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Credit Rating Agencies: Using Historical Research to Reveal a Cultural Pattern
The leading Credit Rating Agencies facilitated the Financial Crisis of 2008. As a result,
extensive reforms were enacted to limit the negative effect of the agencies upon the
marketplace, and therefore society. However, the agencies continue to transgress, and have
become even more profitable and impenetrable. In order to provide some insight to why the
agencies behave in the way that they do, this article will utilise historical research to present
a teleological demonstration that there is an underlying culture that prevails through each
era and is the foundation for their callous disregard to the safety of the financial system.
Revealing this culture may then enable us to think differently when we discuss how best to
regulate this unique sector of the financial arena
Daniel Cash
The Financial Crisis of 2008 was a generation-defining moment, one that shook the economic
system and cost society, depending upon what source one reads, tens of trillions of dollars.
Analyses of the intricacies of the Crisis have been conducted by many since, and will not be
assessed in any great detail in this piece. This is because the aim of this piece is to examine
what led to the rating agencies being complicit in one of the largest collapses in economic
history. In order to be as thorough as space allows, we will begin at the very beginning with
the first recognised rating operations, which were not commercial entities. The early
operations of Baring Brothers, pre-dated only by close-quartered mercantile organisations in
England and Scotland, represent a completely different culture to that one that would be
Lecturer in Law, Aston University ([email protected]); Doctoral Candidate, Durham University
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interwoven into the commercialised operations initiated by the short-lived Law firm Griffen,
Cleaveland, & Campbell, and then by the more successful Mercantile Agency that followed,
led by Lewis Tappan. The divergence between the operations of Baring Brothers, and that of
the Mercantile Agency, will provide us with a clear foundation for the working theory that
there is an underlying and unwelcomed culture that has evolved alongside the evolution of
the rating industry, and which ultimately is caused by the commercialisation of the rating
process.
Once the initial cementation of the culture has been established, we will move on to look at a
number of important milestones in the genealogy of the modern rating industry. For the
purposes of revealing the underlying culture, it will not be necessary to cover every step of
the evolution of the industry. For our purposes, the initial incarnations of the industry,
together with the 1970s, represent the two most revealing periods as to the culture within the
industry. To supplement that analysis, it will also be important to understand why that culture
has been allowed to affect society in the way that it has, so to do that we will also discuss the
complex nature of the relationship between the regulatory bodies, and the ratings industry;
recognising what influences this relationship can help our understanding moving forward.
Before the article begins its excavation into the history of the rating industry, this ‘culture’
that is referred to in this piece needs to be clarified. It is entirely reasonable to suggest that a
private entity, like a credit rating agency, will be predominantly concerned with its own
interests, and moreover its own survival. Whilst this is both acceptable and understood, this
piece operates upon the understanding that to consciously attack and threaten others to
achieve this goal is not acceptable. Also, to proclaim that your company is dedicated to
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providing accurate and reliable products, essentially for the purposes of providing crucial
information to investors, only then to blatantly attack the position of those investors by
colluding with issuers and flooding the marketplace with fraudulent securities, is not only
unacceptable, but reprehensible. Looking at why the agencies conduct themselves in this
manner, and how that culture has been allowed to affect society so negatively, is the reason
for this piece.
The Effect of Commercialisation
Today, the credit rating industry is a multi-billion dollar industry serving a credit market
worth over $150 trillion. Yet, its origins, for the most part, stemmed from the need for a
practical resolution to the problem that faced the larger merchants and financiers in the
Nineteenth Century; how to increase the likelihood of a debtor repaying the credit that was
extended to them, and whether it was worth extending credit at all (Olegario, 2006, 229).
With the expansion of the North American market in the Nineteenth Century, and the
resultant complexities that came with it, the established mercantile techniques of relying upon
personal connections to evaluate the creditworthiness of customers and suppliers became
outdated, impractical, and less than satisfactory (Balleisen, 1996, 494).
Though the issue of credit and investing debt had historically been relatively straightforward,
the introduction of the railroad industry to the Nineteenth Century United States, and the
capital requirements that ensued, created an enormous market for the bonds of the U.S.
railroad corporations, a market that was not only domestic but also international (Abdelal,
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2007, 166). With the expansion diminishing the effectiveness of the close-quartered
mercantile techniques, the internationalisation of the market also introduced entities that had
the capability to transform the mechanics of the U.S. financial arena. Perhaps, the most
influential private entity was Baring Brothers (Hidy, 1939, 81).
Baring Brothers was a merchant firm that had evolved into a financial powerhouse operating
out of London, and then Liverpool, in the U.K. In doing so, the firm had positioned itself to
take full advantage of the many opportunities that were available to those willing and able to
extend credit to the United States; the level of involvement in the United States by these large
financiers resulted in the realisation that “the success of these great lenders and brokers of
credit depended in large measure upon the safety and reliability of their clients in America”
(Olegario, 2006, 25). This was realised by Thomas Baring because, whilst surveying the
American Houses and opportunities in the late 1820s, he hired Thomas Wren Ward, “a retired
well-to-do merchant from Boston”, to the effect that he “should act as a special resident agent
of Baring Brothers and Company in North America”. Within this role, Ward would supply
continuous intelligence, together with a compilation of businessmen “of all ranks and types,
whether or not they had asked for credit from his London principals” (Hidy, 1939, 84). This
compilation ranked businessmen on a scale from 1 to 11, with a particularly impressive
record of accuracy given the complexities of credit assessment during that period.
Yet, whilst the accuracy of Ward’s system was impressive, it is the underlying sentiment that
is important for us. In writing about Baring Brothers, and the role Ward played in their
affiliation with the United States, Ralph W. Hidy notes that the Barings strived to maintain a
list of “safe clients”, and that Ward was “undoubtedly the safest man we can have” to meet
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that goal. The successes that Baring Brothers experienced during that lucrative, yet perilous,
era are a testament to the decision to employ caution rather than speculation. One conclusion
that can be drawn from this is that the marked increase in speculation we witness today, when
compared to the Nineteenth Century, can be attributed to the fact that many who speculate
today do so with the resources of others; Thomas Baring was personally invested in the
dealings in the United States, so it is obvious why caution would have been of paramount
importance in such a perilous endeavour. What we shall see now is the opposite of this; the
early reporting/rating agencies were not looking to protect an already established position,
but were fighting to grow and adopted a ‘by any means’ approach to continue doing so – this
difference is the philosophical foundation for why the modern agencies do what they do.
Flandreau and Mesevage explain for us the reason why commercialised rating agencies came
to be. In addition to the unique requirements of the United States at that time, i.e. the
explosion of the railroad corporations and with it the national economy, there was a system of
finance that differed dramatically from that witnessed on the other side of the Atlantic Ocean.
In Britain, and also Central Europe, there was a bankruptcy network that was centralised
(which affects business decisions, as we shall see shortly), whilst there was also a widespread
market for ‘acceptances’ or ‘bills’ (commoditised commercial credit products) which was
dependent upon the large banking institutions acting as the intermediary in the transactions.
However, in the United States there was an overt demonstration against large and particularly
foreign financial entities, with Flandreau and Mesevage using the example of the
mobilisation of anti-finance sentiment during Salomon de Rothschild’s visit to Cincinnati in
1859; a poster campaign accused the Rothschild’s of coming to the U.S. to “purchase a U.S.
President to their taste”. The vacuum that this sentiment created, namely that there were few
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trusted financial intermediaries to facilitate the movement of credit, was to become the
breeding ground for the preliminary rating industry (Flandreau and Mesevage, 2014a, 229).
Into that vacuum stepped the first commercialised rating operation, undertaken by the New
York Law firm Griffen, Cleaveland, and Campbell. The firm, in 1835, created a “network of
attorneys throughout the city” that operated within a system whereby subscribers, upon
paying an annual subscription fee, would be able to review the (credit status) reports garnered
by those attorneys whenever they so wished. However, those reports were not unbiased, and
in fact represent the first manifestation of the commercialised industry’s understanding of
their assumed role as ‘gatekeeper’, because the partners dictated to the firm’s correspondents
that they should not concern themselves with the ‘many merchants who are too small to come
here to make their purchases’, and that they were simply to “give the names of such
merchants, stating the fact, that, in your opinion, they ought not to come to this city”
(Olegario, 2006, 64). This gatekeeping role that the agency assumed is based upon the
freedom that came with the notion of the reports constituting opinions, which were
constitutionally protected (this would be an issue for all of the firm’s ancestors).
The firm, however, did not survive for long. The “heady economic boom” in the mid-1830s
meant that there was very little appetite for risk analysis, which therefore rendered the
services of the law firm useless (Balleisen, 1996, 495). Historically, the successes of the
ratings industry, and in all truth its darker moments as well, are highly affected by situational
forces. Although many industries are affected by outside influences, the ratings industry as
we know it owes its existence to one key moment in American economic history; the Panic of
1837. The mentality that was in place before the Panic was dramatically altered by the events
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of 1837, because it both affected many citizens for the first time (the economic successes
beforehand had increased the exposure of society to economic shocks), but it also initiated
some important pieces of legislation that would affect the mentality of society for some years
to come. In 1841, the newly elected Whig Congress enacted The National Bankruptcy Act of
1841, which technically “sought to provide relief to the thousands of individuals who had
failed during the dramatic deflation that followed the Panics of 1837 and 1839”, but in
essence allowed for voluntary bankruptcy. However, the United States, at least up unto that
point, was particularly wary of bankruptcy protection, with many citizens viewing the system
as “giving sharpsters a means to escape their debts”. Also, there was a widespread fear that
the new law would bring about a ‘jubilee’, or a ‘universal pardoning of all debt’, which
prompted a uniformed need for creditors to be able to selected debtors ex ante with
confidence; Lewis Tappan, having purchased the remnants of the failed Griffen, Cleaveland,
and Campbell firm (Olegario, 2016, 76), was ready to meet that need – Tappan actually
launched The Mercantile Agency just two days after the Act was enacted (Flandreau and
Mesevage, 2014a, 230). The Act, however, was to be repealed just thirteen months later
(confirming the anti-bankruptcy sentiment), but the fear, fear that the ratings industry was
born out of, could not be reversed and would go onto to leave an enduring legacy that
continues to affect society today.
Before we discuss the first successful commercialised rating agency, or reporting agency as it
may also be referred to (the actual notion of ‘rating’, as we understand it today, was
established later with John Bradstreet’s firm, and then by John Moody), it may be
advantageous if we discuss the man behind the agency. Lewis Tappan, on the face of it at
least, was a hugely contradictory figure. On the one hand Tappan was a highly moralistic
individual, as Wyatt-Brown notes: “[Tappan] belonged to any and every league that had been
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founded for almost any purpose whatsoever, so long as it was benevolent, pious, and
teetotal”, ultimately declaring that Tappan was the formulaic “Yankee Do-gooder” (Wyatt-
Brown, 1971, Preface). One cause that Tappan would be forever associated with was the
abolitionist movement, which saw him, famously, provide counsel and support for the
enslaved peoples on board the La Amistad schooner (Tripp, 2008), whilst also creating a
number of dedicated ventures that broke through established prejudices of that era, like the
Oneida Institute and Oberlin College (Stewart, 2008). In keeping with this vision of Tappan’s
life, Sandage notes that “entrepreneurship and evangelism coexisted for the Tappans”
(Sandage, 2006, 100). However, whilst these actions are, of course, admirable, a person’s true
constitution and commitment to their proclaimed principles can only be tested when they face
hardships. With Tappan’s retirement (and that of his brother’s) being pegged to the successes
of the Mercantile Agency, we can measure the constitution of the man, and therefore the
culture that he was creating, by viewing his actions with regards to business, which reveal a
completely different Lewis Tappan; we shall now see that the claim that, when it mattered,
Tappan was “seldom sentimental”, is perhaps more appropriate (Wyatt-Brown, 1966, 434).
In relation to the analysis above, it is interesting that Tappan “never employed [black people]
as clerks in [his] wholesaling business, even when urged by a black minister to do so”
(Olegario, 2006, 223), although he did send both of his sons to the Oneida Institute, which
was widely recognised as permitting the induction of a small number of black students.
Whilst that is an interesting aside, it is the actions that Tappan took when the Agency faced
its first real crisis that can inform us as to the presence of this ‘by any means’ culture that
would go on to devastate society in 2008. The biggest issue facing the Agency after its initial
successes was that, as Tappan believed, no Southern States would engage in business with the
firm because of Tappan’s connections to the abolitionist movement, ultimately leaving the
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vast opportunity of expansion to his lesser competitors. In attempting to resolve the issue, and
maintain the successes of the Agency, the pious Tappan embarked upon an endeavour
defined by deception, whereby he would seemingly separate the firm and have his partner,
Edward Dunbar, conduct business in his own name in the Southern States. With Dunbar
being the face of the ‘new’ venture, Tappan instructed him to court business amongst
southern attorneys, although Dunbar refused and, despite his frankness, he found a large
number of attorneys who would report for the Agency anyway. Upon hearing the news,
Tappan “changed his mind and reasserted his scruples to justify a return to the original
policy… when the agents returned to New York, he [Tappan] ordered them to burn his letters
in reference to the hint [of deception]” (Wyatt-Brown, 1966, 445).
It would not be long until Tappan’s moralistic principles were to be relegated again in favour
of the ‘by any means’ approach. With his relationship with Dunbar leading him to a Chancery
Court, based upon legal disputes regarding the ownership of those southern reports generated
from that scheme, Tappan would move on from that phase in the Agency’s history and
promote Benjamin Douglass to Partner. This move again highlights Tappan’s wavering
commitment to his alleged principles in the face of profit; whilst previously Tappan would
insist on all those who worked for him attending Church (amongst a number of other things),
Douglass would be allowed to take over the firm (eventually) despite holding particularly
prejudicial views. It has been said that Douglass held similar views to that of his deputy,
Robert G. Dun (who would go on to control the Agency), namely that “it is plain that God
intended the Negro to be the servant and slave of the superior race. This is plain to me that it
is natural for the parent to govern the child; for the mind of the Negro is as that of a child
when compared to the Caucasian” (Olegario, 2006, pp. 59-64). That Tappan would allow for
this sentiment to be prevalent in those who had such an important role in the Agency is a
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clear signal of the ‘by any means’ approach that he, himself, had adopted; Douglass would
guide the Agency through a period of unprecedented success, which benefitted Tappan in his
retirement. This approach ultimately would weigh heavy on the mind of Tappan as he grew
older; one wonders whether he was speaking reflectively, or sanctimoniously when he stated
that:
Eagerness to amass property… robs a man and his family of rational enjoyment…
[and] tempts him to doubtful and disreputable acts (Wyatt-Brown, 1971, 229).
Tappan, however, would be quick to scold Douglass after the fact when, once Tappan had
retired and handed the Agency to Douglass, Douglass would refuse to pay Lewis’ brother
Arthur a pre-arranged amount to buy his shares in the Agency because Arthur had already
been drawing heavily against his position; Tappan would go on to label Douglass a “pro-
slavery man and a Buchananite”. This vacillation is perhaps the most important aspect of
Tappan’s character. Whilst he did indeed do things that have to be regarded as positive, he
also instilled a ‘by any means’ attitude within an industry that would go on to become central
to the movement of credit. Using the scheme for the Southern States that he concocted as just
one example, it is simply not the case that deception had to be instilled within the fabric of
this important industry, as Edward Dunbar proved. What we see however are the actions of a
man who is trying to maximise his position in retirement; whilst some may argue that this is
reasonable, it is the extent to which he was willing to go which is representative of the culture
within the modern industry – there is very little the industry will not do to succeed and
survive, and we saw the ramifications of that approach in 2008. Now we shall look at the
technical effects of that approach that Tappan instilled, which will highlight for us the
methods that the Agency deemed appropriate to achieve its own ends – the similarities
between that era and our own are stark.
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The Societal Effects of the Venal Culture: The Beginnings
In the lead up to the Financial Crisis of 2008, there were a vast number of examples of the
approach that Tappan incorporated in the earliest phases of the Mercantile Agency, namely
the ‘by any means’ approach, being relied upon time and time again. We shall see some those
examples towards the end of this piece, but in continuing our excavation in search of a
pattern to demonstrate the existence of this approach being interwoven into the rating
industry, we shall now look at the actual examples of that approach being utilised not long
after it had been incorporated. In the previous section we saw how Tappan had instituted the
‘by any means’ approach by turning his back on the principles that he had been widely
recognised for. Now, we will see how that approach began to affect society, because the
increased expansion that came with Douglass’ leadership of the Agency brought with it an
increased societal exposure that provides for us the first opportunity to see the truly callous
nature of the industry that is rooted in the ‘by any means’ approach.
Douglass would emerge from the infighting between himself and the Tappans to grow the
Agency exponentially. In gaining outright control of the Agency, Douglass would promote
the aforementioned Robert G. Dun to assist him with the running of the business. In addition
to sharing his political views, Douglass also had a close connection with Dun by way of his
marriage to Dun’s Sister in 1842, and Dun’s marriage to Douglass’ Sister in 1856 (Perez and
Willett, 1995, 14). That stable and cohesive base would be crucial for the Agency as it
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transitioned from leadership from Tappan, through Douglass, to Dun, because its exponential
growth would bring with it a host of problems. The main problem for the early agencies was
the issue of whether the information disseminated by the agencies could be considered as
‘privileged communications’, which essentially means communications that are protected
from liability. Before we discuss those problems, we need to understand the products and
services that the early agencies were selling. The first product was a subscription to the
records of the agency, with which a customer would have the right to make a certain number
of enquiries and would receive the reports in a number of ways (either handwritten, typed, or
orally), but they would always be confidentially made to the enquiring subscriber. Secondly,
John Bradstreet’s Agency pioneered the Reference Book, a document that would be sent to
subscribers and contained summary information of individual ‘capital’ and ‘credit’. Finally,
the agencies sold ‘Notification Sheets’, which were an addendum to the Reference Books and
provided higher frequency updates on the status of those included within the book.
The accepted notion in the literature is that “by the early 1880s… the courts had generally
accepted the broader view of privileged communication” (Madison, 1974, 178). However,
recent studies cast doubt on this understanding, and subsequently reveal a much darker side
to the industry that is demonstrable of the manifestation of the ‘by any means’ principle
referred to in this piece. Flandreau and Mesevage note that the extent of the Agency’s
liability was so large that the liability cost between 1896 and 1890 alone would have been in
excess of $100,000, or 20 per cent of Dun’s annual profits (Dun had taken the reigns at that
point). This exposure served as the trigger for the deployment of the ‘by any means’
approach.
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It has been noted elsewhere in the literature that “a survey of court decisions affecting the
agencies reported no cases in which they were sued for sharing information with
nonsubscribers” (Olegario, 2006, 171). However, Flandreau and Mesevage note that in the
eighteen cases, from 1851 to 1916, that covered libel issues particularly concerned with the
Reference Book and the Notification Sheets, every case came to the same conclusion; the two
products did not constitute privileged communications. So, how is it that there are no reported
cases of the agencies being sued? The answer lies in the notion, classified as such by the
agencies themselves, of ‘strangulation’. Strangulation entailed a number of techniques
designed to prevent the conclusion of unfavourable libel cases, techniques that included
technical defences, venue shopping, dragging out proceedings, intimidation tactics, and
subverting the plaintiff’s counsel (Flandreau and Mesevage, 2014b, pp.232-240). As we shall
see at the end of this piece, these tactics have become tried-and-true for the agencies and
continue to this day.
This is a clear example of the ‘by any means’ approach being deployed. However, to really
solidify the analysis, the case of Beardsley v. Tappan, heard in 1867 when Tappan and
Douglass were in charge of the Agency, is unrivalled in terms of signifying the lengths to
which the industry would, and will, go to in order to continue their advancement. This
analysis of the case will rely heavily on the account of Scott Sandage in his work Born
Losers: A History of Failure in America, which includes a clear representation of why we
must strive to look beyond the rulings in court cases before making assessments.
Firstly, the Mercantile Agency filed a report on John Beardsley’s business in which it was
stated that, owing to John’s wife Mary filing for divorce, his business was soon to close.
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Upon hearing the erroneous report (John and Mary had separated but she had not filed for
divorce), John travelled to New York to get the report removed from the Agency’s records.
Interestingly, Benjamin Douglass had been informed by a ‘Jobber’ that “I think you are doing
this man [Beardsley] or his firm an injustice” (Sandage, 2006, 168), owing to the fact that the
firm had paid the Agency $500 that very day and paid $2000 to other houses. Nevertheless,
Lewis Tappan refused to pull the report, or name the author, which resulted in the famous
libel trial being initiated. It was at that point that the Agency employed its first underhanded
tactic. On the instruction of Lewis Tappan, Sebastian F. Taylor, a local lawyer, initiated
divorce proceedings on behalf of Mary Beardsley. However, Taylor had never met Beardsley
and when the divorce application was heard in 1849, Taylor withdrew it straight away. In
attempting to create the scenario that the original misinformation had confirmed, Tappan
reveals his, and his Agency’s mode of operation which saw him deservedly labelled as a
“thorough fiend” (Sandage, 2006, 183).
Beardsley would go on to win the libel case, and was awarded $10,000 in damages. However,
the decision would be overturned on a technicality that was not concerned with the issue of
privileged communication, after a sustained legal challenge by the Mercantile Agency. As a
result of the reversal, Beardsley subsequently became liable for the legal fees, which had
accumulated to approximately $20,000, ultimately leaving the innocent trader penniless
before his death. After Beardsley had paid the fees, “company brochures made an example of
him, to ‘any person contemplating proceedings against the agency’” (Sandage, 2006, 185).
Given that the leaders of the Agency were aware that Beardsley had been wronged and
covered up the mischievous reporter’s ill deeds (Douglass would spend twenty days in Jail
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for contempt of court for refusing to reveal the identity of the reporter – making him a hero in
the eyes of reporters), this particularly callous endeavour of making an example of a man
who had been unjustly persecuted by a large company is indicative of the culture that was
built by Tappan and continued by his successors. Perhaps the statement that the Agency and
the tactics it used were “ruthless, sometimes mafia-like” (Flandreau and Mesevage, 2014a,
215) is apt.
To show the lineage of this culture, events in 1874, when the Mercantile Agency was under
the leadership of R.G. Dun, demonstrate for us how the attitude towards threats against the
agency continued despite the change in leadership. We have seen how the agency dealt with
threats emanating from those with fewer resources than it, i.e. John Beardsley, but it is
fascinating to see how the agency dealt with threats coming from State Legislators. Between
1873 and 1874, State Legislators in Missouri, Illinois, New York, Pennsylvania, and Ottawa,
introduced bills to make “the agencies responsible for losses suffered by businessmen as a
result of inaccurate reports” (Madison, 1974, 180). Though the bills in Missouri, Illinois,
Ottawa, and New York did not pass the early stages of the legislative process, Pennsylvania’s
bill was sent to the Senate in early 1874. Madison notes a robust and now-typical response
from the agencies to this development; the man responsible for the day-to-day running of
R.G. Dun in 1874, Erastus Wiman, garnered unprecedented support from prominent
businessmen in Pennsylvania – he proudly proclaimed that “this circumstance simply shows
what can be done by a little forethought, manipulation, and management in the shape of
working-up sentiment in the interest of fair play” (Madison, 1974, 181).
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It is therefore clear to see that the agencies understood the culture that underlay their
operations. Additionally, this culture continued to be fortified because of a sustained period
of potential legal threats against the leading agencies (predominantly R.G. Dun & Co., and
the Bradstreet Co.) leading up to, and continuing on past the turn of the century. This period
ultimately resulted in the agencies being granted what Flandreau and Mesevage call a ‘legal
licence’ (based upon Partnoy’s notion of a regulatory licence [Partnoy, 1999]), because the
Judiciary were essentially forced to accede to the agencies because of the overwhelming
reliance upon them by market participants (Flandreau and Sławatyniec, 2013, pp. 240-252).
This notion, of regulatory or legislative bodies reacting to the will of the market, is a very
important one and will be referred to in more detail when we assess the actions of the SEC
during the 1970s next. This ‘legal licence’ was converted into a ‘regulatory licence’ during
the regulatory-unprecedented era of the 1930s with the New Deal programs that were enacted
in response to the Wall St. Crash and the Great Depression; regulatory bodies like the Office
of the Comptroller of the Currency would begin to insert the ratings of the agencies into their
regulations, although the effect upon the fortunes of the agencies was limited because of a
number of external influences.
However, before we continue it is worth pausing for a moment to catch-up with the state of
the industry at that time. Tappan had retired in 1849, although still having a role to play in the
Mercantile Agency for some time (i.e. defending against the Beardsley libel suit). Douglass
had taken over the firm from that point and transferred the control of the business to R.G.
Dun in 1859, who would go on to develop the firm for another 40 years. The reason why this
is important to recognise, apart from taking a moment to re-establish the sequence of events,
is that the rating industry as it is viewed today is often differentiated between credit rating
agencies and credit reporting agencies. R.G. Dun & Co., and The Bradstreet Co., were
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reporting agencies. What differentiated the rating agencies was that they produced ratings on
securities, and this began in 1900 when John Moody founded his initial company, John
Moody & Co., which subsequently published Moody’s Manual of Industrial and
Miscellaneous Securities. Moody’s first venture would prove to be unsuccessful and he
would lose control of that company, and its name, in 1907 (although he would create the
Analyses Publishing Co. in the same year which was responsible for introducing the system
of rating fixed income securities that we are familiar with today). Moody followed this with
Moody’s Analyses of Investments in 1910 which was strongly linked to R.G. Dun & Co
(Poon, 2012, 276).
However, Moody’s’ great ‘rival’, Standard & Poor’s, has a longer history still. Henry
Varnum Poor published History of Railroads and Canals in the United States in 1860 and
would go on to form the H.V. and H.W. Poor Company in 1867 (which would later become
Poor’s Railroad Manual Company [Wilson and Fabozzi, 1996, pp. 210-211]). Henry V. Poor
would also have a very close relationship to the original Mercantile Agency (Henry’s wife
was Lewis Tappan’s niece), and it has been stated that it is very likely that Poor adopted his
business structures and rating scales from the Mercantile Agency (Poon, 2012, 276). The
‘Standard’ element of the modern firm dates back to 1906 when Luther Lee Blake founded
the Standard Statistics Bureau, which would go onto rate its first securities in 1922, and
would merge with Poor’s after Poor’s faced bankruptcy in 1941.
Whilst the reporting agencies would continue to operate at a respectable profit (R.G. Dun &
Co. and The Bradstreet Co. would merge in 1933), the rating agencies would experience
extraordinary growth in line with the explosion in the securities market (including the
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securitisation of mortgages coincidentally). It was these two factors, predominantly, that led
both the Judiciary and then the Regulators to comply with the will of the market and induct
the ratings of the agencies into the regulatory framework. However, the successes that came
with that induction were short lived, which was more than likely due to the receding of the
fervour of risk-aversion in the post-Depression era, and also the events that led up to World
War II would have negated the centrality of the marketplace in the minds of the population.
This downturn in fortunes is demonstrated in the near-collapse of Poor’s agency, and the
reorganisation that occurred throughout the sector to deal with the downturn in interest. Yet,
that downturn, one which would last throughout the so-called ‘Quiet Period’ and up until
1970, would leave a lasting impression on the agencies; never again would they allow
themselves to be at the mercy of the fluctuations that define the market place. Lewis
Tappan’s initial declaration that ‘in prosperous times [subscribers] will feel able to pay for
the information and in bad times they feel they must have it’ was soon to be rendered
obsolete, because the rating agencies, in employing the ‘by any means’ culture, would make a
decision that is perhaps the biggest reason for the Financial Crisis of 2008.
The Societal Effects of the Venal Culture: Evolution
For the decades that followed the conclusion of World War II, the rating agencies all
experienced a period of severe contraction. The confidence in the marketplace that followed
the War meant that the agencies were arguably close to extinction, as Partnoy notes: ‘the
rating agencies were struggling when John Moody died in 1958. By the 1960s, the rating
agencies employed only half-a-dozen analysts each, and generated revenues primarily from
the sale of published research reports’ (Partnoy, 2002, 70). So, if the agencies were
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experiencing such difficulty in the marketplace, how did they then go on to dominate the
market for credit like they do today; what was their ‘Panic of 1837’ moment?
That moment came in 1970, and simultaneously demonstrates for us the utilisation of the
self-concerned aspects of the culture this article has referred to, and also why we should not
differentiate when looking at the evolution of the rating and reporting industries. ‘Penn
Central’ was a conglomerate that operated primarily within the Railroad industry and its
dramatic collapse in 1970, which set the record for the largest bankruptcy at $80-82 million,
sent shockwaves through a marketplace that had been operating upon the age-old
misunderstanding that the market would not collapse. There is a common narrative in the
literature that talks of Commercial Paper, that was the primary source of financing during that
era, as being viewed by investors as “almost entirely without risk” (Hicks, 1976, 227) and
that “investors relied on name recognition as the principal criterion for issuer selection”
(Hudson et al, 2013, 175), which leaves the impression (given that the rating agencies were
facing extinction) that the investors were investing in Commercial Paper on the belief of the
creditworthiness of the issuers. However, this view is misleading because if we do not
differentiate between rating and reporting agencies we will see that the culture, as advanced
by this article, had reared its ugly head again and had negatively affected society by way of
causing a record bankruptcy (the rating agencies would go on to be defined as being involved
in almost every record bankruptcy since). This is found to be the case when we look at the
National Credit Office (NCO), which was a division of Dun & Bradstreet, the leading
reporting agency.
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Arthur D. Whiteside, who had taken a prominent role in the merger between the two original
agencies, had brought with him the ‘National Credit Office’ when he moved over to R.G.
Dun & Co., two years prior to the merger. In addition to this rating capability, Dun &
Bradstreet had acquired the stricken Moody’s Investors Service in 1962 so that it was in a
perfect position to deliver opinions on the creditworthiness of Commercial Paper issuers. In
direct opposition to the predominant narrative on this subject, an SEC investigation into the
collapse of Penn Central found that, rather than investors acting on faith, they had in fact
been acting on the information of the NCO, who had attributed its coveted ‘prime’ rating to
the Commercial Paper being issued by Penn Central (Markham, 2015, 726; Fight, 2004, 48).
The NCO was, in fact, the only national rating service of commercial paper, with the SEC
confirming that customers relied heavily on the prime rating given to Commercial Paper
issuances (SEC, 1972, 10). This fact leads to two conclusions. Firstly, the widespread
dispersal of the highest ratings of an agency, right up until the collapse in question (the NCO
had 800 outstanding in 1970), should obviously strike a chord with us after the identical
actions of the modern rating agencies in the Financial Crisis. Secondly, the notion established
earlier that the rating agencies were struggling before 1970 is, arguably, for one very good
reason, as Fight proclaims: “Who would want to run the risk of a lower credit rating when the
NCO was certain to award a Prime rating?” (Fight, 2004, 48).
Furthermore, it was not the case that the NCO had simply not foreseen the collapse. Penn
Central was a particularly lucrative source of income for the NCO, due to its popularity
amongst investors who were subscribers to the NCO (the alteration in remuneration policy
had not come into effect then – this will be discussed next), so the NCO, in demonstrating its
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engrained cultural outlook, actively aided Penn Central in opposition to its mandate of
providing a service for investors. The NCO was aware that Penn Central was using its
Commercial Paper issuances, which are short-term financing options, as if they were long-
term financing products, thus overleveraging itself. Also, there were multiple warnings of
insider trading with Goldman Sachs, which still did not affect the prime rating of Penn
Central (Mallinckrodt, 1976). Even more familiar for us today, the NCO conducted itself like
this in the knowledge that societally-important investors like pension funds were forced to
invest only in issuances that had been given a prime rating.
It may appear rather bizarre at first instance, but the call from the investing public on the back
of this betrayal was for more intermediation, albeit of a more sophisticated nature. To call for
more third-party verification after a failure of this magnitude does, however, reveal to us the
requirements of the marketplace and why, essentially, we must seek to develop reforms that
maintain the service of third-party verification rather than abandoning it as some have called
for; third-party verification drastically reduces the costs for all the parties involved in the
system.
On the rating side of the industry, the collapse of Penn Central had come at just the right time
for the agencies. If we remember that for agencies who operate on a subscriber-pays basis,
the key to their success is that their information is not duplicable. This means that for the
agencies, prior to the collapse of Penn Central, the development of the first commercially-
available photocopying machine, the Xerox 914 (Wirten, 2004, 61), was the worst thing
imaginable. Demonstrating how much of a threat this development was, Standard & Poor’s
had decided to switch to the now infamous ‘issuer-pays’ system (for Municipal issuers
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initially) in 1969, a year before the Penn Central collapse, with Moody’s switching
completely immediately after the collapse in 1970 (Naciri, 2015, 16). What the agencies had
realised, thanks to their engrained culture of ‘by any means’, was that the need for issuers to
prove their creditworthiness to investors, which had become pivotal in the wake of the
collapse, fundamentally placed the agencies in between the issuers and the investors; it is
clear then, for whatever reason, that investors in 1970 were not too concerned about the
lineage of the ratings industry and that, in fact, the people who they turned to were the very
same who had just knowingly led them into a record collapse.
So, how does the ‘by any means’ approach come to the fore here? Jiang et al provide
empirical evidence for the existence of this approach, which supports the understanding that
the agencies had learned from the events that had led to their near-demise in the late 1960s.
As Moody’s were the first agency to incorporate the change to ‘issuer-pays’ across the board
in 1970, four years prior to Standard & Poor’s in 1974, we have the unique opportunity to
view the effects of the issuer-pays system upon the ratings produced by each agency. Using a
sample of 797 corporate bonds issued between 1971 and 1978, that were rated by both
Moody’s and Standard & Poor’s, the scholars found that between 1971 and June 1974, when
Moody’s charged issuers for bond ratings and Standard & Poor’s charged investors, Moody’s
ratings were, on average, “higher than S&P’s ratings for the same bond”. During the period
in which both Standard & Poor’s and Moody’s charged issuers for the bond ratings – July
1974 through to 1978 – the researchers found that “[Moody’s’] ratings are no longer higher
than those of S&P” (Jiang et al, 2012, 2). This incredible assertion, that the rating agencies
had literally turned their backs on investors and were rewarding their new clients with
inflated ratings, should perhaps leave one in no doubt that the agencies operate on a self-
serving, ‘by any means’ basis.
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This extraordinary development was compounded when, in 1975 (the ruling was actually
promulgated in 1973), the SEC decided to incorporate the rating agencies into its regulatory
framework by way of the Nationally Recognised Statistical Rating Organisation (NRSRO)
designation, that almost entirely safeguarded the future of the industry. In the space of three
years, the rating agencies had gone from the brink of extinction, with the development of the
Xerox machine, to being safeguarded from future shocks, which is both a testament and a
stark warning of the power of the underlying culture that drives the rating industry. In
attempting to understand the requirements of the marketplace and insert themselves
accordingly, the SEC actually started the process that would lead to 2008. In 1975, the SEC
incorporated an industry into the financial regulations that was reeling from facing extinction,
that had just incorporated a remuneration system that would see its resources skyrocket, and
importantly had attached itself, in almost a parasitic fashion, to the successes of the largest
issuers in the financial system; the consequences of that decision continue to be felt today.
The Importance of Recognising the Venal Culture
This article has endeavoured to link the actions of the leading protagonists of the ratings
industry, whether that is in the form of a rating or reporting agency, to the milestone events in
that industry’s evolution. Doing so has allowed us to strip away any pretence of ‘naturalness’;
we know that the agencies adopted a ruthless ‘by any means’ approach in order to protect,
and ultimately maximise, their position. It is particularly hard to argue against this lineage of
unabated self-regard, but what does the realisation of this mean moving forward?
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Before we discuss the issue of regulating the agencies, it is important to clarify, beyond
doubt, that this culture exists and was the underlying reason for the Financial Crisis of 2008
because, without being overly dramatic, the Crisis simply would not have happened had the
agencies done their job. There are a number of aspects of the Crisis that should resonate with
the analysis in this article, and it is important to cover them. So, for example, the intimidatory
tactics used by the Mercantile Agency, and its various forms thereafter, can be seen to be the
same as Moody’s treatment of Hannover Re in 1998. Hannover Re, a large reinsurance
company, had chosen to have their bond issuances rated by Standard & Poor’s and A.M.
Best, a much smaller but specialised credit rating agency (they specialise in the Insurance
market). Moody’s, in reprisal for what they saw as lost business, decided to punish Hannover
Re by issuing an unsolicited credit rating that downgraded their status to junk, in direct
opposition to the two selected agencies’ ratings. As a result, Hannover Re’s position
plummeted and they allege that the firm lost over $175 million through the actions of
Moody’s (Klein, 2004).
There are, of course, a number of other examples that should resonate. One that should
remind us of two eras simultaneously is the agencies’ concerted lobbying approach in the
lead up to the CRA Reform Act of 2006 (McClesky, 2010, 85). The agencies fought
successfully to restrict the SEC’s interference in the methodologies that could be used
because, simply put, they intended to collude with the issuers of structured finance products
in order to maximise their position. The SEC was explicitly restricted from interfering by the
CRA Reform Act, which should echo the account of the challenging of State Legislators
earlier.
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It must be affirmed that it really was at the cost of others; this was not a victimless crime.
One clear example is the agencies’ adopting of the Gaussian Copula Formula, a system that
could at once both roughly interpret even more data than ever before (because of the
unprecedented growth in securitised product issuances) and give the issuers the desired
outcome; the agencies were not concerned with the underlying quality of the issuances, which
were built upon mass-mortgage fraud, and in some cases just unadulterated fraud, but instead
were concerned with meeting the requirements of their paying clients (Farrell, 2010, pp. 21-
27) – which should immediately draw us back to the 1970s when the agencies turned their
backs on investors to the highest bidder.
The lineage of the modern day rating agencies’ culture of venality is therefore clear to see. In
that case, the next question is how that understanding affects society moving forward. This
article has presented this chain of events for the sole purpose of showing that this industry
simply cannot be trusted to act in anyone’s interests other than its own. Regulators, and
indeed Legislators, have for too long focused on a vision of the ratings industry that simply
does not exist. A quick example of this can be seen with the Dodd-Frank Act of 2010, which
as part of its attack on the agencies made central the idea of competition. Competition, so the
narrative went, would force the existing agencies to act responsibly, through fear of lost
business, which would ultimately increase transparency, timeliness, and responsible rating
practices. However, the rating industry is what is referred to as a ‘natural oligopoly’ (Tennant
and Tracey, 2015, 53), in that increased competition will actually reduce the usefulness of the
industry to its interested parties; issuers, for example, would (more than likely) be
inconvenienced by having to select from more rating agencies, whilst their costs may go up
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because a lack of historical reputational capital displayed by new entrants in the eyes of
investors (reputational capital, as a concept, was largely diminished as a result of the recent
crisis).
So, in order to recalibrate the lenses of regulators and legislators when it comes to the rating
industry, it is argued here that understanding the underlying culture of the industry will allow
for an increased chance of regulating efficiently, rather than wasting the once-in-a-generation
opportunities for impactful regulation like the recent Crisis represented. Seeing the agencies
for what they are – venal entities that have been interwoven into the framework simply
because they lower the costs for issuers and investors – means that rather than calling for
them to be removed, which will not happen, or creating regulations which foreseeably will
not have an effect, we can finally begin to enact impactful change. There are a number of
proposals in the literature, that range from removal of ancillary service divisions to rating
pools so that there is no contact between agency and issuer, that can reduce the impact that
venal agencies have upon society. However, for that reduction to take place, an alteration
must occur in the minds of Legislators and Regulators, which is essentially the call for this
article. In a perfect world the rating agencies would be banned from lobbying elected
officials, but in the real world it is the increasing exposure of the narrative that shows the
agencies to be venal, destructive, and ultimately incapable of change, that is the first step that
must be taken.
Conclusion
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Beginning with Griffen, Cleaveland, and Campbell, and running right through the history of
the commercialised rating industry, the agencies have operated upon a completely different
basis to that imagined by Ward and Baring Brothers. With one being founded upon caution,
the other was founded upon venality. The commercialised agencies, from the Mercantile
Agency lead by the pious Lewis Tappan to the Warren Buffett-lead Moody’s of the modern
day, have all sought to conspire against anyone who may pose a threat to their existence, and
also to those that do not were profit can be made. The modern economy is built upon the
notions of self-preservation, and rightly so, but what the agencies do transcends this ideal so
that it becomes acceptable, to them, to threaten society for their own gain. Well, for this
article, that is not acceptable.
In order to reduce the destructive effect that this venal culture has upon society, this article
has endeavoured to show a lineage in the rating industry by utilising specialised historical
research that unearthed the underlying sentiment to commonly accepted moments in the
industry’s evolution. By revealing this the article aimed to contribute to an alteration in the
minds of regulators regarding who they are actually regulating. Arguably this aim was
achieved, because the article does indeed reveal the true nature of the commercialised rating
industry. However, the real issue is whether regulators are willing, or at the very least able to
make that alteration and protect society in advance of the next attack by these venal entities.
The answer to that question remains to be seen.
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