1909-1930s: Origins of the Credit Rating Industry

1. Emergence of the First Credit Rating Agencies

Security ratings were inaugurated at the beginning of the twentieth century in the light of the experience of commercial credit ratings.⁶⁷ Security rat-ings were first published by Moody’s in 1909.⁶⁸ Compared with mercantile agencies, Moody’s idea was to synthesize the complex data in the reports into a single rating symbol for each security.⁶⁹ The credit ratings applied to both stocks and bonds. The second agency to go into the business was Poor’s Publishing Company.⁷⁰ Further, in the 1920s and 1930s, Moody’s and Poor’s Publishing Company faced competition from a third CRA, the Standard Statistics Company.⁷¹ This CRA began to interpret the collected data, condensing their language into a symbol or rating.⁷² At the fourth place in the field of security ratings appeared the Fitch Publishing Com-pany.⁷³

2. Attitude of Investors to Credit Ratings

In general, the security ratings were warmly received, especially by com-mercial banks and many individual investors. However, some traders – especially those who were capable of intelligent analysis themselves –

65 Id. at 184 (adding that one type of agency that was created in the 1870s which provided more legitimate competition to the older agencies: this was the local or specialty agency, which concentrated on a small geographical area or on one line of trade).

66 See infra Part 1, Chapter 2(II)(1).

67 HAROLD,Bond Ratings as an Investment Guide, An Appraisal of their Effectiveness, at 9.

68 Id. at 12; see also ESTRELLA ET AL., Credit Ratings and Complementary Sources of Credit Quality Information, at 97.

69 PARTNOY,The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 638.

70 HAROLD, Bond Ratings as an Investment Guide, An Appraisal of their Effectiveness, at 12.

71 WEST, Bond Ratings, Bond Yields and Financial Regulation: Some Findings, at 160; ABDELAL, Capital Rules, The Construction of Global Finance, at 167 (also mentioning that in 1941, Poor’s Publishing Company merged with Standard Statistics Company to form Standard & Poor’s).

72 HAROLD, Bond Ratings as an Investment Guide, An Appraisal of their Effectiveness, at 13.

73 Id.

greeted their arrival coldly. They probably regarded the application of the ratings as a factor limiting the probable market fluctuation of the rated bonds. According to them, security ratings acted as a brake on their own speculative profits.⁷⁴

Since their inauguration as concise judgments on investment quality, bond ratings had been used widely by commercial banks and individual investors.

Financial institutions relied on credit ratings to varying degrees. The gen-eral rule seemed to be that the larger New York city institutions used the ratings merely as a check on their own findings, while the smaller and the outside banks depended on the credit ratings almost exclusively as authori-tative guides.⁷⁵ Furthermore, with respect to investment houses, the manu-als of one or more CRAs were freely displayed in the reading rooms of practically all brokerage offices or other places where customers used to congregate.⁷⁶ Insurance companies too, as well as other types of institu-tional investors, were daily consultants of the credit ratings.⁷⁷

One important factor in the growing use of credit ratings appeared to be a saving in the costs of investigation. Large institutional investors, even though they employed investment staff, did not have to employ such large departments or so many analysts as would be required if ratings were not available.⁷⁸ Among the large institutional investors the process of individual analysis – though not eliminated – was reduced by the availability of credit ratings; among the smaller institutions, the tendency to rely on credit rat-ings was more pronounced.⁷⁹ The greater change brought by the CRAs was that even individual investors could take part in the capital markets. Direct access to the capital markets seemed to improve the position of the ordinary investor. However, during this period, the chief deterrent to individual in-vestors to become subscribers to the credit ratings was apparently the cost because rating manuals were very expensive.⁸⁰

The investing community as a whole however was willing to pay for the credit ratings given the valuable information that CRAs provided. The suc-cess of the credit ratings confirmed the belief that investors did not want detailed analyses but positive statements of the relative value of investment securities.⁸¹ Even though large institutions relied on their own findings and

74 Id. at 14.

75 Id. at 20.

76 Id. at 21.

77 Id. at 22.

78 Id. at 38.

79 Id. at 39.

80 Id. at 25.

81 Id. at 35.

own analysts, they consulted credit ratings to compare their results.⁸² Smaller institutions bought rating manuals because they were dependent on credit ratings as an exclusive source of information.⁸³ The books were too expensive for individual investors but they could consult them in invest-ment houses.

3. Building Reputational Capital

During the first phase of their existence, CRAs had to provide the investing community with credit ratings of good quality in order to build reputational capital.

CRAs continued to accumulate reputational capital during the 1920s while being able to gather and synthesize valuable information.⁸⁴ In a competitive market for financial information, CRAs would issue inaccurate credit rat-ings at their peril given the low barriers to entry.⁸⁵ A CRA’ name, integrity and credibility were subject to inspection and critique by the entire invest-ment community.⁸⁶ Therefore, reputational considerations were the most important driver of CRA behavior in order to gain market share. The mar-ket for credit ratings was a competitive marmar-ket.

By the end of the 1920s the credit ratings systems and scales were well es-tablished.⁸⁷ Credit ratings were divided into different categories based on the credit quality of the rated financial instrument.⁸⁸ Even though a diver-sity of rating symbols was used, by 1930 it was possible in practice to match CRAs’ rating symbols with each other.⁸⁹

82 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 644.

83 HAROLD, Bond Ratings as an Investment Guide, An Appraisal of their Effectiveness, at 20.

84 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 640.

85 Id.

86 Id.

87 Id. at 641.

88 Id.

89 HAROLD, Bond Ratings as an Investment Guide, An Appraisal of their Effectiveness, at 75;

PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 642.

III. 1930s-1970s: Decreasing Interest in the Credit Rating