scales are available for different financial instruments. The debt ratings on bonds are the most commonly recognized, but S&P also has scales for commercial paper, preferred stock, certificates of deposit, money market funds, mutual bond funds, and insurance company claims-paying ability. S&P and Moody's bond rating scales are given in table 2, along with brief definitions of these ratings.
In the scales, an important distinction is made between investment and speculative "grades.” These grades, which neatly cleave the rating scale in two, are a result of securities legislation passed during the 1930s, which permits fiduciaries such as pension funds and insurance companies to invest only in bonds above a level deemed prudent. Over the years this distinction has become a market convention and serves to define the demarcation between speculative, high-yield, or junk bonds and those considered acceptable for investment."
Ratings have a greater role in the investment process than raters publicly acknowledge. Smith has discussed the ways in which knowledge comes to be “objectified”and acquires “authority” in the process of its creation.55

Table 2. Bond rating symbols and definitions
Grade
S&P
S&P Definitionsb
Moody's
Moody's definitions
Investment
AAA
An obligation rated AAA Aaa has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong
Bonds and preferred stock which are rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edged." Interest payments are protected by a large or by an exceptionally stable margin and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues.
Investment
AA+
Aal
АА
Aa2
AA
An obligation rated AA differs from the highest rated obligations only in small degree. The obligor's capacity to meet its financial commitment on the obligation is very strong.
Aa3
Bonds and preferred stock which are rated Aa are judged to be of high quality by all standards. Together with the Aaa group they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there may be other elements present which make the long-term risk appear somewhat larger than the Aaa securities.
Investment
A+
A1
A
A2
A3
An obligation rated A is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher rated categories. However, the obligor's capacity to meet its financial commitment on the obligation is still strong.
Bonds and preferred stock which are rated A possess many favorable investment attributes and are to be considered as upper medium-grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present which suggest a susceptibility to impairment sometime in the future.


Grade
S&P
S&P Definitions
Moody's
Moody's definitions
Investment
BBB+
BBB
BBB
An obligation rated BBB Baal exhibits adequate protection parameters. Baa2 However, adverse economic conditions or Baa3 changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. Obligations rated BB, B, CCC, CC, and Care regarded as having significant speculative characteristics. BB indicates the least degree of speculation and the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.
Bonds and preferred stock which are rated Baa are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well.
Speculative
BB+
Bal
BB
Ba2
BB
Ba3


Grade Speculative
S&P B+
S&P Definitionsb Moody's An obligation rated B is BI more vulnerable to nonpayment than obliga B2 tions rated BB, but the obligor currently has the B3 capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitment on the obligation.
Moody's definitions Bonds and preferred stock which are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small.
B
Speculative
Bonds and preferred stock which are rated Caa are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest.
CCC+ An obligation rated CCC Caa
is currently vulnerable CCC to nonpayment, and is
dependent upon favorCCC
able business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation.
Speculative
C
Ca
An obligation rated CC is currently highly vulnerable to nonpayment.
Bonds and preferred stock which are rated Ca represent obligations which are speculative in a high degree. Such issues are often in default or have other marked shortcomings.
C
A subordinated debt or preferred stock obligation rated C is currently highly vulnerable to
Bonds and preferred stock which are rated Care the lowest-rated class of bonds, and issues so rated can be regarded as having


Table 2-cont.
Grade
S&P
Moody's
Moody's definitionsd
extremely poor prospects of ever attaining any real investment standing
S&P Definitionsb nonpayment. The Crating may be used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued. A C also will be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that is currently paying.
An obligation rated Dis in payment default. The Drating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless Standard & Poor's believes that such payments will be made during such grace period. The Drating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized.


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The New Masters of Capital

Her argument is that knowledge, once produced, loses its concrete social origins. One way in which the information output of the rating process acquires this objective status is through its frequent publication in many different forms. A perusal of Standard & Poor's Canadian Focus indicates that S&P regularly produces forty-four different serial products in hard copy, CD-ROM, real-time online news, and fax.
The rating agencies' outputs are used by key capital market actors-pension funds, investment banks, other financial institutions, and government agencies. Moody's has four thousand clients for its publications, and the company estimates that around thirty thousand people read its output regularly. 56 Annual subscription fees range from $15,000 to $65,000 for heavier users, who also have the opportunity to talk to analysts directly. Increasingly, outputs are produced for the Internet. “Relationship-level clients” may attend conferences and take part in other events related to credit quality. Moody's actively puts its analysts in front of journalists and, like Standard & Poor's, issues regular press statements on credit conditions. Standard & Poor's produces an even wider range of products, in both traditional and digital format. Their core weekly publication, Credit Week, has some 2,423 subscribers. Global Sector Review is bought by 2,988 clients. 57
The rating product becomes "externalized” through these means, and opinions acquire “facticity,” as a consequence.58 O'Neill underscored this when he observed
at “what makes our ratings such a strong factor in the market is that they take into account all the factors that surround a debt obligation and reduce it to a letter symbol which is easily understood."59 McGuire observed, in congressional testimony on junk bonds, that “when you're on a symbol system you inherently suppress some information and the simplicity of the rating system and its usefulness around the world depends on that simplicity." The clarity of ratings as measures of performance has made them important in the U.S. corporate planning process. The effectiveness of ratings in communication has led to their use in advertising. When they were AAA institutions, the Union Bank of Switzerland and Credit Suisse used ratings in print advertisements, most notably in the Economist.


41
One of these advertisements, for Union Bank, began with the line, “There are three standards for measuring banks: Moody's, S&P's and our clients.” Ratings have even been used in television commercials. 62
Surveillance
Surveillance of issuers' financial condition is a key aspect of the rating agencies' work, because creditworthiness is a dynamic condition. Economic circumstances do not stand still. Wars break out, and enterprises strategize for good or ill. The quality of any rating output immediately starts to deteriorate as new events impinge on the issuer. Accordingly, the agencies place great emphasis on the ongoing monitoring of issuers.
This monitoring allows agencies to react to events and give appropriate signals about the issuer to the market. A major criticism of the agencies has been the backward or historical focus of their credit analysis. 63 Hence, attention to surveillance presumably increases analysts' proactive capacity, based on deeper knowledge of the institutions they are rating and their likely risks. The willingness of firms and governments to subject themselves to this monitoring has been heightened by SEC Rule 415, which instituted "shelf registration," allowing issuers to file with SEC to sell a given amount of securities when market conditions seemed favorable.64 Consequently, issuers have increasingly placed a premium on keeping the agencies informed so that their ratings are always current.
Surveillance should be thought of as the continuation and extension of the links between issuers, raters, and investors. Information can hasten (or preclude) discipline, should it reveal a break in the understanding--the basis for rating that underpins the relationship.65 The relationship is important to the issuer to the degree the debt markets are attractive places to raise funds. Discipline may take the form of a rating change or a listing on Moody's "Watchlist" and S&P's "Credit Watch," signaling positive rating trends or, more usually, negative rating concerns prior to a downgrade. S&P emphasizes that credibility is gained when the “record demonstrates" an issuer's actions are consistent with plans. This credibility may carry an

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The New Masters of Capital
issuer over a rough patch, because “once earned, credibility can support the continuity of a particular credit rating,” despite, say, short-term liquidity problems. 66
Ratings and Regulation
Ratings have been incorporated into government regulation since 1931. Government regulation of rating agencies, which in the United States began in the 1970s, reinforced an oligopolistic ratings market and made it harder for new entrants to launch ratings businesses.
The sharp decline of credit quality the Depression produced and the consequent problems of domestic financial institutions led the U.S. Office of the Comptroller of the Currency (OCC) to rule in 1931 that bank holdings of publicly rated bonds had to be rated BBB or better to be carried on bank balance sheets at their face or book value. Otherwise, the bonds were to be written down to market value, imposing losses on the banks.67 Many state banking departments subsequently adopted this rule. New OCC rules in 1936 prohibited banks from holding bonds not rated BBB by the two agencies. This condition had far-reaching consequences, because 891 of 1,975 listed bonds were rated below BBB at the time. The high-yield or junk bond market was effectively closed for the next forty years, until the end of the 1970s. The bond business and bond rating became quiet, predictable occupations.
Nationally Recognized Statistical Rating Organizations In 1975, the SEC further pulled ratings into the regulatory system through Rule 15c3-1, the net-capital rule. This rule created a major barrier to entry for new rating agencies in the United States. Under 1503-1, brokers who underwrote bond issues had to maintain a certain percentage-a “haircut”-of their securities in reserves. However, the rule gave "preferential treatment" to bonds rated investment-grade by at least two ‘nationally recognized statistical rating organizations' (NRSROs), who would get a "shorter haircut."68 The SEC did not define the substance of an NRSRO in any detail.
The NRSRO concept has since been incorporated into many regulatory initiatives. Subsequently, “state authorities, self-regulatory organizations, and great swathes of the U.S. mutual fund industry have adopted ratings to define, control and advertise risk."69 The NRSRO concept remains vague and unspecified in law but


43
Table 3. Ratings in U.S. regulation
Year adopted
Ratings-dependent
regulation
Minimum
rating
Number of ratings?
Regulator / regulation
1931
Required banks to mark-to-market BBB lower-rated bonds
1936
BBB
Prohibited banks from purchasing "speculative securities”
N.A.
OCC and Federal Reserve examination rules OCC, FDIC, and Federal Reserve joint statement NAIC mandatory reserve requirements
1951
Various
N.A.
1975
BBB
Imposed higher capital require- ments on insurers' lower rated bonds Imposed higher capital haircuts on broker/dealers' below-investment-grade bonds Eased disclosure requirements for investment grade bonds
1982
BBB
1984
Eased issuance of nonagency mort- AA gage-backed securities (MBSs)
1987
AA
Permitted margin lending against MBSs and (later) foreign bonds Allowed pension funds to invest in high-rated asset-backed securities
1989
A
1989
BBB
Prohibited S&Ls from investing in below-investment-grade bonds
SEC amendment to Rule 15c3-1: the uniform net capital rule SEC adoption of Integrated Disclosure System (Release #6383) Secondary Mortgage Market Enhancement Act, 1984 Federal Reserve Regulation T Department of Labor relaxation of ERISA Restriction (PTE 89–88) Financial Institutions Recovery and Reform Act, 1989 SEC amendment to Rule 2a-7 under the Investment Company Act, 1940 SEC adoption of Rule 3a-7 under the Investment Company Act, 1940 Federal Reserve, OCC, FDIC, OTS Proposed Rule on Recourse and Direct Credit Substitutes Transport Infrastructure Finance and Innovation Act 1998
1991
B1
Required money market mutual funds to limit holdings of lowrated paper
1992
BBB
Exempted issuers of certain asset- backed securities from registration as a mutual fund
1994
AAA & BBB
1
Imposes varying capital charges on banks' and S&Ls' holdings of different tranches of asset-backed securities
1998
Department of Transportation can BBB only extend credit assistance to projects with an investment grade rating

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The New Masters of Capital
Table 3---cont.
Year adopted 1999
Minimum
rating
Number Regulator/ of ratings? regulation
Gramm-Leach-Biley Act of 1999
A
Ratings-dependent
regulation Gramm-Leach-Biley Act of 1999, Title I, p. 91. Restricts the ability of national banks to establish financial subsidiaries Agencies exempted from Regula- tion FD requirement to disclose investment-relevant information to public. As long as information is for purposes of making a rating
2000
Entity's rating must be public
N.A.
SEC Rule 100 (b) (2)
Sources: Cantor and Packer, “The Credit Rating Industry,” 1994, 6; Arturo Estrella et al., "Credit Ratings and Complementary Sources of Credit Quality Information,” Basel Committee on Banking Supervision, Working Paper No. 3, August 2000 (Basel, Switzerland: Bank for International Settlements, 2000), 54; testimony of Jonathan R. Macey, Cornell Law School, before the Committee on Governmental Affairs, U.S. Senate, March 20, 2002, 2 (available in the online archives of the Committee at http:// gov-aff.senate.gov/032002 witness.htm, accessed August 6, 2004). * Mark-to-market involves recording the price or value of a security on a daily basis.
If a bond is rated by one NRSRO, one rating is adequate. Otherwise, two ratings are required. "If a bond is rated by one NRSRO, one rating is adequate. Otherwise, two ratings are required.
significant in practice. The most explicit statements of the NRSRO criteria are contained in SEC“no action” letters to Fitch Investors Service, Thomson Dankwatch, and IBCA. The letters indicate the SEC would take no enforcement action if ratings from these agencies were used to satisfy the requirements of Rule 15c3-1.

The elements the SEC mentioned in these letters are conflict of interest scrutiny; appropriate institutional separations, to avoid mixing investment advice and rating; adequate financial resources; adequate staff; sufficient training. 70 "Adequate" and "sufficient" are not defined. Moody's and S&P were deemed NRSROs. The SEC's control limits NRSRO designation to agencies that can demonstrate they are “nationally recognized.” But there is no codified process for demonstrating this recognition to the SEC.
The NRSRO constraint made life difficult in the 1990s for Canadian agencies, which were denied the status, even though harmonization of securities disclosure laws between the United States and Canada under NAFTA meant that Canadian bonds could be sold in the United States without passing through SEC procedures. However, such sales are contingent on issues being rated by two NRSROs. The SEC was sympathetic but had concerns about the credibility of Canadian (and other foreign) agencies.”



45
Finally, in February 2003, the SEC changed its view and issued a "no action" letter to Dominion Bond Rating Service, stating that it “will not recommend enforcement action,” just as the SEC had done with the U.S. agencies years before.72
In August 1994, the SEC took the first steps toward changing the NRSRO system. It issued a "concept release" seeking comment on the use of NRSRO ratings in SEC regulation, the process of becoming an NRSRO, and SEC regulation of NRSROs. 73 This release was at the initiative of middle-level SEC officials, who were trying to get the commission to take a stand on the issue.74 Lobbying was subsequently intense, as the established rating agencies attacked this effort to create formal procedures for designating and monitoring NRSROS.
They invoked the market recognition test of ratings as the most appropriate means for keeping rating accurate and suggested that future regulatory uses of ratings be considered carefully, on a case-by-case basis.75 However, the current system "clearly favors incumbents," as Cantor and Packer observe, because new entrants to the rating business cannot hope to become “nationally recognized" without NRSRO status.76 White also opposed the NRSRO designation, advocating adoption of a regulatory framework rather than certification of raters, which he argued limits competition.77
In 1997, SEC issued a proposed rule change to the Securities Exchange Act of 1934. This rule set forth a “list of attributes,” couched in very broad terms, for the SEC to consider in designating NRSROs and in the NRSRO application process.78


46
The New Masters of Capital

The proposed rule has lingered on the shelf since. But the Enron bankruptcy has revived the NRSRO issue and the question of rating agencies' performance in the corporate bankruptcies of 2001 and 2002.79
The initiative to make NRSRO status more transparent reflects intensified competitive conditions within global finance. The emphasis is on removing barriers to entry and the U.S. need to reciprocate where S&P and Moody's have been incorporated into foreign rating agency regulations, such as in Japan or Mexico.
Financial regulation is becoming more codified, institutionalized, and juridified. Rules are more elaborate and formal, with fewer tacit understandings.80 This tendency both devolves state activities onto nominally private institutions such as the rating agencies, which find themselves increasingly bound by disclosure rules, and establishes the framework for these institutions to operate. 81 In these circumstances, governments actively set the “limits of the possible” for rating agencies. From public scrutiny, the agencies potentially emerge in a strengthened position, with the conviction that they are socially sanctioned judges of prudent economic and financial behavior.
The use of ratings in financial regulation is most developed in the United States, but over the past twenty years ratings have increasingly become a key regulatory tool outside the United States, as depicted in table 4.
The latest and most significant example of ratings used as a regulawwry tool internationally is the Basel II capital adequacy proposals, mandating ratings for less sophisticated banks as a means of specifying these institutions' risk exposure. The much-delayed proposals have been controversial and the object of considerable lobbying. 82

Conclusions

We have seen the key stages in rating history, the workings of the rating process, and the use of ratings in public regulation. Delineating these purposes demonstrates that rating knowledge is very much a social phenomenon. Rating involves an admixture of quantitative and qualitative data, and it is thus inherently a process of judgment.

47
The form of knowledge that dominates the rating process is narrowly analytical and largely avoids long-run issues of development.
The inherent tentativeness of the rating process is not something the agencies publicize. The agencies assert that rating determinations are opinions but simultaneously seek to objectify and offer their views as “facts.” To understand the social foundations of the rating agencies and what they do, we now return to the mid-range arguments about investment, knowledge and governance.

Table 4. Ratings in financial regulation in selected OECD and APEC countries
Country         
Argentina


Details of the regulation
Banks and financial companies must seek a rating from an authorized rating agency. The rating reflects the ability of the financial institution to repay its medium and long-term liabilities. Although the rating scales are identical to those used by international rating agencies, the ratings do not encompass the country risk analysis. In the case of branches of foreign banks or subsidiaries wholly owned by foreign banks whose headquarters guarantee the obligations of their subsidiaries irrevocably, there is an alternative ratings system. Financial institutions must provide copies of the reports to customers who request them free of charge. However, they cannot be used in advertising campaigns or printed documents. The central bank prepares a list of banks that can receive time deposits from institutional investors (pension funds). Banks with weak ratings are excluded from this list. The Comision Nacional de Valores (CNV), the stock-market watchdog, does not extend authorization for the public offer of a security unless its issuer has sought two ratings. In addition, pension funds are not allowed to invest in assets that do not exceed a certain rating threshold, which is set at BBB for domestic credit ratings and B for ratings issued by international agencies on securities of resident issuers. The same provisions are extended to the insurance industry. In this case, the insurance industry is being asked to invest in rated securities with a minimum rating, and also to seek a rating as policies issued by them increasingly are being sold to pension funds.

Australia
Prudential statement C1: Recognizes mortgage insurance for risk-weighting loans secured by residential mortgages where the lenders' mortgage insurer carries a credit rating of A or higher from an approved credit rating agency. Prudential statement C2: Covers securitization and funds management, and also makes references to credit ratings. Prudential statement C3: Capital Adequacy for Banks, ratings are used to determine the capital requirement for specific risk for interest rate risk in the trading book.

Belgium
CAD (Capital Adequacy Directive] /Market risk amendment. Prudential reporting: the descriptive tables relating to the composition of a bank's securities portfolio require information on securities' ratings and the agencies which issued the ratings.



Country       Details of the regulation
New Zealand
A registered bank is required to disclose ratings in its quarterly disclosure statement if it has a credit rating on its senior unsecured long-term New Zealand dollar debt payable in New Zealand. Information to be disclosed must include:
1. Name of the rating agency
2. Date of the rating
3. Nature of the rating nomenclature used
4. Changes to ratings over the previous two years

In the event that a bank does not have a rating of specified debt obligations, this fact is required to be stated in its quarterly disclosure statements.

Philippines
The SEC requires issuers of long-term commercial paper to obtain a rating from the local rating agency.


Sweden
CAD/Market risk amendment

Switzerland
Market risk amendment
Credit risk: some risk-weights depends on whether the counterparty is located within an OECD country. Where OECD countries are defined as full members of the OECD, or countries that have concluded special credit agreements with the IMF in connection with the General Agreements on Credit of the latter, excluding those which have re-scheduled their external debts during the previous 5 years, or have a lower rating than investment grade on its long-term foreign currency debt (where it has no rating, its yield to maturity and remaining duration must not be incomparable with those of long-term liabilities with investment grade ratings).
Investment funds: fund managers are restricted with whom they may conclude certain derivative transactions, dependent on the counterparty's credit rating.




Thailand
There is one local credit rating agency, Thai Rating and Information Services. To ensure independence, no single shareholder is allowed to own more than 5 percent of TRIS. Current ownership is divided almost equally among commercial banks, finance companies, securities companies and other firms/organizations (including the ADB and the Ministry of Finance).
The SEC is pursuing some reforms such as the creation of another credit rating agency and an increase in the variety of debt issues.
Unsecured debt issues must be rated.




United Kingdom

CAD/Market risk amendment
Liquidity reporting guidelines for non-clearing banks.