GLOBAL MONITOR Bond Rating Agencies

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

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 surveil- lance 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 147 DOI: 10.1080/1356346032000078769 Timothy J. Sinclair 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.Bythe 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. Internation- alisation 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 high- handed 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 148 Bond Rating Agencies 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 French- owned 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 McGraw- Hill 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. 149 Timothy J. Sinclair

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 projec- tions, 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 net- work; (d) financial management and accounting policies—in the case of a non-US issuer, their accounting standards and whether they use GAAP (Gener- ally 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 150 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, 151 Timothy J. Sinclair 1. Rating symbols and definitions obligation rated ‘D’ is in payment default. subordinated debt or preferred stock obligation rated ‘C’ is n ABLE CURRENTLY HIGHLY VULNERABLE to nonpayment. An obligation rated ‘CCC’ is currently vulnerable toeconomic non-payment, conditions. nonpayment. A An obligation rated ‘BB’ is less vulnerable touncertainties. non-payment than An obligation rated ‘B’ is more vulnerable tomeet non-payment its than financial commitment on the obligation. An obligation rated ‘BBB’ exhibits adequate protection circumstances are more likelythe to obligor lead to to meet a its weakened financial capacity commitment of on the obligation. An obligation rated ‘AA’ differs from the highest rated obligations An obligation rated ‘A’ is somewhat more susceptibleconditions to than the obligations in higher rated categories. T ϩ Ϫ ϩ Ϫ Ϫ ϩ Ϫ ϩ ϩ Ϫ ϩ Ϫ DA CCCCCC and is dependent upon favourable business, financial, and CC Ba2Ba3B2 BBB3 BB other speculative issues. However, it B faces major ongoing B obligations rated ‘BB’, but the obligor currently has the capacity to Baa2Baa3 BBB BBB parameters. However, adverse economic conditions or changing Aa2Aa3A2 AAA3 AA only in small degree. A A adverse effects of changes in circumstances and economic Speculative Ca CC An obligation rated ‘CC’ is currently highly vulnerable to Speculative B1Speculative Caa B CCC Speculative Ba1 BB Investment A1 A Investment Baa1 BBB GradeInvestmentInvestment Aaa Moody’s* Aa1 S&P† AAA AA An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. S&P Definitions‡

152 Bond Rating Agencies Federal Reserve Bank ). The ratings from “AA” to “CCC” may be modified by the addition of a plus Ϫ minus( r Vol. 19, No. 2 (1994), p. 3. )o , ϩ ‘Rating definitions’ at http://www.standardandandpoors.com and http://www.moodys.com. Accessed 13 June 2002. : mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.’ Quoted from ‘Issue Credit Rating Definitions’, at http://www.standardandpoors.com. Accessed 13 June 2002. According to Moody’s, ‘Moody’s applies numerical modifiers 1, 2, and 3 in each generic rating classification from AaAccording through to S&P, ‘Plus ( or minus sign to‡ show relative standing within the major rating categories’. Various Moody’s and S&P publications; Richardof Cantor and New Frank York Packer, ‘The Quarterly Credit* Rating Review Industry’, Caa. The modifier 1 indicatesa that the obligation ranks in† the higher end of its generic rating category; the modifier 2 indicates Source

153 Timothy J. Sinclair 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. Demonstrat- ing 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 announce- ment 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 154 Bond Rating Agencies 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 Fried- man, 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 155 Timothy J. Sinclair failing to warn investors of the Enron collapse. This was serious. No longer were the victims unknown citizens of foreign countries, but red-blooded US citizens, who had lost their pensions, jobs and futures. John Diaz, Managing Director at Moody’s, defended the company’s work in front of the Senate Committee hearing in March 2002. ‘Enron was an anomaly’, he said, ‘its responses to our specific requests for information were misleading and incomplete’. Moody’s rating process, he observed, ‘was undermined by the missing information’.69 Ronald M. Barone, the S&P analyst on Enron for several years, used harsher language. He suggested Enron had made ‘what we later learned were direct and deliberate misrepresentations to us relating to matters of great substance’.70 Former Securities and Exchange Commission (SEC) Chairman Arthur Lev- itt—who actually had shown little enthusiasm for codification of the rules about rating agencies during the 1990s—now called for ‘greater accountability’ of the agencies, the requirement for the agencies to ‘reveal more about how they operate’, an assessment of their ‘impact on the markets’, and ‘new authority’ for the SEC to ‘oversee’ their work.71 Much of the talk from the agencies focused on ‘speeding up’ the rating process in response to market calls for change.72 The SEC’s role in creating and maintaining the environment in which the agencies operate was noted by New York University Professor of Economics, Lawrence White, who suggested the SEC’s NRSRO designation was anti-competitive and had ‘lured these rating agencies into complacency’.73 The Nationally Recognized Statistical Rating Organization designation—NRSRO—was intro- duced in 1975 as a way of reducing the regulatory capital requirements for debt issuers with bond ratings. At the Senate committee hearings, Isaac C. Hunt, Jr, SEC Commissioner, defended the NRSRO designation as intended ‘largely to reflect the view of the marketplace as to credibility of the ratings [of an agency] rather than representing a “seal of approval” of a federal regulatory agency’.74 He noted the SEC proposal to codify NRSRO criteria had not yet been acted on by the Commission, that the Commission had not determined that the NRSRO designation was a ‘substantial barrier to entry’ into the rating business, and observed that ‘growth in the business of several credit rating agencies, not recognized as NRSROs suggests that there may be a growing appetite among market participants for advice about credit quality … and that this makes it possible for new entrants to develop a national following for their credit judgments’. Nevertheless, the Commission determined to examine the competitive impact of the NRSRO designation. If greater supervision of NRSROs is needed, ‘additional oversight’ could become a condition of NRSRO recognition of an agency. A law professor called to give testimony at the Senate Committee hearings attacked the NRSRO designation vigorously. Jonathan Macey argued that NRSROs, free of competitive forces as a result of their government designation, have incentives to ‘reduce costs as much as possible’. They know that regulation creates a steady demand whatever they do.75 Fees paid to the raters, he suggested, are better viewed as a form of tax, rather than a fee for service. Another lawyer, Steven Schwarcz, suggested the anti-competitive effect of NRSRO designation, if any, was mitigated by the need of rating agencies to 156 Bond Rating Agencies maintain their reputations with or without regulation. Further regulation would not be likely to improve materially on the effects of this reputational incentive.76 Glenn L. Reynolds, Chief Executive Officer of CreditSights, Inc., a credit risk consultancy, cautioned the ‘need to make sure that the cure is not worse than the disease’ in considering alternatives to the NRSRO designation.77 What needs to change, suggested Reynolds, is the quality of analysis; and the fees rating agencies earn are lucrative enough to fund a material improvement in their output. NRSROs should, he suggested, be more activist, and quality standards should be imposed on them by regulation.78 All material risks not covered by public disclosure should be reported to SEC by NRSROs.79 He feared the agencies have not so much improved the quality of their work as become ‘trigger happy to overcompensate for Enron’, effectively changing the rules of the game.80 One of the distinctive things about the reaction of the rating agencies to the Enron crisis is the effort to consult with interested parties about developing the rating process in order to avoid future mistakes. When Moody’s announced its intentions, concerns were expressed about a ‘dramatic increase in the volatility of ratings’ which could raise the price of debt, as investors started to perceive higher risk.81 Moody’s subsequently said that while it will incorporate stock and bond prices in its analysis, it will not ‘let market volatility displace fundamental credit analysis’.82 Nor, according to its senior managing director and the chairman of its credit policy committee, Chris Mahoney, will Moody’s engage in ‘unannounced multinotch ratings changes’.83 According to Moody’s, market analysts were concerned that changes to ratings should not disrupt the markets, although they did expect the agencies to pursue accounting issues and demand undisclosed data. Although Moody’s still expects ratings to be valid through business cycles, they will in future be adjusted more frequently ‘in periods of heightened credit stress’.84 Emphasis on going beyond the information formally provided by issuers was reinforced in the Senate Committee hearings chaired by Senator Joseph Lieber- man.85 Senator Thompson (R., Tenn.) questioned whether the agencies added value and noted that, in his view, they did not ‘really go beyond the documents’.86 The SEC announced a re-examination of the role of the agencies and possible need for greater regulation in future. A requirement to undertake a study and report back on the issue to the US Congress was contained in the Sarbanes–Oxley Act of 2002.87 However, at the time of writing, it remains unclear just how far this challenge will go in changing the circumstances faced by the agencies.

Conclusions Traditionally, there have been few financial industry institutions with greater claim to anonymity than the major bond rating agencies, Moody’s Investors Service and Standard & Poor’s. Since the mid 1990s, however, this picture has changed, and the agencies and what they do have become of much greater interest to those concerned with the dynamics of global finance, and how policy and democratic life at home and in far away places are increasingly 157 Timothy J. Sinclair affected by international capital mobility. On the one hand, the demand for the work of the agencies has grown with the expansion of capital markets as the prevailing means of international financing. This has made the agencies more important than ever before, granting them significant power in some circumstances over those seeking bond financing. On the other hand, risks have grown for the agencies too. Corporations like Enron play by a new rule book, one perhaps increasingly hard for the agencies to decipher. Although change in global finance has increased the importance of the bond rating agencies, they have also become more vulnerable to a sudden collapse in their franchise, as suffered dramatically by Arthur Andersen in late 2001. We should anticipate a more proactive response from the rating agencies to these opportunities and threats in the future.

Notes 1. The relatively weak reputational assets of Fitch Ratings mean that it cannot yet be compared with Moody’s and Standard & Poor’s. With more investment, and importantly, time, Fitch may accumulate the reputational assets needed to meaningfully create a ‘Big Three’ in the rating world. 2. Parts of this section draw upon Timothy J. Sinclair, ‘Private makers of public policy: bond rating agencies and the new global finance’, in: Adrienne He´ritier (ed.), Common Goods: Reinventing European and International Governance (Rowman & Littlefield, 2002), pp. 279–91. Also see important chapters on credit rating in this volume by Dieter Kerwer and Torsten Strulik. 3. Edward C. Kirkland, Industry Comes of Age: Business Labor and Public Policy 1860–1897 (Holt, Reinhart & Winston, 1961), p. 233. 4. See ‘History of Standard & Poor’s’ at http://www.standardandpoors.com. Accessed 25 January 2002. 5. Kirkland, Industry Comes of Age,p.233. 6. ‘Moody’s History’, available at http://www.moodys.com. Accessed 5 June 2002. 7. ‘Moody’s History’, in: ‘About Moody’s,’ at http://www.moodys.com. Accessed 25 January 2002. 8. Alvin Toffler, Powershift: Knowledge, Wealth, and Violence at the Edge of the 21st Century (Bantam, 1990), pp. 43–57. 9. Richard S. Wilson, Corporate Senior Securities: Analysis and Evaluation of Bonds, Convertibles, and Preferreds (Probus, 1987), p. 327. 10. See, for example, Ann Monroe, ‘Rating the Rating Agencies’, Treasury & Risk Management, July 1995, pp. 35–41; and United States Department of Justice, ‘DOJ urges SEC to increase competition for securities ratings agencies’, press release, Washington, DC, 6 March 1998. Also see surveys by Cantwell & Co., available at http://www.askcantwell.com/iscr_survey.htm. 11. Based on comments made by senior Moody’s officials during interviews in New York, March 2000. 12. Jenny Wiggins & Peter Spiegel, ‘Enron’s fall may spark credit rating rethink’, Financial Times, 19–20 January 2002, p. 1. 13. Paul Abrahams, ‘Dun & Bradstreet opts for divorce’, Financial Times,1November 1996, p. 26. Also see Moody’s Corporation, 2001 Annual Report (Moody’s Corporation, 2002). 14. Interview with Joanne W. Rose, Vice President and General Counsel, Standard & Poor’s Ratings Group, New York, 16 February 1993. 15. See http://www.moodyskmv.com. Accessed 23 September 2002. 16. See ‘Company Description’, in: ‘About Fitch’ at http://www.fitchibca.com. Accessed 25 January 2002. 17. Susan Greenberg, ‘New rating agency causes a stir’, The Guardian,13February 1993. A comprehensive listing of the new agencies can be found at http://www.everling.de. 18. Edward Comor strongly promoted this view during our many discussions in the early 1990s. 19. See ‘Introduction to Moody’s’, in: ‘About Moody’s’ at http://www.moodys.com. Accessed 25 January 2002. 20. Moody’s Investors Service, Moody’s Introduction (Moody’s Investors Service, 1989), p. 6. 21. See Hyman C. Grossman, ‘Introduction to the debt rating process’, presentation to the Standard & Poor’s seminar, Institute for Professional Development, New Jersey Law Center, New Brunswick, NJ, 7 August 158 Bond Rating Agencies

1992. The Euromoney Institute of Finance frequently runs credit analysis training workshops which feature Moody’s analysts speaking on the influence, scope and methods of rating agencies. 22. David F. Hawkins, Barbara A. Brown & Walter J. Campbell, Rating Industrial Bonds (Financial Executives Research Foundation, 1983), p. 38. Also see Hugh C. Sherwood, How Corporate and Municipal Debt is Rated: An Inside Look at Standard & Poor’s Rating System (John Wiley, 1976), pp. 21–6. 23. Jan Konstanty, Moody’s Starts with the Basics (Moody’s Investors Service, 1991), p. 1. 24. David Stimpson (ed.), Global Credit Analysis (Moody’s Investors Service/IFR Books, 1991), p. 98. 25. Standard & Poor’s, S&P Corporate Finance Criteria (Standard & Poor’s, 1992), p. 9. 26. Canadian Bond Rating Service, The CBRS Method of Rating (Canadian Bond Rating Service, 1989), p. 13. 27. Moody’s Investors Service, Moody’s Introduction,p.7. 28. In ten years of field research on capital markets and bond rating agencies, this author has not had access to documents directly involved in a rating determination. The author hopes Moody’s and S&P will donate archival material to a library, so that historians can research specific rating decisions as they can in the mercantile rating field, using the archives of R.G. Dun & Company, held at Baker Library, Harvard Business School. These files, which cover mercantile rating and not debt securities rating, stop in 1892 and unfortunately tell us little about contemporary bond rating processes. Sadly, a senior rating official told me in April 2002 that, at least as far as his agency was concerned, such archives had not been established. 29. Moody’s Investors Service, Moody’s Rating Methodology Handbook (Moody’s Investors Service, 2000), pp. 174–5. 30. Standard & Poor’s, S&P’s Corporate Finance Criteria,p.65. 31. Communication with the author from Andrew Chmaj, Senior Vice President/Marketing, Moody’s Investors Service, London, 31 July 2000. 32. ‘Standard & Poor’s ratings services subscription services’, memorandum prepared for the author by Standard & Poor’s, New York, courtesy of the President, 13 November 2000. 33. No author, ‘The markets: currencies’, The New York Times,4April 1998, Section D, p. 3. 34. No author, ‘Moody’s to review some Japanese debt’, The New York Times,23July 1998, Section D, p. 5. 35. No author, ‘The markets: currencies’, The New York Times,24July 1998, Section D, p. 6. 36. Bloomberg News, ‘Moody’s decides to downgrade its financial ratings for Japan’, The New York Times, 17 November 1998, Section C, p. 2. 37. Sakamoto Sakae, ‘Japan’s downgrading fans criticism of U.S. rating agencies’, Journal of Japanese Trade & Industry,19August 1999, no page number, accessed from Lexis-Nexis on 26 February 2002. 38. Ibid. 39. Kurosawa Yoshitaka, quoted in ibid. 40. Sakae, ‘Japan’s downgrading’. 41. Stephanie Strom, ‘Japan to turn to direct loans from its banks’, The New York Times,29January 2000, Section A, p. 1. 42. Stephanie Strom, ‘S&P concerned about prospects for recovery in Japan’, The New York Times,23 February 2000, Section C, p. 4. 43. Gillian Tett, ‘Growth at last’, Financial Times,12September 2000, p. 24. 44. No author, ‘S&P lowers its rating on Japanese debt’, The New York Times,24February 2001, Section C, p. 4. 45. Hakuo Yanagisawa, quoted in No author, ‘Japan blasts S&P for cutting long-term credit rating’, Bangkok Post,24February 2001, no page number, accessed from Lexis-Nexis, 26 February 2002. 46. S&P, quoted in ibid. 47. No author, ‘Review of Japan debt rating’, The New York Times,7September 2001, Section W, p. 1. 48. Masajuro Shiokawa, quoted in Ken Belson, ‘S&P cuts credit rating of Japan’, The New York Times,29 November 2001, Section W, p. 1. 49. Ken Belson, ‘Moody’s lowers debt rating on government credit in yen’, The New York Times,5December 2001, Section W, p. 1. 50. Council on Economic and Fiscal Policy, quoted in Ken Belson, ‘Japan’s debt under study for new cut in rating’, The New York Times,14February 2002, Section W, p. 1. 51. David Pilling & Bayan Rahman, ‘Japan’s debt rating may fall below Botswana’s’, Financial Times,14 February 2002, p. 12. 159 Timothy J. Sinclair

52. Bayan Rahman, ‘Downgrade fears cast shadow over Japan: Moody’s is considering a drop of two notches to A2’, Financial Times,14February 2002, p. 33. 53. On the impact of equity market mark-to-market rules on Japanese banks, see No author, ‘The non-perform- ing country’, The Economist,16February 2002, pp. 24–6. 54. Ken Belson, ‘Despite protest, Moody’s cuts Japan’s rating’, The New York Times,1June 2002, p. B2. 55. Arran Scott, ‘Japan rebukes ratings agencies for falling grades’, The Wall Street Journal,1May 2002, p. A14; Michael Williams & Phred Dvorak, ‘Japan seethes over comparisons to Botswana’, The Wall Street Journal,13May 2002, p. C1: David Ibison, ‘Japan hits out as rating downgrade looms’, Financial Times, 25/6 May 2002, p. 3; and Michael Williams & Phred Dvorak, ‘Tokyo fears ratings downgrades to hit borrowing’, The Wall Street Journal,28May 2002, p. A16. 56. Williams & Dvorak, ‘Japan seethes’. 57. Kuroda, quoted in ibid. 58. Mariko Sanchanta, ‘Conﬁdence in Japan hit as bonds fall from favour’, Financial Times, 21/2 September 2002, p. 7. 59. Peter Cook, ‘The illogical left and the logic of debt’, The Globe and Mail (Toronto), 2 March 1995, p. B2; and Peter Cook. ‘Is Canada now a serious country?’, The Globe and Mail (Toronto), 14 April 1995, p. B2. Also see Peter Cook, ‘Sweden’s plight resembles Canada’s’, The Globe and Mail (Toronto), 6 February 1995, p. B9. 60. Thomas L. Friedman, ‘Don’t mess with Moody’s’, The Globe and Mail (Toronto), 27 February 1995, p. A15 [reprinted from The New York Times]. 61. For background on the issue, see Marie Brenner, ‘The Enron Wars’, Vanity Fair, April 2002, pp. 181–209. The article cites attorney William Lerach, who asserted that ‘Enron’s goal … was to keep these debts off the balance sheet so the rating agencies would not be able to see them’, p. 185. 62. No author, ‘The real scandal’, The Economist,19January 2002, p. 9. 63. Malcolm S. Salter, Lynne C. Levesque & Maria Ciampa, ‘The rise and fall of Enron’, paper prepared for the Faculty Symposium on Enron Corp., Harvard Business School, 10 April 2002 (revised 23 April 2002). 64. Also see Sheila McNulty, Peter Martin, Adrian Michaels & Michael Peel, ‘Called to account’, Financial Times, 12/13 January 2002, p. 6. 65. On accounting reform after Enron, see Michael Peel & Simon London, ‘Wall St. and regulators: watchdog to go as accountants return to principles’, FT.com,18January 2002, accessed 12 June 2002; Randall Smith & Michael Schroeder, ‘Pitt’s SEC plan for self-regulation of accountants may have pitfalls’, The Wall Street Journal,18January 2002, p. C15; Roger Lowenstein, ‘Auditor independence: the SEC chairman doesn’t get it’, The Wall Street Journal,23January 2002, p. A22; Peter Spiegel & Michael Peel, ‘SEC set to mull range of rule reforms’, FT.com,5February 2002, accessed 12 June 2002; No author, ‘When the numbers don’t add up’, The Economist,9February 2002, pp. 57–9; and Jane Mayer, ‘The accountants’ war’, The New Yorker,22and 29 April 2002, pp. 64–71. 66. Nicholas Kulish & John R. Wilke, ‘Indictment puts Andersen’s fate on line’, The Wall Street Journal,15 March 2002, p. C1; and Ken Brown, Cassell Bryan-Low, Carrick Mollenkamp & Mitchell Pacelle, ‘Andersen’s foreign ofﬁces defect’, The Wall Street Journal,22March 2002, p. C1. 67. On the astonishment among Andersen workers about their ‘death sentence’, see Dennis O’Toole, letter to the editor, ‘Where is justice for Andersen workers?’, USA Today,27March 2002, p. 12A. 68. Betty W. Liu, ‘Big downgrades in Asia are criticized’, The Wall Street Journal Europe,13October 1997, p. 12. 69. Testimony of John Diaz, Managing Director, Moody’s Investors Service, before the Committee on Government Affairs, United States Senate, 20 March 2002, pp. 2–3. 70. Testimony of Ronald M. Barone, Managing Director, Standard & Poor’s, before the Committee on Government Affairs, United States Senate, 20 March 2002, p. 2. 71. Arthur Levitt, ‘Who audits the auditors?’, The New York Times,17January 2002, Section A, p. 29. 72. Emma Moody, ‘Moody’s looks at speeding ratings’, The Ottawa Citizen,19January 2002, p. H1; Jenny Wiggins & Peter Spiegel, ‘Enron’s fall may spark credit rating rethink’, Financial Times, 19/20 January 2002, p. 1; Gregory Zuckerman & Christine Richard, ‘Moody’s and S&P, singed by Enron, may speed up credit downgrades’, The Wall Street Journal,22January 2002, p. C1; Christopher Mahoney, The Bond Rating Process in a Changing Environment (Moody’s Investors Service, 2002); and Jenny Wiggins, ‘S&P outlines ratings overhaul’, Financial Times, 26/7 January 2002, p. 10. 73. Lawrence White, ‘Credit and credibility’, The New York Times,24February 2002, p. 13. 160 Bond Rating Agencies

74. Testimony of Isaac C. Hunt, Jr., Commissioner, U.S. Securities and Exchange Commission, before the Committee on Governmental Affairs, United States Senate, 20 March 2002, pp. 2 and 4. 75. Testimony of Jonathan R. Macey, Cornell Law School, before the Committee on Governmental Affairs, United States Senate, 20 March 2002, p. 3. 76. Testimony of Steven L. Schwarcz, Duke University, before the Committee on Governmental Affairs, United States Senate, 20 March 2002, pp. 2–3. 77. Testimony of Glenn Reynolds, CEO of CreditSights, Inc., before the Committee on Governmental Affairs, United States Senate, 20 March 2002, p. 1. 78. Ibid.,p.2. 79. Ibid.,p.3. 80. Ibid.,p.6. 81. Louise Purtle, credit strategist at Deutsche Bank in New York, quoted in Zuckerman & Richard, ‘Moody’s and S&P’. 82. John Dooley, ‘Moody’s planned overhaul of its ratings process includes effort to limit volatility, shorten reviews’, The Wall Street Journal,13February 2002, p. C16. 83. Chris Mahoney, senior managing director, Moody’s Investors Service, quoted in Dooley, ‘Moody’s planned overhaul’. 84. Dooley, ‘Moody’s planned overhaul’. 85. Michael Schroeder, ‘SEC weighs curbs on credit-rating ﬁrms’, The Wall Street Journal,21March 2002, p. A3. 86. Senator Fred Thompson, quoted in Schroeder, ‘SEC weighs curbs’. 87. See http://www.senate.gov/ ϳ banking/. Accessed 23 September 2002.

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