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.

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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
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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.


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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.



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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.

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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

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Table 1




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


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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.


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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


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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.


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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.


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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


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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.


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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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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


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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


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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.

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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.