Financial History Issue 112 (Winter 2015) | Page 37
Collection of the Museum of American Finance
Opening page of the Fitch Stock Record, 1943.
to predict the future movements of prices
and future conditions in the economy
overall, Moody applied his methods to
individual firms and bond issues.
As with his Manual, it wasn’t long
before other publishers saw the value
in Moody’s bond rating business and
entered the market themselves. Poor’s
Publishing launched its bond rating service in 1922, offering ratings for corporate
and municipal bonds. In 1923, Standard
Statistics also joined the market, and in
1924 Fitch Publishing Company began
to publish bond ratings as well. Standard
Statistics and Poor’s Publishing merged
in 1941, forming Standard and Poor’s.
Thus emerged today’s “Big Three” credit
rating agencies.
The country’s reaction to the Great
Depression produced a piece of regulation that cemented the place of these three
firms in the securities industry. In 1936,
the Office of the Comptroller of the Currency (OCC) banned banks from holding
non-investment grade securities. But since
“investment grade” was a term used specifically to refer to bond ratings, this effectively required all securities to be rated
if they were to be sold to institutional
investors. Similar measures linking capital
requirements of insurance companies to
bond ratings were enacted by insurance
regulators in the decades that followed.
The “Big Three” have retained their place
as the foremost names in bond rating ever
since, but they have had their share of
struggles as well.
The key problem arose from a major
change in their business model. Traditionally, rating agencies had charged subscription fees to investors. However, in
response to a changing marketplace in the
1970s, they began to charge issuers to have
their bonds rated. This provided a solution
to a very real free-rider problem exacerbated by the proliferation of inexpensive
photocopying. Namely, investors who did
not pay for agencies’ books were able to
obtain the ratings from other investors.
Then, in 1975, the SEC enacted capital
requirements for broker-dealers, also linking them to bond ratings.
Fearing that companies might skirt regulations by dealing with less-than-reliable
rating agencies, the SEC created a new regulatory category: Nationally Recognized
Statistical Rating Organization (NRSRO);
that is, credit rating agencies whose ratings could be relied on for regulatory purposes. Unsurprisingly, Moody’s, S&P and
Fitch immediately received NRSRO designation. By 2000, although other rating
agencies had been designated NRSROs, a
series of mergers meant that the only ones
remaining were the “Big Three.”
The “issuer pays” business model has
resulted in public criticism over the years,
as many believe it contains an inherent
conflict of interest. Rating agencies could
be tempted into a “race to the bottom,”
inflating ratings for fear of losing business
to other agencies. The NRSRO designation
by the SEC does limit this sort of competition, but it also limits the incentive to
improve the quality of ratings.
In addition, the “Big Three” have been
criticized by some for being too slow
to downgrade ratings and by others for
being too slow to upgrade ratings when
conditions change. Largely because of
overly optimistic ratings given to mortgage-backed securities during the recent
financial crisis, the Dodd-Frank Act of
2010 mandates a review of the regulatory
reliance on ratings. The full effect of this
and other legislation on the status of the
rating agencies remains to be seen.
Lesyk Voznyuk is a senior at Augustana
College in Sioux Falls, SD, majoring in
physics, religion and economics. He is an
undergraduate research fellow with the
Thomas Willing Institute for the Study
of Financial Markets, Institutions and
Regulations and plans to begin a career
in financial analysis upon graduation in
May 2015.
Sources
Acharya, Viral V. and Matthew Richardson.
Restoring Financial Stability: How to Repair
a Failed System. Hoboken, NJ: John Wiley
& Sons, 2009.
Acharya, Viral V., Thomas F. Cooley, Matthew P. Richardson and Ingo Walter, eds.
Regulating Wall Street: The Dodd-Frank Act
and the New Architecture of Globa