Rating the analysis in the current recession: a review of Moody's and Standard and Poor's.

Author:Dreibelbis, Steven
 
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INTRODUCTION

For financial markets to be truly efficient, information must be clear, consistent, and available. Most variations of the efficient market hypothesis assume that information is accurate and transparent. Credit reporting agencies, also referred to as debt rating agencies, primarily composed of Standard and Poor's, Moody's, and Fitch Ratings, are essential to the maintenance of efficient markets by assessing the quality of certain investments. When these ratings, which are relied upon by investors and governments alike, are erroneous, the entire economy suffers. The history and purpose of the credit reporting agencies and how these companies operate with limited accountability will provide insight into the responsibility the agencies share in the worst economic disaster since the Great Depression. While there were many organizations and

agencies to "blame" for the credit crash, the purpose of this paper is to provide a comprehensive historical context in which to view Moody's and Standard and Poor's recent role.

HISTORICAL BACKGROUND

The credit agencies' primary function is to determine the creditworthiness of the various issuers of securities. These agencies can trace their roots to the early nineteenth century during which the railroads were the first major industry of the United States and perhaps the world (Levich, Majnoni, & Reinhart, 2002). By 1832, the railroad industry began publication of The American Railroad Journal which was a highly specialized publication that reported on current events within the industry (Levich et al., 2002). Henry Varnum Poor became editor of the journal in 1849 and began focusing on investors as the target audience (Levich et al., 2002). During his tenure as editor from 1849-1862, Mr. Poor published information about the holdings of the railroads, and their assets, liabilities, and earnings (Levich et al., 2002). After the American Civil War, Henry Poor formed his own company and publication called the Manual of the Railroads of the United States (Levich et al., 2002). Poor only obtained and reported on factual information about companies which may be obtained on a company's annual report today. During the twentieth century, financial information about a company was difficult to acquire and very few understood the accounting and meaning of the reported data. It was not until 1916 that the Poor Company entered the bond rating business by analyzing various securities (History, 2006). The Poor Company began publishing its U.S. focused ninety-stock composite price index which was computed daily (History, 2006). This would become the S&P 500, a market value weighted index, which focused on the value of the five hundred most widely held companies in the U.S. economy (History, 2006). During the Great Depression, Poor's Publishing went bankrupt and was refinanced. Poor's Publishing eventually merged with Standard Statistics in 1941 (History, 2006). In 1966, The McGraw-Hill Companies, currently a dominant textbook publishing, magazine, and construction company, purchased Standard and Poor's (History, 2006).

John Moody also founded a company in 1900 that produced manuals detailing company information and statistics on stocks and bonds (Moody's History, n.d., para. 1). Moody fell victim to the 1907 stock market crash and was forced to cease operations (Moody's History, n.d., para. 2). Two years later, John Moody returned to the financial markets by offering investors an analysis of security values instead of a compilation of data (Moody's History, n.d., para. 3). During the early to mid twentieth century, analysis of companies' securities was expanded. In 1914, Moody's Investors Service was incorporated and expanded rating coverage to include municipal bonds (Moody's History, n.d., para 4).

From the first manuals ever published until the 1970s, Moody's and Standard & Poor's charged investors a fee for access to financial information--the only income received from their analysis (Moody's History, n.d., para 5). Rated companies were not charged a fee to have an analysis given on securities. Until recently, Standard & Poor's consistently lagged behind Moody's in analysis and ratings of municipalities, money market mutual funds, and bond funds. Standard & Poor's and Moody's now dominate the market for securities analysis with a combined market share of over eighty percent (Leone, 2006). Therefore, the following analysis of the credit agencies will focus on Standard & Poor's and Moody's.

RATINGS--THEIR MEANING AND MARKET

Today, credit ratings are required by individuals and institutional investors seeking to purchase fixed-income securities. All rational investors will undertake a discretionary amount of risk only if they will be adequately compensated. Ratings are now more important because low ratings may preclude institutional investors from even considering a security as a particular investment. Credit ratings are used by everyone because, to most, it signals the financial health of the issuers of securities. Issuers must use credit ratings if they want to have access to the capital markets where investors will buy securities. These ratings are designed to enhance market transparency, efficiency, and investor protection (McDaniel, 2008). Ratings standardize information for all investors and businesses alike and reduce the risk of asymmetric information. Ratings are also used because it reduces the aggregate costs of borrowing for issuers of securities and for lenders who do not have to conduct their own analysis as to the risks of an issuer. The role of these ratings has greatly increased with most investors excessively relying on them to determine which investments are safe.

According to the president of Standard & Poor's, Deven Sharma (2008), ratings on various securities only represent "an opinion about the creditworthiness of issuers and their debt". Some investors may interpret the ratings as being an accurate measure of default risk. Others may treat the ratings as insurance that the investment will not decline in value. Actually, credit ratings are "useful" but they "do not speak to the market value of a security or the volatility or its price, and, critically, ratings are not recommendations or commentary on the suitability of a particular investment" (Sharma, 2008). In other words, the ratings should not be used as a recommendation to purchase--or not to purchase--a particular security. However, some portfolio managers and investors assume that securities with the highest rating are a relatively safe investment. The rating agencies constantly attempt to limit liability by claiming the ratings are an opinion based on current information furnished by obligors (Ratings, 2008). All credit agencies make it known that an audit is not performed which may be seen as a way of not claiming responsibility for the quality of the information obtained. Despite a constant attempt to limit liability, credit reporting agencies' services rely upon their reputation of many years of experience.

The market for Moody's and Standard & Poor's analyses is dependent upon the extent to which investors trust that a proper rating was afforded to a security. The rating agencies and most practitioners claim that without the positive reputation of the agencies, the demand for rating services would decline. This is somewhat true because many investors will not demand ratings from questionable companies. Ratings are so important that Standard & Poor's brags that they predicted the collapse of the financial markets in 1929 by warning investors to liquidate all assets (History, 2006).

The government has made it extremely difficult for other companies to enter the credit analysis market. In the 1970s, the U.S. government enforced regulations so that a duopolistic ratings market with limited competition could exist (Sinclair, 2005). Rating agencies are indirectly guaranteed existence due to government regulations in a multitude of countries. Most governments, including the United States, regulate the type of investments banks and government agencies may invest in according to a security's particular rating. Since 1931, the U.S. Office of the Comptroller of the Currency has set strict, specific guidelines into what assets national banks may hold (Sinclair, 2005). The Securities and Exchange Commission (SEC) has adopted rules saying that underwriters of debt must maintain a certain percentage of securities in reserves (Sinclair, 2005). However, the rule allowed a smaller percentage for bonds "rated investment-grade by at least two nationally recognized statistical rating organizations." (Sinclair, 2005). The notion of "nationally recognized statistical rating organizations" has been incorporated into many regulations all across the world (Sinclair, 2005). Moody's and Standard & Poor's have little competition to fear and only have to be concerned about the remote possibility of government intervention which may affect operations. Because of the requirements set by governments, rating agencies are all but guaranteed a market for their analysis and should be primarily concerned about their reputation amongst the governments of the world. Some of these governments have securities that are rated by the reporting agencies. This presents a conflict of interest where these agencies rate securities from governments that effectively guarantee their existence with little interference.

POSSIBLE CONFLICT OF INTEREST

Credit rating agencies have potential conflicts of interest with the corporations that they rate. The goal of Moody's and Standard & Poor's is to make a profit and increase shareholder wealth. These companies are not intended to provide a service for the greater good; instead, their goal is to increase their own stock price--just like any other corporation. There may be a conflict of interest because companies pay Moody's and Standard & Poor's directly to render...

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