The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies
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Washington University Law Quarterly VOLUME 77 NUMBER 3 1999 ARTICLES THE SISKEL AND EBERT OF FINANCIAL MARKETS?: TWO THUMBS DOWN FOR THE CREDIT RATING AGENCIES FRANK PARTNOY* I. INTRODUCTION .......................................................................................... 620 II. A “REPUTATIONAL CAPITAL” VIEW OF CREDIT RATINGS ....................... 627 A. Reputational Capital .................................................................... 628 B. Development of Credit Ratings .................................................... 636 C. The Modern Credit Rating Agency............................................... 649 III. PROBLEMS WITH THE REPUTATIONAL CAPITAL VIEW ............................ 655 A. Credit Spread Estimation............................................................. 656 B. Ratings-Driven Transactions ....................................................... 665 1. Asset-Backed Securities........................................................ 666 2. Derivative Product Companies ............................................ 670 3. Financial Guarantees........................................................... 672 4. Arbitrage Vehicles................................................................ 674 5. Other Problems and Corrections ......................................... 676 C. Credit Derivatives ........................................................................ 677 * Associate Professor, University of San Diego School of Law. J.D., 1992, Yale Law School. I am grateful for comments on an earlier draft of this article by participants in a conference on Reexamining the Regulation of Capital Markets for Debt Securities, sponsored by the Duke University Global Capital Markets Center and The Bond Market Foundation, and held in Washington, D.C., on Oct. 18-19, 1999, and at a faculty colloquium held at the University of San Diego on Jan. 15, 1999. In particular, I want to thank Jim Cox, Lynne Dallas, Howard Schneider, Steven Schwarcz, Stephen Wallenstein, and Chris Wonnell. 619 Washington University Open Scholarship p619 Partnoy.doc 02/01/00 5:36 PM 620 WASHINGTON UNIVERSITY LAW QUARTERLY [VOL. 77:619 1. Credit Swaps ........................................................................ 678 2. Credit Options...................................................................... 680 3. Credit Notes ......................................................................... 681 IV. A “REGULATORY LICENSE” VIEW OF CREDIT RATINGS ........................ 683 A. Regulatory Licenses ..................................................................... 683 B. 1930s Regulation.......................................................................... 688 C. Post-1973 Regulation: The Creation of NRSROs ........................ 692 V. RECOMMENDATIONS................................................................................ 706 A. Substituting Credit Spreads for Credit Ratings............................ 706 B. Market Risk Ratings ..................................................................... 709 C. Recent Litigation .......................................................................... 711 VI. CONCLUSION........................................................................................... 713 “There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.”1 “The most that we can safely assert about the evolutionary process underlying market equilibrium is that harmful heuristics, like harmful mutations in nature, will die out.”2 I. INTRODUCTION Is a AAA3 rating of an institution’s bonds any different from a five-star Morningstar4 rating of a mutual fund, or a four-diamond American Automobile 1. The News Hour with Jim Lehrer: Interview with Thomas L. Friedman (PBS television broadcast, Feb. 13, 1996) (transcript on file with author). 2. Merton H. Miller, Debt and Taxes, 32 J. FIN. 261, 273 (1977). 3. A credit rating of “AAA” generally is regarded as the highest quality rating; a credit rating of “D” (signifying default) is the lowest. The various rating systems are described in detail infra at Part II.C. Credit rating agencies provide ratings for credit instruments, typically bonds, although they also rate more complex investments, including derivatives, whose value is based on or derived from some other underlying financial instrument or index. See discussion infra at Part III.B. 4. Morningstar Inc., the Chicago-based publisher of mutual fund information, has a “star” rating system of from one to five stars. Mutual fund managers and analysts whose funds earn the coveted “Five Star” ratings from Morningstar earn the highest, seven-figure salaries. See Charles Gasparino, Mutual Funds Show Managers The Money, Seeking Big Returns, WALL ST. J., March 7, 1997, at C1. There are only about 100 Five Star managers out of approximately 8,000 U.S. mutual funds. To gain a Five Star https://openscholarship.wustl.edu/law_lawreview/vol77/iss3/1 p619 Partnoy.doc 02/01/00 5:36 PM 1999] TWO THUMBS DOWN FOR THE CREDIT RATING AGENCIES 621 Association rating of a hotel, or a three-star Michelin rating of a restaurant, or a “two-thumbs-up” Siskel and Ebert rating of a film, or a single UL5 symbol on a blender? 6 And if bond ratings differ from ratings of mutual funds, hotels, restaurants, films, and appliances, to what extent have legal rules caused those differences? To what extent should legal rules operate to minimize differences? This article addresses these questions. Credit ratings pose an interesting paradox. On one hand, credit ratings purport to provide investors with valuable information they need to make informed decisions about purchasing or selling bonds;7 credit rating agencies seem to have impressive reputations and most bond issues are rated by multiple agencies. On the other hand, particularly since the mid-1970s, the informational value of credit ratings has plummeted;8 credit rating agencies, faced with the challenges of globalized, technologically innovative markets and with competition from providers of more current, detailed, and accurate information, have become reactive rather than proactive, and some evidence indicates they have maintained accurate credit ratings (i.e., ratings correlated with actual default experience) due more to after-the-fact corrections than to predictive power.9 rating, a fund must place within the top 10 percent of its peer group for at least three years, based on its performance and a measure of its risk versus return. See id. at C23. Some top mutual fund managers have been compared to professional sports stars. See id. 5. I analyze the Underwriters Laboratories (UL) rating system infra at 685-86. 6. Institutions, not individuals, provide most ratings, presumably because institutions are better able to capture economies of scale in gathering and providing information. Nevertheless, a few individuals have thrived as raters, including the late Gene Siskel and Roger Ebert, the well-known film critics from Chicago; Robert Parker, the international wine connoisseur; and numerous celebrity endorsers. Although an individual, John Moody, invented and first issued credit ratings, and although some individual stock analysts acquire a kind of “brand equity” due to their prominent, public role in rating securities (e.g., Abby Joseph Cohen, a partner of Goldman, Sachs & Co.), the financial market—and this article—are centered on raters as institutions, not individuals. 7. Numerous studies conducted by both rating agencies and independent groups have demonstrated that credit ratings have a high correlation with actual default experience. See discussion infra at 647-48. 8. There have been multiple unexpected defaults and sudden credit downgrades in recent years, involving major issuers such as Orange County, Mercury Finance, and the governments and banks of numerous countries in Latin American and Southeast Asia. See discussion infra at 658-62. 9. Many recent credit downgrades occurred after the rated entity already had disclosed substantially increased risk. For example, the recent near-collapse of Long-Term Capital Management, the Greenwich, Connecticut, hedge fund that reported losses of $4 billion in September 1998, prodded Standard and Poor’s (“S&P”) and Moody’s to review the credit quality of all major U.S. and European banks, and to downgrade the senior debt of one of them, Bankers Trust. See CNN Moneyline News Hour with Lou Dobbs, at 10 (CNN Television Broadcast, Sept. 25, 1998) (available in LEXIS-NEXIS, Curnews database; transcript on file with author) (addressing credit issues related to Long-Term Capital Management); see also Frank Partnoy, Playing Roulette with the Global Economy, N.Y. TIMES, Sept. 30, 1998, at A17 (describing role of derivatives and hedge funds in the near-collapse of Long-Term Capital Management). Such evidence supports arguments by economists that rating agencies’ claims that Washington University Open Scholarship p619 Partnoy.doc 02/01/00 5:36 PM 622 WASHINGTON UNIVERSITY LAW QUARTERLY [VOL. 77:619 This paradox—continuing prosperity of credit rating agencies in the face of declining informational value of ratings—has generated extensive debate both in the popular press and among financial economists.10 Since John Moody introduced his clever and simple rating system for railroad bonds in 1909,11 credit