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 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 busi- nesses 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 busi- ness 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 quanti- tative 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.