An Historical Primer on the Business of Credit Rating

Abstract

In capital market history, credit rating agencies were relatively late to appear, being less than a century old. John Moody founded the first rating agency in 1909, in the United States, which in comparison with other countries had a large private bond market and an investing class clamoring for better information. Extensive research by W.B. Hickman and others established that credit rating agencies were able to provide investors with good information on bond quality and the probability of default, but that the agencies’ record was not appreciably different from implicit ratings of public regulatory authorities and the bond market’s own ratings indicated by interest rate spreads. The paper concludes with a discussion of various rationales that have been given for the success of credit rating agencies as businesses in the United States and, increasingly, the world.

When the business of bond credit ratings by independent rating agencies began in the United States early in the twentieth century, bond markets—and capital markets generally—had already existed for at least three centuries. Moreover, for at least two centuries, these old capital markets were to an extent even ‘global.’ That in itself indicates that agency credit ratings are hardly an integral part of capital market history. It also raises several questions. W h y did credit rating agencies first appear when (1909) and where (the United States) they did in history? What has been the experience of capital market participants with agency credit ratings since they did appear? And what roles do agency ratings n ow play in those markets, which in recent decades have again become global, to an even greater extent than previously in history.

This essay explores the historical origins of agency bond ratings and the experience the capital markets have had with them in the twentieth century. T h e latter is pretty much a U.S. story until the 1970s, when the modem globalization of capital markets initiated a rerun of the U.S. story on a worldwide scale. Issues to be addressed include, in part 1, how and why the capital markets were able to function without agency bond ratings for so much their history, and why the agency rating business arose when it did. Part 2 examines the U.S. experience with agency ratings from their inception early in the century to the 1970s, with reference to the markets for both corporate and state and local governmental debt. Part 3 discusses the globalization of the agency bond rating business that has accompanied the globalization of capital markets since the 1970s, with some discussion of various rationales or explanations of the continuing importance of agency ratings in U.S. and global capital markets.