The credit rating industry

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Richard Cantor, Frank Packer

As financial market complexity and borrower diversity have grown over time, investors and regulators have increased their reliance on the opinions of the credit rating agencies. At the same time, the number of rating agencies operating in the United States and abroad has risen sharply. Together, these trends have prompted market participants and policymakers to reassess the performance of the agencies and the adequacy of public oversight of the ratings industry. This article provides background for such a reassessment by investigating the evolution and economics of the industry, the growth of ratings-dependent regulations, and the reliability and comparability of the agencies' ratings. We examine the correspondence of ratings with default rates and report differences among major agencies in their ratings for junk bonds, international banks, and mortgage-backed securities.

Our findings raise several questions about the current uses of ratings. While the agencies provide accurate rank-orderings of default risk, the meanings of specific ratings vary over time and across agencies. Since these ratings are used as the basis of most investor guidelines and government regulations, the variations in meaning could have serious implications. Moreover, as the number of agencies increases, differences in ratings may encourage borrowers to "shop" for the most favorable ratings. In light of the possibilities for ratings misuse, the current reevaluation of ratings-dependent regulations and the adequacy of public oversight seems well justified.

THE EVOLUTION AND ECONOMICS OF THE RATINGS INDUSTRY

RATING AGENCY ORIGINS, OWNERS, AND SYMBOLS The precursors of bond rating agencies were the mercantile credit agencies, which rated merchants' ability to pay their financial obligations. In 1841, in the wake of the financial crisis of 1837, Louis Tappan established the first mercantile credit agency in New York. Robert Dun subsequently acquired the agency and published its first ratings guide in 1859. A similar mercantile rating agency was formed in 1849 by John Bradstreet, who published a ratings book in 1857. In 1933, the two agencies were consolidated into Dun and Bradstreet, which became the owner of Moody's Investors Service in 1962.

The expansion of the ratings business to securities ratings began in 1909 when John Moody started to rate U.S. railroad bonds. A year later, Moody extended his ratings activity to utility and industrial bonds. Poor's Publishing Company issued its first ratings in 1916, Standard Statistics Company in 1922, and the Fitch Publishing Company in 1924. The number of bond rating agencies in the U.S. reverted to three when Standard Statistics and Poor's Publishing Company merged to form Standard and Poor's (S&P) in 1941. The most significant new entry in the United States since that time has been the Chicago-based Duff and Phelps, which began to provide bond ratings for a wide range of companies in 1982, although it had researched public utility companies since 1932. Another major ratings provider--McCarthy, Crisanti, and Maffei--was founded in 1975 and acquired by Xerox Financial Services before its fixed income rating and research service was merged into Duff and Phelps in 1991.

The four major rating agencies face additional competition from more specialized agencies. For example, Thomson Bankwatch and IBCA in the United States exclusively rate financial institutions, and A.M. Best rates insurance companies' claims-paying abilities. More generally, the analysts employed by many financial institutions regularly make recommendations to buy or sell that implicitly confirm or contradict the agencies' ratings. To the extent that the analyses underlying these recommendations are made public, they provide alternative perspectives to the judgments of the rating agencies.

As capital flows in international financial markets have shifted from the banking sector to capital markets, credit ratings have also begun to make a mark overseas. Credit ratings are in use in the financial markets of most developed economies and several emerging market countries as well (Dale and Thomas 1991). With demand rising in foreign countries, the number of foreign-based rating agencies has increased. Along with the four largest U.S. raters, one other U.S., one British, two Canadian, and three Japanese firms are listed among the world's "most influential" rating agencies by the Financial Times in its publication Credit Ratings International. The principal characteristics of all eleven agencies are reported in Table 1.

[TABULAR DATA 1 OMITTED]

The ownership structures of the U.S. rating agencies do not generally present serious conflict of interest problems.(1) The major agencies are all either independent or owned by nonfinancial companies, though two had until recently been owned by financial companies. Moody's is a subsidiary of Dun and Bradstreet, which dominates the market for commercial credit ratings. Standard and Poor's is a subsidiary of McGraw-Hill, a major publishing company with a strong business information focus. Fitch, initially a publishing company, was bought by an independent investors group in 1989. Duff and Phelps Credit Ratings is a subsidiary of Duff and Phelps, Inc., whose affiliates offer investment management, financial consulting, and investment research services. By late 1994, however, Duff and Phelps Credit Ratings is expected to become an independent company as its shares are spun off to the shareholders of Duff and Phelps, Inc., itself a closely held company. Thomson Bankwatch was a subsidiary of Keefe, Bruyette, and Woods, a brokerage firm, until March 1989, when it was sold to the Thomson Corporation, a large private international publishing conglomerate. Most of the non-U.S. firms are also independent. The London-based rating agency, IBCA, is independently owned, as are the two Canadian rating agencies. Two of the rating agencies from Japan, however, are owned by consortia of financial institutions, including some for which credit ratings are issued.