PART 4: System-Wide Effects of Credit Rating Downgrades
I. Before 1907: From Informal Sources of Information to
1. Dominance of Informal Channels and Increasing Need for Credit Information
For almost three centuries, capital markets developed without the benefit of external credit ratings.41 In fact, in the early decades of US history, business was inherently local and therefore transactions were between people who knew each other.42 Early nineteenth-century American merchants could rely for much of their credit information on personal ties.43 This system worked well as long as trade was local or conducted by merchants who traveled and came into direct contact with suppliers and customers.
However, the nineteenth century heralded the era of industrialization. In this context, the expansion of capital markets was needed to foster the pool-ing of sufficient resources to modernize the industrial infrastructure. The scale and geographical scope of transactions increased. At the same time, credit information on suppliers about whom business merchants had no per-sonal knowledge was needed as the US population and the volume of trade increased.44 Informal channels were no longer sufficient to satisfy the rising need for information.
More particularly, the market area expanded as the construction of railroads required the allocation of significant resources.Railroad corporations were indeed America’s first big businesses, in the sense of multi-divisional en-terprises operating over large geographical distances and employing cadres of professional managers.45 From a structural perspective, only large bank-ing houses could afford to hire full-time credit agents or develop their own systems of reporting as it was too costly for other merchants.46 Moreover, the need for knowledge about distant and unknown customers stimulated several larger business houses to develop more formal methods of acquiring
41 SYLLA, An Historical Primer on the Business of Credit Rating, at 21.
42 Id. at 23.
43 MADISON, The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America, at 165 (“Country merchants from the West and South traveled to seacoast cities where year after year they purchased their goods from the same wholesalers. Even if the seller did not know a prospective buyer personally, he had available sources of information in the form of the experience and opinions of other merchants”).
44 SYLLA, An Historical Primer on the Business of Credit Rating, at 22-23 (“The crying capital need of the United States during much of the nineteenth century was for funds to build railroads, to open up and knit together an economy of continental proportions”).
45 Id. at 23.
46 MADISON, The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America, at 166.
credit information.47 Reports of higher quality could be obtained from an agent with specific responsibility for credit reporting only. Hence structural changes in the capital markets called for innovative solutions.
2. Creation of Mercantile Agencies
Mercantile agencies were the precursors of modern CRAs.48 The most im-portant immediate factor leading to their creation was the financial crisis of 1837.49 The severity of the collapse of 1837 was due in part to the inade-quacy of existing methods of gaining information. Information asymmetries were perceived as an obstacle to the reallocation of financial resources.
Merchants began to realize that one cause of the crash was inherent in the conditions that governed the granting of credit.50 Many merchants discov-ered that their trust in some of their customers had been ill-founded.51 Therefore, mercantile agencies came into existence in the aftermath of that financial crisis as a response to a need for improved scrutiny of credit risks.
The financial crisis of 1837 hit New York businessmen especially. Lewis Tappan was a New York merchant who suffered heavily from the crisis.
When the house of Tappan failed in the crisis, the credit records which Tap-pan had wisely gathered were in great demand; TapTap-pan decided to extend and elaborate his well-known records and sell them to the business world.52 In 1841 he founded the Mercantile Agency.53 The Agency sold information about the business standing and creditworthiness of US entities all over the US.
Broadly speaking, credit reporting agencies attempted to provide in a for-mal and institutional manner a service that had so far been almost exclu-sively a function of personal ties within the mercantile community.54 More-over, the business of credit reporting agencies was centered in New York.
At the time mercantile agencies expanded their coverage there were high
47 Id.
48 LYNCH, Deeply and Persistently Conflicted: Credit Rating Agencies in the Current Regulatory Environment, at 236-237.
49 HAROLD,Bond Ratings as an Investment Guide, An Appraisal of their Effectiveness, at 7.
50 BECKMAN,Credits and Collections in Theory and Practice, at 135.
51 MADISON, The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America, at 166.
52 HAROLD, Bond Ratings as an Investment Guide, An Appraisal of their Effectiveness, at 7.
53 SYLLA, An Historical Primer on the Business of Credit Rating, at 23.
54 MADISON, The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America, at 167 (also explaining that Tappan recruited correspondents across the country who submitted reports to the firm’s New York office twice a year; clerks copied them into large ledgers and read the reports aloud for subscribers who called at the Mercantile Agency’s office).
expectations about their eventual merits based on the belief that reliable reports would reduce losses by bad debts to a minimum.55
Credit reporting agencies continuously faced criticism and had to improve their practices in order to satisfy subscribers’ needs. The primary charge leveled against them was the inaccuracy of their ratings. The source of the problem can be traced back to the very beginning of the credit information process, i.e. with the correspondents who gathered the data.56 During the first half-century of their existence mercantile agencies made gradual but significant improvements in two major areas of credit reporting. First, they modified their procedures for the acquisition of information.57 Second, they also modified their procedures for the transformation of data to subscrib-ers.58 The major new service was the rating or reference book: the first ref-erence book was published by Bradstreet in 1857.59 Later, in 1868, Henry Varnum Poor started to publish his annual report on the creditworthiness of the railroads.60
Severe criticism tended to destabilize the credit reporting agencies. First, legal threats came from rated businessmen who were outraged by their commercial credit ratings.61 However, the credit reporting agencies defend-ed them well against these legal suits. The courts held that if the agencies exercised reasonable diligence they could not be held liable even if their reports were inaccurate.62 Second, there were attempts to pass regulatory legislation. This failed partly due to strong resistance from the Dun Agency.
Third, the entry of new competitors challenged the Bradstreet and Dun agencies. After attacking the established agencies, these new agencies pro-mised better service at lower rates.63 “In order to offer lower subscription rates, the cheap agencies cut the costs of gathering credit data, largely by reducing the number of middlemen.”64 However, such competition did not
55 EARLING,Whom to Trust: A Practical Treatise on Mercantile Credits, at 31-32.
56 MADISON, The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America, at 170.
57 Id.
58 Id. at 170-171 (adding that the major weakness in the mercantile agencies’ system was their low-paid, part-time correspondents).
59 Id. at 173 (stating that the agencies first published annual volumes; by the early 1870s, they published quarterly editions).
60 CHANDLER,Henry Varnum Poor: Business Editor, Analyst and Reformer; ABDELAL, Capital Rules, The Construction of Global Finance, at 167.
61 MADISON, The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America, at 177.
62 Id. at 179.
63 Id. at 182.
64 Id. at 183-184 (mentioning further that some new agencies even subscribed to an established credit reporting service and simply resold the credit information to their own subscribers).
last long due to the fact that investors preferred to pay well for reliable re-ports.65 Unreliable reports were considered useless even at discount prices.
Quality counted above everything else. Although mercantile agencies thriv-ed in the late 1800s, their reports containthriv-ed complex information and very detailed data that would eventually deserve to be distilled into more simple rankings.66