The Legitimacy of Credit Rating Agencies in the Bond Market Hsueh Chen-hua Department of Sociology Tunghai University June 2017 A dissertation submitted for the degree of Doctor of Philosophy Table of Contents TABLE OF CONTENTS………………………………………………………...... I LIST OF TABLES AND FIGURES ………..…………………………………….. VI GLOSSARY……………………………………………………………………..... VII ABSTRACT……………………………………………………………………..... VIII DECLARATION………………………………………………………………...... X ACKNOWLEDGMENTS………………………………………………………… XI CHAPTER 1: INTRODUCTION…………………………………………….... 1 1.1 STORIES AFTER 2008 FINANCIAL CRISIS…………………………… 1 1.1.1 Settlements of Banks……………………………………………………….. 2 1.1.2 Aftermaths about Credit Rating Agencies..………………………………… 6 1.1.3 Settlements of Credit Rating Agencies…….……...………………………... 10 1.2 RESEARCH QUESTIONS……………………………………………….... 17 1.3 RESEARCH PURPOSES…………………………………………………... 18 1.4 POTENTIAL CONTRIBUTIONS………………………………………..... 19 1.5 STRUCTURE OF THE THESIS…………………………………………… 20 CHAPTER 2: LITERATURE REVIEW……………………………………..... 21 2.1 GENERAL REVIEW………………………………………………………... 21 2.2 A HISTORICAL PERSPECTIVE………………………………………...... 25 2.3 MANIFESTATION OF THEORETICAL CONCEPTS..……………......... 31 CHAPTER 3: METHODOLOGY……………………………………………… 36 I 3.1 CASE STUDY METHOD…………………………………………………… 37 3.2 CRITICAL DISCOURSE ANALYSIS……………………………………... 38 3.3 INTERVIEWS……………………………………………………………...... 39 CHAPTER 4: FROM COMMERCIAL TO FINANCIAL CREDIT………… 41 4.1 THE FORMATION OF CREDIT………………………………………….. 41 4.1.1 The Meaning of Credit……………………………………………………… 41 4.1.2 Credit between Fifteenth and Eighteenth Centuries……………………........ 44 4.2 COMMERCIAL CREDIT…………………………………………………... 47 4.3 PUBLIC CREDIT…………………………………………………………… 54 4.4 FINANCIAL CREDIT………………………………………………………. 64 CHAPTER 5: CASE STUDY OF BANKING FAMILIES…………………..... 67 5.1 THE MEDICI………………………………………………………………... 67 5.1.1 Background………………………………………………………………...... 68 5.1.2 Banking Business…………………………………………………………… 70 5.1.3 Credit and Information……………………………………………………… 71 5.1.4 Summary…………………………………………………………………….. 74 5.2 THE FUGGER……………………………………………………………...... 75 5.2.1 Background……………………………………………………………….…. 77 5.2.2 Banking Business…………………………………………………………… 78 5.2.3 Credit and Information……………………………………………………… 81 5.2.4 Summary……………………………………………………………………. 84 5.3 THE BARING………………………………………………………………... 85 II 5.3.1 Background……………………………………………………………….... 86 5.3.2 Banking Business…………………………………………………………… 87 5.3.3 Credit and Information……………………………………………………… 88 5.3.4 Summary……………………………………………………………………. 93 5.4 THE ROTHSCHILD……………………………………………………….. 94 5.4.1 Background……………………………………………………………….... 95 5.4.2 Banking Business…………………………………………………………… 96 5.4.3 Credit and Information……………………………………………………… 99 5.4.4 Summary……………………………………………………………………. 105 CHAPTER 6: DEVELOPMENTS OF THE BOND MARKET……………… 109 6.1 FUNDAMENTAL CONCEPTS OF BONDS……………………………..... 109 6.2 KEY DEVELOPMENTS OF BONDS……………………………………… 112 6.2.1 Bond Trading in Italian City-States……………………………………......... 113 6.2.2 Development of Bonds in Netherlands……………………………………… 115 6.2.3 Development of Bonds in Britain…………………………………………... 118 6.2.4 Development of Bonds in the U.S……………………………....................... 121 6.3 EURO-DOLLAR AND EUROBOND MARKETS……………………....... 124 6.3.1 Euro-dollar Market as an Off-shore One…………………………………..... 125 6.3.2 Historical Background of Euro-dollar Market………………………………. 126 6.3.3 Eurobond…………………………………………………………………..... 129 6.4 MARKET EXPANSION……………………………………………...…....... 131 6.4.1 Factors for Market Expansion………………………………………………. 131 6.4.2 Some Trends in the Current Market………………………………………… 136 III CHAPTER 7: DEVELOPMENTS OF CREDIT RATING AGENCIES…….. 141 7.1 INFORMATION MATTERS……………………………………………...... 143 7.1.1 Information in Research…………………………………………………….. 145 7.1.2 Information in Trading Context……………………………………………... 147 7.1.3 Information as Core of Credit Rating……………………………………….. 149 7.2 DEVELOPMENTS OF CREDIT RATING………………………………... 150 7.2.1 From Personal Information to Financial Statements………………………... 151 7.2.2 From Amateurs to Professionals…………………………………………...... 154 7.2.3 From Verbal Messages to Publications…………………………………….... 158 7.3 ESTABLISHMENT OF CREDIT RATING AGENCIES……………......... 162 7.3.1 Establishment of Dun & Bradstreet………………………………………..... 163 7.3.2 Establishment of Big Three………………………………………………..... 166 7.3.3 Ratings from Big Three……………………………………………………... 172 7.4 LEGALLY DEFINED CREDIT RATING AGENCIES…………………... 174 7.4.1 Rating Requirements from OCC…………………………………………..... 175 7.4.2 Capital Requirements from SEC……………………………………………. 177 7.4.3 Identifications from NRSRO……………………………………………....... 179 7.5 DOMINANCE OF BIG THREE………………………………………….... 182 CHAPTER 8: DISCUSSIONS AND CONCLUSIONS……………………….. 187 8.1 DOMINANCE OF CREDIT RATING AGENCIES………………............. 187 8.1.1 Practical Impacts from Credit Rating……………………………………..... 188 8.1.2 Dependence from Investors……………………………………………….... 191 8.1.3 New York City as the Core of CRA………………………………………… 192 IV 8.2 LEGITIMACY OF CRA’S…………….......................................................... 199 8.2.1 Traditional Legitimacy of Dominance……………………………….……... 199 8.2.2 Legal/Rational Legitimacy of Dominance………………………..………… 208 8.3 CHANGES IN FORMS OF THE SOCIETY……………………………… 215 8.4 LIMITATIONS AND FUTURE DIRECTIONS ..……................................. 221 8.5 CONCLUSIONS ..…….................................................................................... 226 NOTES…………………………………………………………….……................ 231 REFERENCES………………………………………………………………….... 243 APPENDIX Interview Questions……………………………………………….... 260 V List of Tables and Figures Number Page Table 1. Payments of Settlements between DoJ and Banks after 2008 Crisis 5 Table 2. Payments of Settlements of CRAs after 2008 Crisis 16 Table 3. Commercial Credit vs. Financial Credit 64 Table 4. NRSROs in Some Years 180 Table 5. Breakdown of Credit Ratings by Category in 2015 183 Table 6. Percentage of Total Reported NRSROs’ Revenue in 2015 184 Figure 1. Milestone of $100 Trillion in World Bond Market 132 Figure 2. Volume of International Bonds between 1970 and 1977 133 Figure 3. Railway Mileages between 1850 and 1990 166 Figure 4. Stock Prices of Moody’s 185 Figure 5. Portions of Different Types of Securities rated by CRAs 186 Figure 6. Population Growth in the U.S. between 1790 and 1920 195 Figure 7. Territory Expansion in the U.S. between 1790 and 1920 195 Figure 8. Occupational Distribution of Jewish, 1621-1977 225 Figure 9. Explanation for Claim Making 228 VI Glossary CalPERS The California Public Employees’ Retirement System CDO Collateralized Debt Obligation CDS Credit Default Swap CMBS Commercial Mortgage-Backed Securities CRA Credit Rating Agency DoJ The U.S. Department of Justice Fitch Fitch Ratings Inc. MBS Mortgage-Backed Securities Moody’s Moody’s Investors Service Inc. NACM National Association of Credit Men NRSRO Nationally Recognized Statistical Rating Organizations OCC Office of the Comptroller of the Currency RMBS Residential Mortgage-Backed Securities SEC The U.S. Securities and Exchange Commission S&P Standard & Poor’s Global Ratings The Fed The U.S. Federal Reserve System VII Abstract The world has suffered from a recession since the 2008 financial crisis which made countless investors worldwide lose a huge amount of money. After this trauma, some legal settlements were made between governmental organizations and banks or credit rating agencies. Credit rating agencies remain influential and even grow more powerful although collapses or reshuffles happened to several gigantic investment banks. The puzzles of the dominance of credit rating agencies, particularly in the bond market, triggered this research. While most researches focus on the impacts of credit rating agencies from a business or a marketing viewpoint, this thesis targets at the legitimacy of credit rating agencies from a historical and sociological perspective. Besides, while researchers who discussed the historical background of credit rating agencies tend to treat the establishment of The Mercantile Agency in 1841 as the inception, this thesis, by contrast, claimed that the origin of credit rating agencies needs to be traced back to a much earlier era—at least three centuries before that—since some banking families had started to deal with credit in essence. The main research methods consist of case study, critical discourse analysis and interviews. In this thesis, four cases of banking families—the Medici, the Fugger, the Baring, and the Rothschild—were studied in terms of the way they handled credit and then were compared with what is carried out nowadays by credit rating agencies, mainly the Big Three—Standard & Poor’s, Moody’s and Fitch. Theoretically speaking, Max Weber’s arguments about legitimation of domination—both traditional legitimation and legal/rational legitimation—were adopted to explore the legitimacy of credit rating agencies via critical discourse analyses. In addition, via interviews with bond traders, VIII the connection between academic discussions in this thesis and practical experiences in the trading context is thus enhanced. This research found that, first, after the comprehensive review of the four banking families in terms of credit and information, what they conducted actually was similar to what credit rating agencies function in the modern era. Yet, no term such as credit rating was used back to several centuries ago, partially owing to the linguistic unavailability. Thus, the origin of credit rating agencies is argued in this thesis to be as early as the fifteen century instead of the nineteen century