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New Political Economy, Vol. 8, No. 1, 2003

GLOBAL MONITOR Bond Rating Agencies

TIMOTHY J. SINCLAIR

Emerging from relative obscurity in the 1990s, the major bond rating agencies, Moody’s Investors Service and Standard & Poor’s (S&P), have recently acquired a global reach from their US home base. Their views on the creditworthiness of corporations, municipalities and sovereign governments have become much more significant as capital markets have grown more important as sources of financing relative to traditional bank loans. This new international role for the bond rating agencies builds upon a century of prior experience of rating and information provision in the United States.
The long gestation undertaken by the rating industry is usually ignored by analysts, but it is central to understanding the resources the rating agencies bring to their work, and why they are able to shield themselves from some of the rating ‘failures’ that took place in the 1990s. What the agencies actually sell is a feeling of confidence in the future, and how that feeling is created, managed (and challenged) are key moments in understanding the rating system. Rating agencies vary by reputation, the more eminent firms being more successful at inducing confidence.1
I begin this report by briefly outlining the origins and current standing of the
US agencies. The rating process and outputs are the focus of the second part, as these activities are key to understanding what makes rating work. In the third element of this report, I examine the controversy over the downgrading of Japanese sovereign bonds. In the subsequent section, I discuss the Enron bankruptcy, a key recent rating ‘failure’ that risks degrading or destroying the reputation of the global rating agencies. The report concludes with some speculation about future developments.

Bond rating—origins and development

What do we know about the rating agencies?2 Rating agencies should be thought of as one institutional product of a process of development of market surveillance mechanisms that took place after the Civil War in the USA. From this time until the First World War, American financial markets experienced an explosion

Timothy J. Sinclair, Department of Politics and International Studies, University of Warwick, Coventry CV4 7AL, UK.

ISSN 1356-3467 print; ISSN 1469-9923 online/03/010147-15  2003 Taylor & Francis Ltd DOI: 10.1080/1356346032000078769

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of information provision. Poor’s American Railroad Journal appeared in the mid 1850s.3 This was followed by Henry V. Poor’s History of the Railroads and

Canals of the United States of America in 1860.4 In 1868 Poor’s produced the first Manual of the Railroads of the United States. By the early 1880s this

publication had 5000 subscribers.5
The transition between issuing compendiums of information and actually making judgements about the creditworthiness of debtors occurred after the 1907 financial crisis and before the 1912 Pujo congressional hearings into bankers’ power. By the mid 1920s nearly 100 per cent of the US bond market was rated by Moody’s.6 The 1907 crisis was so bad that it forced John Moody to sell John Moody & Company, his manual business. He returned with a business assessing creditworthiness in 1909, based on the mercantile credit rating of retail businesses and wholesalers like R. G. Dun and Company.7
The growth of the bond rating industry subsequently occurred in a number of distinct phases. Up to the 1930s, and the separation of the banking and the securities businesses in the USA with passage of the Glass–Steagall Act of 1933, bond rating was a fledgling activity. Rating entered a period of rapid growth and consolidation with this separation and institutionalisation of the securities business after 1933, and rating became a standard requirement to sell any issue in the USA after many state governments incorporated rating standards into their prudential rules for investment by pension funds. A series of defaults by major sovereign borrowers, including Germany, made the bond business largely a US one from the 1930s to the 1980s, dominated by American blue chip industrial firms and municipalities.8 The third period of rating development began in the 1980s, as a market in junk or low-rated bonds developed. This market—a feature of the newly released energies of financial speculation—saw many new entrants participate in the capital markets.
The contemporary rating system has a number of central features. Internationalisation is the first and most obvious. Cheaper, more efficient capital markets now challenge the role of banks in Europe and Asia. Ratings became a standard feature of Eurobond offers by the mid 1990s. The New York-based rating agencies have grown rapidly to meet demand from these newly disintermediating capital markets. Second, rapid innovation in financial instruments is a major feature. Derivatives and structured financings, amongst other things, place a lot of stress on the existing analytical systems and outputs of the agencies, which are developing new rating scales and expertise in order to respond to these changes. The demand for timely information is greater than ever. Resources reflect this. Compared to the hundreds of staff today, in the mid 1960s S&P had only ‘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’.9 Third, competition in the rating industry has started to develop, for the first time since the inception of the industry. The basis for competition lies in niche specialisation and in better service to issuers by second-tier rating firms. The global rating agencies, especially Moody’s, have been characterised as highhanded in surveys of both issuers and investors.10 While this has not yet produced significant change in the institutionalisation of markets subsequent to the Asian financial crises of 1997–8, Moody’s corporate culture became much

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less secretive during the late 1990s.11 The Enron bankruptcy of 2002 accelerated this switch at Moody’s, prompting this previously guarded institution to ‘invite comment’ from market stakeholders on proposed improvements in the rating process.12
The two major American agencies easily dominate the market in ratings.
Both Moody’s and S&P are headquartered in the lower Manhattan financial district of New York City. Moody’s was sold in 1998 as a separate corporation by Dun and Bradstreet, the information concern, which had owned Moody’s since 1962, while S&P remains a subsidiary of publishers McGraw-Hill, which bought S&P in 1966.13 Both agencies have numerous branches in the USA, in other developed countries and in several emerging markets. S&P is famous for the S&P 500, the benchmark US stock index listing around US$1 trillion in assets.14 Moody’s KMV Inc., a company created by Moody’s in 2002, based on a merger of Moody’s Risk Management Services (MRMS) and the quantitative risk management firm, KMV Inc., creates and sells credit risk software and related products to financial institutions.15 Unlike Moody’s, S&P also offers recommendations on stocks. A distant third in the market is the Frenchowned Fitch Ratings. It has forty branch, subsidiary and affiliate offices worldwide.16 A number of domestically-focused agencies exist in OECD countries (including Japan from 1985 and Germany from the late 1990s) and in emerging markets since the mid 1990s, including China, India, Malaysia, Indonesia, Thailand, Israel, Brazil, Mexico, Argentina, South Africa and the Czech Republic.17
In the late 1960s and early 1970s raters began to charge fees to bond issuers to pay for ratings. A number of scholars have suggested that charging fees to bond issuers constitutes a conflict of interest.18 This may indeed be the case with the smaller, lower-profile firms eager for business. However, 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 US$602 million in 2000.19 Revenue figures for S&P are not broken out from McGrawHill data, but are likely to be similar. Moreover, inflated ratings would diminish the reputation of the major agencies, and reputation is the very basis of their franchise.

The rating process

How do the raters do what they do? I examine the information inputs to the process, which are both quantitative and qualitative, and discuss the analytical determination and the output of the process. For this discussion, I will treat the rating universe in an undifferentiated manner. In other words, I do not discuss the differences between the rating of, say, municipalities and corporations. Although there are substantial differences in the data inputs into these different processes, the core judgment processes are sufficiently similar to make this approach valid.

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Information inputs

For first-time issuers, typically there is a meeting with rating officials to familiarise them with the information requirements of the agencies.20 However, S&P and Moody’s organise seminars with the same intent.21 Hawkins, Brown and Campbell note that the rating process incorporates information on: (a) quantitative data provided by the issuer on its financial position; (b) quantitative data gathered by the agency on the industry, competitors and economy; (c) legal advice relating to the specific issue; (d) qualitative data provided by the issuer on management, policy, business outlook, accounting practices and so forth; and (e) qualitative data gathered by the agency on competitive position, quality of management, long-term industry prospects and economic environment, amongst other things.22
The rating agencies are most interested in data on cash flow relative to debt service obligations.23 They want to know how liquid the company is, and whether there will be timing problems likely to hinder repayment. Fluctuations in the flow of cash into the entity will thus be important, as will the timing of major obligations.24 Other information may include five-year financial projections, including income statements and balance sheets, analysis of capital spending plans, financing alternatives and contingency plans.25 This information, which may not be publicly known, is supplemented by agency research into the value of current outstanding obligations, stock valuation and other publicly available data which allow for an inference of the corporation’s quantitative basis for future repayment of debt obligations. As became evident with Enron, none of the rating agencies, however, conduct independent audits themselves.26
Issuers also provide qualitative information on their policy choices and strategic plans, including: (a) background on the company or other entity; (b) outline of corporate strategy or philosophy; (c) operating position, including competitive position, manufacturing capacity, distribution and marketing network; (d) financial management and accounting policies—in the case of a non-US issuer, their accounting standards and whether they use GAAP (Generally Accepted Accounting Principles); and (e) topics of concern: risk of government regulation, major investment plans, litigation, and so forth.27

Analytical determination

How is the analysis undertaken? The agencies assemble analytical teams to undertake research, meet with issuers and prepare a report containing a rating recommendation and rationale. This team present their views to a rating committee of senior agency officials which make 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 bond rating business is the analytical process that bond rating firms conduct to arrive at their judgments.28 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 less revealing about criteria used to arrive at its ratings than its major rival. Moody’s gradually abandoned this

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Bond Rating Agencies position during the 1990s. Moody’s Rating Methodology Handbook, issued in

February 2000, contains financial ratio appendices.29 S&P publishes a great number of criteria books that contain guidelines on appropriate financial ratios for different types of credits. 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.

S&P’s Corporate Finance Criteria contains a section that links ratios with

specific ratings. For example, a utility company distributing gas that is seeking a ‘AA’ rating will need to ensure that ‘funds flow interest coverage’, that is, the number of times cash flow into the business covers interest payments out equals 4.25 or better. For a ‘BBB’ rating, the company will need to ensure coverage is in the range 2.25–3.5. To issue junk bonds in the upper ranges, anything under 2.5 is considered adequate by S&P.30

Rating outputs

At the end of the rating committee meeting a rating is typically agreed. There now exist a variety of rating scales for different financial instruments. The debt ratings on bonds are the most commonly recognised, but S&P also has established scales for commercial paper, preferred stock, certificates of deposit, money market funds, mutual bond funds and insurance company claims-paying ability. The bond rating scales used by S&P and Moody’s are given in Table 1, along with brief definitions from S&P.
Standard & Poor’s regularly produces 44 different serial products in hard copy, CD-ROM, real time on-line news, and fax. The outputs of the rating agencies are consumed by key capital market actors, including pension funds, investment banks, other financial institutions and government agencies. Moody’s had 4000 clients for their publications and estimate around 30,000 people read their output regularly in 2000.31 Annual subscription fees range from US$15,000 to US$65,000 for heavier users, who also have the opportunity to talk to analysts directly. Increasingly, outputs are produced on-line. Standard & Poor’s produce a wider range of products in both traditional and digital format. Their core weekly publication, CreditWeek, had 2423 subscribers in 2000. S&P’s Global Sector Review was bought by 2988 clients.32

Judging Japan’s creditworthiness

Unlike other rich OECD states whose creditworthiness improved during the late 1990s, Japan’s deteriorated sharply as repeated efforts to lift the country out of its decade-long economic malaise met with failure. Moody’s first signalled it was considering downgrading Japan in April 1998.33 In July of that year Moody’s commented on the governance issues in Japan that frustrate dealing with structural problems, observing that ‘an apparent lack of consensus among policy makers on a medium-term strategy’ exists.34 This warning on Japan’s governance structures led to a three-day yen depreciation on the currency exchanges.35 Moody’s followed through with a downgrade in November 1998, its first downgrade of a Group of 7 (G7) country since Canada’s in 1995.36 This event,

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the loss of Japan’s AAA from Moody’s, led reportedly to a ‘strong feeling of displeasure’ from Finance Minister Miyazawa Kiichi.37 Some commentators accused Moody’s of being biased against Japan, others suggested the rating of Japan was unsolicited and therefore ‘may be considered a kind of intimidation’. Some Japanese parliamentarians reportedly wanted to summon the chief executive officers of the US rating agencies to the Diet. More sober comment from the government-financed Japan Center for International Finance cited Japan’s large foreign reserves, trade surplus and savings rate, and suggested that only the

  • narrow capacity to service debt should be considered in making a rating.38
  • A

Japanese scholar, Kurosawa Yoshitaka of Nihon University in Tokyo, added that the US agencies do credit ratings ‘on the basis of their home standards’.39 Sakamoto Sakae observed further that, for the Japanese, the value of ratings is hard to understand, used as they are to trusting legal authority. He noted that the Japanese media—like some US Congressmen—initially described the rating firms as public-sector agencies.40
The impact of the downgrade was evident in 2000 when the Japanese government started seeking finance from banks and not the capital markets, as had been the usual procedure during the postwar era. Jesper Koll, chief economist at Merrill Lynch Japan, observed that a recourse to banks meant ‘one of two things: either you don’t believe in the efficiency of the financial markets or you’re admitting you have a credit problem’.41 Stephanie Strom writing in the New York Times suggested the government wanted to avoid ‘drawing additional scrutiny from Moody’s and S&P’.
The Japanese government did not avoid agency scrutiny. S&P began to signal in early 2000 that governance failure—allowing the pace of structural reform to decline—risked generating a downgrade from it as well.42 Moody’s downgraded Japan for the second time in September 2000.43 S&P finally lowered its rating on Japan to AA ϩ in February 2001, in what was seen as a ‘clear criticism’ of Japanese politicians and their ability to tackle reform.44 Financial Services Minister Hakuo Yangisawa, reacting, ‘dismissed the downgrade, saying the move was nothing but interference’ and ‘unnecessary meddling’.45 S&P cited diminished fiscal flexibility, debt levels and the ‘protracted approach’ of the government to reform, which amounts to the ‘political reluctance to address rigidities in the economy’.46 S&P said the government must embrace structural reform more aggressively. Moody’s began to contemplate a third downgrading in late 2001.47 S&P also downgraded again on 28 November 2001. Demonstrating a more receptive attitude, Prime Minister Koizumi’s finance minister, Masajuro Shiokawa, observed: ‘We will have to work to regain trust in government bonds’.48 Moody’s downgraded yen-denominated debt again soon after to Aa3, and suggested further rating cuts might occur.49 Moody’s announcement that it was considering lowering Japan’s rating again in February 2002 led to Moody’s being accused of making a ‘serious government debt problem worse’ by Japan’s Council on Economic and Fiscal Policy (a government committee).50 The Financial Times observed that a downgrade from Moody’s would put Japan below the rating of Botswana, the African state ‘where a third of the population is infected with HIV/Aids’.51 Such bonds would carry a 20 per cent risk weighting under the revised Basle capital adequacy rules.52 Accounting

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rules, which now force Japanese banks to ‘mark to market’, would magnify the domestic impact of a sell-off of Japanese government bonds.53
Japan’s local-currency national debt was downgraded two notches by
Moody’s on 31 May 2002.54 In the weeks leading up to this event, a veritable war of words was launched by senior Japanese government officials, adamant that Japan’s current account surplus, foreign exchange reserves and international creditor status made comparisons with developing countries implausible.55 The Japanese government ‘began jawboning’ the agencies and then, on 26 April, a letter from Vice Finance Minister Haruhiko Kuroda explicitly criticised the agencies.56 The letter attacked the qualitative explanation of Japan’s ratings, noting the absence of ‘objective criteria’.57 The low confidence in Japanese finances was subsequently reflected in the unprecedented failure of the Japanese government to sell all 1.8 trillion yen worth of 10-year government bonds issued in late September 2002.58
What does the work of the rating agencies mean for democracy? One interpretation is that because in countries like Japan (or Canada and Sweden) there are so many beneficiaries of state intervention, ‘democracy no longer works in the public interest’ and a bond rating downgrade ‘holds the feet of recalcitrant politicians to the fire’.59 New York Times columnist, Thomas Friedman, has similarly suggested that Moody’s and S&P are ‘imposing on democracies economic and political decisions that the democracies, left to their own devices, simply cannot take’.60 States may not be victims of rating downgrades in all circumstances. Sometimes downgrades may help them temper demands from their citizens.

Rating Enron

Enron and the other corporate financial scandals are a product of the basic incentives underpinning modern US (and increasingly global) capitalism.61 Just a few years ago the Texas-based energy-trading corporation, which declared bankruptcy on 2 December 2001, was the USA’s seventh-largest company.62 At the start of 2001 Enron’s market capitalisation had been US$62.5 billion.63 The ‘one big issue’ raised by Enron’s demise, according to The Economist, was the role played by auditors, who missed the exotic financial strategies pursued by the firm.64 The question of who regulates accounting, conflict of interest problems when auditors are also consultants, and the rigour of the GAAP standards, are all now up for debate and action.65 The big victim of the public panic about Enron has been its auditor, Arthur Andersen.66 What is interesting about the attack on Andersen is that it demonstrates that a high repute institution, whose only real asset is its reputation, can see that asset go up in a puff of smoke if circumstances are right. Enron was not the first time in recent years that Andersen had made significant errors. It survived these other problems. It is Enron that destroyed the company.67
Enron was also a major crisis for the rating agencies. They had got emerging markets ‘wrong’ with the Asia crisis, where they were accused of not signalling early enough the problems in Asia, and then of making things worse by downgrading excessively.68 Now they had got it ‘wrong’ in the USA itself by

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    S. HRG. 107–1140 EXAMINING ENRON: THE CONSUMER IMPACT OF ENRON’S INFLUENCE ON STATE PENSION FUNDS HEARING BEFORE THE SUBCOMMITTEE ON CONSUMER AFFAIRS, FOREIGN COMMERCE AND TOURISM OF THE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION UNITED STATES SENATE ONE HUNDRED SEVENTH CONGRESS SECOND SESSION MAY 16, 2002 Printed for the use of the Committee on Commerce, Science, and Transportation ( U.S. GOVERNMENT PRINTING OFFICE 94–690 PDF WASHINGTON : 2005 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001 VerDate 0ct 09 2002 11:42 Sep 27, 2005 Jkt 094690 PO 00000 Frm 00001 Fmt 5011 Sfmt 5011 S:\WPSHR\GPO\DOCS\94690.TXT JACK PsN: JACKF SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION ONE HUNDRED SEVENTH CONGRESS SECOND SESSION ERNEST F. HOLLINGS, South Carolina, Chairman DANIEL K. INOUYE, Hawaii JOHN MCCAIN, Arizona JOHN D. ROCKEFELLER IV, West Virginia TED STEVENS, Alaska JOHN F. KERRY, Massachusetts CONRAD BURNS, Montana JOHN B. BREAUX, Louisiana TRENT LOTT, Mississippi BYRON L. DORGAN, North Dakota KAY BAILEY HUTCHISON, Texas RON WYDEN, Oregon OLYMPIA J. SNOWE, Maine MAX CLELAND, Georgia SAM BROWNBACK, Kansas BARBARA BOXER, California GORDON SMITH, Oregon JOHN EDWARDS, North Carolina PETER G. FITZGERALD, Illinois JEAN CARNAHAN, Missouri JOHN ENSIGN, Nevada BILL NELSON, Florida GEORGE ALLEN, Virginia KEVIN D. KAYES, Democratic Staff Director MOSES BOYD, Democratic Chief Counsel JEANNE BUMPUS, Republican Staff Director and General Counsel SUBCOMMITTEE ON CONSUMER AFFAIRS, FOREIGN COMMERCE AND TOURISM BYRON L.
  • NEA Newsletter October 06

    NEA Newsletter October 06

    NEA NE WSLETTER Volume 33, Number 4 • October 2006 C O VER–– E & B Markets, 1973?, plastic shopping bag. I NSIDE–– Processing and Providing Access to Boston's Based on The Big Push (for CBS), 1957. Courtesy of Stephen African American and Latino History (Archival Insight, page Lee Taller Ben Shahn Archive, Fine Arts Library, Harvard 4); Community and Communication--The Story of the University (Around and About, page 20). Archives for Women in Medicine (Open Forum, page 12); The Stephen Lee Taller Ben Shahn Archive at Harvard University (Around and About, page 20). ❦ ❦ N EW E NGLAND A RCHIVISTS 2 NEA NE WSLETTER Volume 33, Number 4 • October 2006 Table of Contents WPI Archives and Special Collections Gordon Library 100 Institute Road • Worcester, MA 01609 <www.newenglandarchivists.org> From the Editors ....................................................... 3 NEA Executive Board President: Nora Murphy Archival Insight ......................................................... 4 President-Elect: Chris Burns Past President: Paul Carnahan Processing and Providing Access to Boston’s Secretary: Elizabeth Slomba Treasurer: Lois Hamill African American and Latino History ................ 4 Representatives-at-Large: Tom Hyry Brenda Lawson Internet Tidbits .......................................................... 6 Karen Adler Abramson Mark Savolis Clerk: Jean Nielsen Berry Inside NEA ................................................................ 7 PR Coordinators: Tracy Messer Tara Hurt From the President ...............................................
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    American University National Security Law Brief Volume 11 Issue 2 Article 2 2021 The Capitol Riot, Racism and the Future of American Democracy Ryan T. Williams Follow this and additional works at: https://digitalcommons.wcl.american.edu/nslb Part of the National Security Law Commons Recommended Citation Ryan T. Williams "The Capitol Riot, Racism and the Future of American Democracy," American University National Security Law Brief, Vol. 11, No. 2 (2021). Available at: https://digitalcommons.wcl.american.edu/nslb/vol11/iss2/2 This Article is brought to you for free and open access by the Washington College of Law Journals & Law Reviews at Digital Commons @ American University Washington College of Law. It has been accepted for inclusion in American University National Security Law Brief by an authorized editor of Digital Commons @ American University Washington College of Law. For more information, please contact [email protected]. The Capitol Riot, Racism and the Future of American Democracy Ryan T. Williams* ABSTRACT The Capitol Riot in Washington D.C. was a coup attempt intending to upend American democracy. Although the attempted coup was ultimately unsuccessful, it remains a matter of ongoing concern. The socioeconomic and political factors that lead to the coup, namely the ever-broadening gap between the rich and poor in America, along racial lines, massive unemployment leftover from a worldwide pandemic, and social unrest and discord, still exist. History has shown when these factors are present—democracies fail. This Article examines the current, precarious state of American democracy, starting with unsettling comparisons to 1930’s Germany and concluding with an examination of famed historian Juan Linz’s Litmus test for a healthy democracy.
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    March 2019 Members in the News Interface Media Group, Dinners Across Region, Tatiana Breslin, Penny Lee, Lisa Mao, Cheryle Franceschi, Jacquie Greff, Mya Montgomery, Tracy Baumgardner, Bonnie Erbe, Bridget Bell McMahon, Michael D. Nephew, DC Arts Advocates, Brainwave Inc., Flora Nicholas, OAS Federal Credit Union, Call for Articles IMG Sizzle - Scooter Safety Networking Dinners - March 22 IMG Animation rocked an entertaining, merit-based PSA Register here regarding Scooter Safety. The American College of In 1979 nearly a dozen women Emergency Physicians and August, Lang & Husak teamed hungry for change gathered at with IMG to create a lasting impactful message. Featured at Ginny Durrin's house for the the February Animators Roundtable, click the image below to first, informal meetings of what see what they saw. would become Women in Film & Video DC. The WIFV Advisory Committee and Board look forward to welcoming you to dinners across the region on March 22, 2019 as we celebrate those first gatherings, the community that exists to this day, Women's History Month, and the upcoming 40th WIFV Anniversary! Dinners will be hosted at four homes on March 22 with the following hosts: Robin Noonan-Price (Alexandria, VA), Catherine Wyler (NW,DC), Rebecca Bustamante (Herndon, VA), and Melissa Houghton (NE, DC). You may list your preference of neighborhood when you register, but Breslin's Stowe Story Labs Blog we do not guarantee any locations. by Tatiana R. Breslin (Zaharchenko) Please note that registration will close on Monday, March The Least We Can Do: Reflections 18th at 5 pm. After registration closes we will reach out to about A PRIVATE WAR, a feature film you with your host's address.
  • Collapse of the Enron Corporation

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