Lawrence J. White on the History of the Bond Rating Agencies

12 08 2011

Lawrence J. White, a professor at NYU’s Stern School of business recently spoke about the history of the bond rating agencies on the NPR radio show Planet Money.

He notes that there was a major change in the bond rating industry in the late 1960s. Up to that point, the rating agencies were paid by investors, who had a strong interest in getting accurate information. Under this system, the rating agencies did a pretty good job of separating good from bad investments.

In the late 1960s, the rating agencies switched to charging the people who were issuing bonds, which created all sorts of conflicts of interest. According to Professor White, this change was driven by technology.

White blames the shift on the invention of “the high-speed photocopy machine.” The ratings agencies were afraid, he says, that investors would just pass around rating information for free. So they had to start making their money from the company side.

Read more here.

Before you study the analyst’s report, study the analyst

8 08 2011

Yesterday I posted some questions about Nikola Swann, the S&P analyst who downgraded the US debt. I complained that we know almost nothing about Swann or the other individuals responsible for the downgrade. A helpful reader has provided some information that remedies the situation.

Nikola Swann is a Director, having joined the Toronto office in 2002. Nikola is primary analyst for the United States of America, Canada and Bermuda, as well as several public sector entities, including the International Bank for Reconstruction and Development, the International Finance Corporation, and la Caisse de dépôt et placement du Québec.

Prior to joining Standard & Poor’s, Nikola worked as an Economist in the Canadian Federal Government’s Department of Finance. Previously, he worked in the Monetary and Financial Analysis Department of the Bank of Canada.

So it appears that Swann was working in the Canadian government in the 1990s, when Finance Minister Paul Martin was battling to eliminate Canada’s the large fiscal deficit. Martin famously said that he would eliminate the deficit “come hell or high water” and would use any means necessary.  Martin managed to eliminate the deficit by a mixture of spending cuts and revenue increases. I’ve put the cover of Martin’s memoir below.

As the chart below shows, the Canadian deficit was mostly eliminated by spending cuts, but there were some tax increases that were part of the mix as well.

This background is critical to understanding why Swann’s report is critical of right-wing US politicians who think that deficit elimination can be achieved solely by cutting spending. The Tea Party movement is adamantly opposed to any tax increases whatsoever, even those that fall on just on the very wealthiest Americans (some of whom run the Tea Party movement).

It is possible to attribute Swann’s belief that deficit reduction take both tax increases and spending cuts to simple common sense. However, I also think that we need to take an individual’s personal and political background into account when evaluating their reasons for arriving at a particular position. In this case, we would look at Swann’s first-hand experience in a government that succeeded in balancing its books through a mixture of tax increases and spending cuts. Moreover, Swann’s perspective can be seen as reflecting the Canadian habit of seeking compromises or balanced approaches to problem, a habit of thought that informs Canadian thinking about the social contract. Most Canadians would shy away from a approach to deficit reduction that relied exclusively on either spending cuts or increased taxes on the rich. Canadians tend to gravitate towards the via media, the middle of the road. As I’ve argued before, the Canadian belief in compromise is something that we inherited from the United Kingdom. (See shameless self-promotion publication reference below).

My point is this: before you study the analyst’s report, study the analyst.

Many historians train their students using document analysis assignments. The students are given a particular document, say a papal bull or one of Napoleon’s decrees, and are then told to write an essay that discusses the document’s creator, the author’s context, and their motives for writing x, y, or z. It’s a great exercise as it imparts a habit of thought that the students can apply in their future careers, which will likely be in a field outside of history, such as business or politics or journalism.

It seems to me that in a future history class, students might be asked to do a document analysis of the S&P’s now famous report.


Andrew Smith, “Canadian Progress and the British Connection: Why Canadian Historians Seeking the Middle Ground Should Give 2½ Cheers for the British Empire” in Contesting Clio’s Craft: New Directions and Debates in Canadian History edited by Christopher Dummitt and Michael Dawson (Washington D.C.: Brookings Institution Press, 2009).

History of Bond Rating Agencies

30 07 2011

“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

James Carville, Wall Street Journal (February 25, 1993, p. A1)

There has been a lot of discussion recently about the possibility that the United States might lose its triple-A bond rating as a result of the standoff between President Obama and House Republicans. For press coverage see here, here, here, and here. For blogosophere reaction, see here, here, and here.

Speculation about the results of a rating downgrade was fueled when Mohamed El-Erian, chief executive of bond trading giant Pimco, said that the debt-ceiling political crisis in the United States has hurt that nation’s reputation in the financial markets and that the loss of the triple-A credit rating would have dire consequences.

El-Erian wrote:

America’s already-fragile economic psyche and its global standing have taken a material hit. Forget about “animal spirits” for now. Instead, worry even more about an economy that is already having tremendous difficulty sustaining an acceptable growth momentum, and that already suffers from an unemployment crisis that is increasingly protracted in nature. Analysts will now scramble to again revise down their projections for growth, and up those for unemployment… America’s friends and allies are bewildered at what is going on here (and its enemies rejoicing).

Read more here.

El-Erian’s piece in the Huffington Post generated lots of discussion. There has, however, been relatively little discussion of the history of the agencies that issue these ratings.

An excellent paper by Richard Sylla on this subject is available online. Sylla is the Henry Kaufman Professor of the History  of Financial Institutions and Markets and Professor of Economics at the Stern School of Business in New York. Anway, here is the first paragraph of his paper.

When the business of bond credit ratings by independent rating agencies began in
the United States early in the twentieth century, bond markets—and capital markets
generally—had already existed for at least three centuries. Moreover, for at least two
centuries, these old capital markets were to an extent even ‘global.’ That in itself
indicates that agency credit ratings are hardly an integral part of capital market history. It
also raises several questions. Why did credit rating agencies first appear when (1909)
and where (the United States) they did in history? What has been the experience of
capital market participants with agency credit ratings since they did appear? And what
roles do agency ratings now play in those markets, which in recent decades have again
become global, to an even greater extent than previously in history.

As Sylla shows, it is entirely possible to have a lively bond market without rating agencies. Like many people, I am skeptical of the predictive value of bond ratings because they come from for-profit companies that have conflicts of interest that undermine their credibility. The 2008 Global Financial Crisis destroyed much of the reputational capital of these agencies. As we all know, the credit rating agencies granted very high ratings to dodgy subprime mortgage securities. As one observer pointed out, “a primary cause of the recent credit market turmoil was overdependence on credit ratings and credit rating agencies.”   Read more about the role of the rating agencies in the subprime crisis  here.

If the rating agencies turn on the United States government and downgrade its credit rating at this critical moment in the history of the American empire, it would be a rather ironic turn of events, since the global political clout of the bond rating industry is largely a creation of regulations put in place by American officials during the New Deal era. These regulations were strengthened in the 1970s, after which an increasing number of financial professionals were forced to use the ratings produced by a small group of government-approved ratings agencies. These agencies are known as “National Recognized Statistical Rating Organizations”. Read more here.

The NRSRO business is rather uncompetitive with considerable barriers to entry. As of 2011, American companies are allowed to use the ratings produced by just ten such agencies. See here. To the credit of the US SEC, which licences the NSRSOs, not all of these agencies are American. There is one Japanese firm and one Canadian company on the list, which shows that the Americans aren’t being protectionist here. In other ways, however, these agencies are remarkably homogenous in terms of their corporate structure and underlying business model. All are in the private sector. All of them are for-profit businesses. In all ten cases, the agencies make their money from payments from bond issuers rather than from the people who make decisions based on their ratings. (Holy conflict of interest Batman!)  None of these agencies is a non-profit organization and it is unlikely the US SEC would designate a non-profit agency staffed by disinterested volunteers as a NRSRO. For one thing, such an agency wouldn’t have the money for the required campaign contributions to members of Congress.

I have nothing against homogeneity in an industry if the industry is functioning properly. But it seems to me that in the NRSRO business, it would be beneficial to have some heterogeneity. Why not have a mixture of non-profits, profitable companies, and government departments issuing bond ratings?

Very few people actually believe that the rating agencies have much predictive power, so by themselves their ratings wouldn’t have much impact on investor behaviour. What makes the ratings produced by these agencies so damn important are US laws that require financial institutions to take the bond ratings produced by these agencies into account.

Here is an analogy. Suppose there was a notoriously unreliable weather forecaster who worked for a particular TV station. In the normal course of events, nobody would trust his forecasts. They make decisions about travel plans, clothing choices, bringing umbrellas, etc based on the weather forecasts on competing TV stations or some other method. But if the government passed a law saying that only the predictions of this one forecaster could be used to make decisions about, say, when it was unsafe for a scheduled flight to go ahead,  then this forecaster would have a captive market in the country’s airport and airlines. Moreover, if the weather forecaster had a financial stake in say, a particular airport, he or she might be inclined to say “Yeah, it’s ok to fly today” than would otherwise be the case. At the very least, there would be an obvious conflict of interest, since an airport loses money every day it is closed.

Image of a weather forecaster randomly selected from the Wikimedia Commons

At this point in the crisis, it would be worthwhile for all players and commentators to pay more attention to the history of the rating agencies and to financial history more generally. We should also think long and hard about why the ratings issued by these NRSROs matter so much.

Further Reading

Flandreau, Marc, N. Gaillard and F. Packer, (2009), “Ratings Performance, Regulation and the Great Depression: Lessons from Foreign Government Securities”, CEPR Discussion Paper 7328.

Goodhart, Charles A.E. (2008), “The Financial Economists Roundtable’s statement on reforming the role of SROs in the securitisation process”,, 5 December 2008.

Partnoy, Frank (2001), “The Paradox of Credit Ratings”, UCSD Law and Economics Working Paper.

Partnoy, Frank (2006), “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers”, in Yasuyuki Fuchita, and Robert E. Litan (eds.), Financial Gatekeepers: Can They Protect Investors?, Brookings Institution Press and the Nomura Institute of Capital Markets Research.

Portes, Richard (2008), “Ratings agency reform”,, 22 January 2008.

Should We Care What Debt Rating Agencies Say About National Governments?

11 05 2010

The financial turmoil in Greece has focused attention on bond markets and credit rating agencies. The yields on Greek government bonds have shot up, meaning that it costs the Greek government to borrow money because investors think that a default is fairly likely.

The election of a minority parliament in Britain has created fears that that the agencies that rate the creditworthiness of sovereign debtors could downgrade UK bonds from the current AAA status. The Guardian’s Katie Allen reports: “The prospects of a weak coalition government has rattled UK markets, sparking growing fears that a downgrade to Britain’s coveted top-notch credit rating could follow.”

There have been repeated references to bond-rating agencies in the discussion of the various proposed coalitions in Britain. There was relief when one of the bond-rating agencies announced that the hung parliament would not affect the UK’s credit rating. “The fate of the UK’s gold-plated sovereign debt rating will not be decided until the end of 2010 despite a hung Parliament, Standard & Poor’s said.”  See also here.

Political commentators are quite right to pay attention to the reaction of the bond markets to political events. In the last few centuries, capital markets have proven to be a sensitive register of political and even military events.  For instance, during the American Civil War and the Second World War, the prices of the combatant governments’ bond fluctuated as news from the battlefield arrived. Financial markets can be spectacularly wrong when it comes to predicting the future (as the Sub-Prime Mortgage Crisis suggests), but overall they are useful tools. Capital markets exploit what James Surowiecki calls “the wisdom of crowds” because they aggregate the intelligence of large numbers of people. They also rely on the self-interest of investors: because people are putting money on the line, they are more likely to put aside sentiment (what they want to happen) and focus on what will happen.

The price of Confederate government bonds reflected events on the battlefield during the American Civil War. Image Courtesy Vanderbilt University Library.

However, I’m not certain that we should pay any attention at all to the bond-rating agencies, as they have had a spectacularly bad track record of predicting defaults by sovereign and other major borrowers. Just a few weeks ago, executives from a credit rating agency testified before Congress about their role in the sub-prime mortgage crisis. The rating agency is accused of having given unjustifiably high ratings to the mortgage-backed securities that were at the heart of the sub-prime mortgage crisis.  Gullible investors saw the ratings and then purchased the securities. When the dead-beat homeowners who were the other end of this complex financial chain defaulted on their mortgages, people came to realise that the securities were not nearly as safe as had been made out. Just today there was word that Moody’s, one of the bond-rating agencies, is being investigated by the SEC.

Much of the criticism of credit-rating agencies in recent months has revolved around the conflict of interest inherent in the agencies current business model, whereby borrowers rather than lenders pay the agency to issue ratings.  To my mind, this is only one of the problems with ascribing too much credibility to the statements that come out of bond rating agencies. Here are some other big problems with having credit rating agencies assign ratings to the debts of governments in large industrialized countries.

1)      Decisions are credit-rating agencies are made by relatively small teams of people, so you don’t have the benefit of the “wisdom of crowds” effect.

2)      There are currently few penalties for making a rating that turns out to be inaccurate. A bad rating agency is unlikely to lose business since the business of rating sovereign debt is very oligopolistic, meaning it is dominated by only a handful of firms. There is little competition, which means that a rating agency can deliver inaccurate ratings without fear of losing business to other firms. Moreover, the legal penalties for making an inaccurate prediction are unclear. It is true that the California state employees’ pension fund and other investors who lost money in the sub-prime mortgage meltdown are trying to sue the relevant credit rating agency, but it is unclear whether this lawsuit will be successful. The rating agency can always deflect charges that its rating was dishonestly high by pleading that they made the rating in good faith and that no human being is infallible.

3)      The agencies that rate sovereign debt are supposed to compete with each other, but it appears that they cooperate in rating countries.  Martin Weiss, the head of one such agency,  recently published an open letter calling on Standard and Poor’s, Moody’s, and Fitch to downgrade U.S. government debt. See here.

4)      Can political bias influence a rating agency’s statement? I wouldn’t want to question the professional credibility of Martin D. Weiss or anyone else as a rater of bonds, but it would be interesting to know if he is a registered Republican, a registered Democrat, or an Independent.  Being based in the academic world, I am very familiar with the phenomenon of professors who tailor their lectures and research to suit a political agenda. With historians, this is particularly likely when it comes to people dealing with recent periods of history and the histories of their own countries.  Academics can allow ideology to bias their judgement because there are few penalties for doing so.  The uncompetitive nature of the rating-agencies game and the fact there are few clear legal penalties may give a similar sense of licence to the handful of individuals who rate sovereign debtors. The fact that Weiss is an American means that his comments about the US government are likely to be coloured by his personal background. Perhaps ratings of sovereign creditworthiness should only be made by non-citizens of the country in question. Swiss experts should rate the US, and US experts should rate the Swiss government’s chances of defaulting. I must also say that Americans seem to get more emotional about their politics than the Swiss– this needs to be taken into account in thinking about how Americans speak about their own country’s chances of defaulting.

5)      Sovereign bond rating agencies haven’t been around for that long. According to Timothy J. Sinclair, the author of an excellent book on bond-rating agencies, rating agencies only really began rating government debt in the 1970s and 1980s. The fact that sovereign bond ratings were not around before the great defaults of the early 20th century makes it hard to tell whether ratings of sovereign debt are any good.

6)      The social, political, and monetary consequences of a default on government debt by a major industrialized country would be so massive as to destroy the legal and economic foundations of the bond-rating agency. To put things in human terms, I’m not certain what life would be like for a bond-rating agency employee in New York or London in the event of the collapse of the US government’s ability to pay interest on its debt.  Would the legal system still be in operation? Would paper money be worth much? Or would firearms and tinned food be more valuable in the new environment? How would the bond-rater be able to get off Manhattan Island?

This means that the ratings (i.e., predictions) issued by the agency aren’t worth that much. It’s like asking a bookmaker to tell you the odds of a nuclear war that destroys all live on earth. He is free to promise to pay you pretty much any sum of money he can think of in the event of such a war, because you won’t be around to collect it. Rating agencies may do an adequate job of predicting the chances of default on the part of a particular homeowner with a mortgage, company’s bonds, or even a small country like Greece.  I’m not certain rating agencies are equipped to predict the probability of truly catastrophic events of the sort that might wipe out the agency. Similarly, prediction markets can’t predict events that would wipe out the prediction market itself. This is the major problems I have with the prediction-market concept advanced by Robin Hanson. Prediction markets can’t deal with the once-in-a-lifetime Black Swan events.

I have one other point—Timothy Sinclair should complete the promising-looking website on ratings agencies he has started.