Article Preview – “Credit Rating Agencies and the Protection of the ‘Public Good’ Designation: The Need to Readdress the Understanding of the Big Three’s Output”

Today’s post previews a forthcoming article by this author entitled “Credit Rating Agencies and the Protection of the “Public Good” Designation: The Need to Readdress the Understanding of the Big Three’s Output’, to be published in the Business Law Review (the pre-published version can be found here). The article, which aims to promote another reason for why the credit rating agencies not only survived the Financial Crisis, but increased its profitability, suggests that an underlying sentiment that exists within academia and policymaking corridors fundamentally protects the agencies’ position in an ideological manner. The proposal in the article is that by a. revealing this sentiment, and b. correcting that sentiment, we can begin to build an environment whereby the regulatory, legislative, and judicial focus is aimed more accurately, so that potentially a truly effective deterrent can be established. So, with that in mind, we will examine just some of the key components to the article in this post, and draw out some of the conclusions found in the research.

The article begins by examining the notion of rating agencies being vital for the economy in detail, in order to reveal why that notion exists, and from angles it is promoted. The reason for this is that by analysing why this overriding sentiment of importance exists, where it comes from, and why it comes from those channels, we can begin to unravel the myth and position the focus on the agencies more effectively. However, at the very beginning of the article an important point is made abundantly clear: the proposition of the article, that there exists within academia especially a narrative which supports the agencies’ position is both innocent – i.e. it is not, to all intents and purposes, developed and maintain maliciously – and also not widespread – there are a number of academics who perpetuate this sentiment, but there are many who do not. The reason why this is an important clarification to make is because academics, from a number of disciplines (Economics primarily), have been accused of being complicit in the creation of the environment that allowed for the Financial Crisis to materialise – this is not suggested to be the case here; the likely scenario is that some academics have fallen into the trap of believing in the ideological version of a rating agency, rather than focusing upon the actual rating agencies, which is the crux of the article. There is a constant dichotomy between looking at the agencies as one would desire them to operate before looking at how they actually operate, which can only even lead to one outcome: mis-regulation.

After looking at this perceived importance of the agencies in terms of their usefulness to the economy, from the viewpoints of investors, issuers of debt, and also the State in the ideological stance of the supervisor of society that is centred on the marketplace (putting people’s respective political allegiances aside for one moment), the article continues by looking at this notion of ‘Intellectual Sustenance’. This term is promoted as the understanding that something underlies the position of the agencies, rather than just circumstance: and that understanding focuses on the term ‘public good’. Although it is rather crude, there is evidence in the literature of the term being used in its theoretical sense (from the ‘public choice’ school of economic thought) and the literal sense of the output being ‘good’ for society. In turn, the economic notion of a ‘public good’ is, in layman’s terms, related to the word ‘good’ as meaning a product. For a ‘public good’ to be a ‘pure public good’, it must contain two specific qualities: it must be ‘nonexcludable’ – which means that once the product has been provided it is difficult, if not impossible, to exclude others from receiving the benefit of that good; think the light from a streetlight – and it must also be ‘nonrival’ – which means that the product can be consumed by one person without detracting from the opportunity of another person to consume that same good; think algae that consumes carbon. The theory goes that it is the State’s responsibility to produce and maintain the provision of these goods because a. they are usually socially positive products, and b. a private company that serves to derive profit cannot derive profit from a good that is universally consumed without exclusion – profit is usually derived from exclusion. However, one leading theorist – Ronald H. Coase – argued that quite often the State will not be the most optimal provider of the public good for a number of reasons stemming from a lack of ability or appetite to properly fund the production of the good, to conflicts of interests against other competing pressures that any State will have to balance. To alleviate this problem, the theory goes that a ‘public-private-partnership’ will be induced whereby a private company is incentivised to provide the good by way of the State allowing for the reduction in one of the two key components of a public good. Rather than provide an abstract example to demonstrate this scenario, we have a perfect real-life example with which to do so: the credit rating agencies.

Before the late 1960s, credit rating agencies sold their ratings to investors. This system was not particularly profitable for a number of reasons ranging from an widespread amnesia within the United States that there was little need to be too concerned with ranking creditworthiness (the oft-argued reason), to rival companies undercutting their business with inflated ratings (the real reason). Before the collapse of Penn Central in 1970, the National Credit Office, which was the rating vehicle of Dun and Bradstreet – an amalgamation of two of the oldest credit reporting agencies and direct competitor to the rating agencies we know today – were busy awarding ‘prime’ credit ratings to large railroad companies in spite of being aware of an impending economic disaster (sound familiar?). The widespread faith in these ratings developed into a widespread panic once the massive Railroad company collapsed, and investors scurried to find alternative forms of creditworthiness rankings – step forward S&P and Moody’s. At the same time, however, advancement in technology saw Photocopying machines become commonplace, which fundamentally affected the rating agencies’ ability to exclude people from disseminating the rating they received in physical form – a process known as ‘free-riding’ whereby one purchases the rating and then disseminates it to others, leaving the rating agencies unable to charge those others for acquiring their products. Ingeniously, Moody’s began the process of charging issuers to be rated, on the basis that investors needed to be reassured of an issuer’s creditworthiness since the Penn Central collapse (although Moody’s did experiment with this model a year earlier). The now infamous ‘issuer-pays’ model was therefore established, with S&P following suit in 1974. Now, where the public-private-partnership comes in is with the Security and Exchange Commission’s ratification of the process in 1973 (formally ratified in 1975) when it instructed brokers that the usage of ratings needed to come from ‘Nationally Recognised Statistical Rating Organisations (NRSRO) – the agencies had been formally allowed by the State to conduct the sale of a required good in a manner where it could be compensated. Coincidentally, the State had failed to consider the effect that this systemic switch had created, with research confirming that the rating agencies substantially inflated their ratings once issuers were paying for the ratings, which flies directly in the face of this notion of the output of the agencies being ‘good’ for society. Yet, this system allows for academics to declare that rating agencies are, by economic definition, a ‘public good’, because they now tick both boxes of containing nonexcludable and nonrival characteristics – i.e. the ratings are freely available, and everyone can use them because the issuers pay for their production. However, research confirms that what is ‘freely available’, as the rating agencies themselves declare, is of such low quality in terms of content and timeliness, that the freely available ratings constitute nothing more than ‘advertising messages’ which are conveniently located behind pay-walls – something which instantly removes the ‘public good’ moniker once realised. Yet this has not stopped that categorisation being advanced; but, however, it is not the only one.

The article then provides examples of academics appropriating the public ‘good’ version of the understanding to the agencies, by stating that ratings can be considered alongside infrastructure and energy provision in terms of social usefulness. Yet, this is clearly not the case when the majority of investors are bound – both internally and latterly, officially, externally – to use them and then only factor the ratings in to a much larger statistical endeavour. Furthermore, the ‘good’ element is hard to find when we look at the investigations into the Financial Crisis which show, quite clearly, that ratings were inflated for profit, and also miscommunicated to investors for the benefit of the agencies and the issuers – which, in simple terms, means fraud and criminality. The article concludes this section by affirming that both understandings focus on a rating agency which simply does not exist in reality. The rating agencies that do exist in reality actively operate in the opposing manner to that which is described by these prevailing narratives.

Ultimately, the article’s conclusion makes the point clear that not only does this dichotomy exist, but it is actively providing a façade for the agencies to operate behind and, to be clear, they are hiding behind it. In order to rectify the problem of the rating agencies, there are a number of actors which must play their part. Legislators and regulators must be fearless in their pursuit of justice against such obvious, disrespectful, and widespread fraud – whether or not $2 billion in fines does this is another story and, in my forthcoming book Credit Rating Agencies and Regulation: Restraining Ancillary Services, I argue that it does not come close. Yet, scholars have their own role to play, and almost as one that role must be played emphatically. It is now important that the perception of rating agency regulation is fundamentally altered so that whenever the words ‘credit rating agencies’ are used, a clear definition of whether one is referring to the ideological and generic rating agency, or a real-life agency accompanies the analysis. The reason for this is clear: policy makers rely upon this theoretical background to make decisions, arguably, and credit rating agencies have proven, beyond doubt, that the credit rating industry is no place for ideology. We all must be emphatic and consistent when we speak of the rating agencies and proclaim them to inherently self-interested, venal, and ultimately societally-hazardous. There can be no room for the argument that their corporate bond ratings are consistently accurate because bubbles are often caused by financial instruments like that witnessed in the 1980s, 1990s, and predominantly in the 2000s (looking at the lead-up to the Great Depression, one will see the overwhelming presence of ‘securities’ there too) – only by consistently making it clear that these agencies cannot be trusted to put anyone before their interest, in any form, can effective regulation be imagined and ultimately implemented.