Gaming the Ratings Game
Rating agencies in the capital markets — like Moody’s credit ratings — have dominated the investing landscape for decades.
Gaining steam following the Great Depression of the 1930s, ratings agencies have always had a major impact, and still do. The high-profile August 2011 downgrades and warnings on U.S. debt by all three major credit agencies, for example, were largely responsible* for the $9.7 trillion loss in global equities for the third quarter of that year. And now that the 2012 election is over, the agencies will consider further downgrades, as American politicians struggle with how to solve the nation’s long-term debt problem.
Ostensibly, the purpose of a rating is not to sway the markets. Ratings agencies like Moody’s are simply supposed to provide credible information so that users — investors — can base their decisions on “unbiased” data. Likewise, other financial institutions, such as those that offer securities ratings of management and firm performance (like Goldman Sachs) and the ratings of a firm’s governance quality (like Institutional Shareholder Services), are also supposed to give investors “objective” assessments in these areas. Taken together, the ratings by these professional service firms (PSRs) should offer investors the ability to make decisions based on the accuracy of a firm’s credit worthiness, performance, and governance.
If only it were true in practice.
It’s well known that, prior to the 2008 financial crisis, many high ratings on corporate bonds and stocks, mortgage-backed securities, and other debt instruments were inaccurate, if not illusory.
It didn’t happen overnight. When Professor Sue Newell and I researched PSRs, we found an erosion of ratings quality over a long period of history. While the PSRs producing these ratings were initially intent on policing the integrity of their information, our analysis showed that eventually, the ratings no longer followed their stated policy of being objective and neutral, even as the PSRs continued to say they were.
Then comes the irony: Key regulatory changes** actually exacerbated the downward slide in the integrity of these ratings. And yet the ratings continued to be not only heavily relied upon but also treated as legitimate. Having become integral to the entire market system (from helping firms to grow, to avoiding legal problems, to getting insurance), these ratings served as the price of admission for companies wanting to get in.
Looking at the history, we found a five-stage process from legitimate to illegitimate analysis by PSRs:
- Initially, PSRs were established following the stock market crash of 1929 and the bank failures of 1930. Their purpose was to help maintain the functioning of the capital markets by responding to an information integrity problem.
- In stage two, these practices gradually became institutionalized across the vast network of capital markets actors with the help of various regulations. The ratings system worked and was trusted.
- Next, as the market grew further and demand for ratings skyrocketed especially during the housing boom, the PSRs’ work began to depart from their stated policies. The policing efforts became mere window dressing because the ratings did not reflect the underlying risk.
- In the fourth stage, serious and complicated complicity emerged. The rated firms, the PSRs and the regulators developed a highly interdependent coalition that opened up opportunities for collusion across the entire field.
- In the fifth, “partial repair” stage, the firms undertook small repairs — really more window dressing — that failed to correct the underlying problems among this now complicated and interconnected set of market players.
This is all part of a larger problem. The financial debacle seems to illustrate the general shift in corporate ethics over the past decade toward what is technically legal and away from what is morally right. It is in this setting that conflicts of interest are tolerated.
Of course, there is plenty of blame to go around. For decades, most investors were doing very well. Housing prices were rising, as were rates of return on stocks. It was in everyone’s interests to believe that high ratings actually reflected investments that had little risk of default.
The fact that there was virtually no attempt to delve behind the façade of the ratings, speaks to the human tendency to believe data when it confirms what we already want to believe. Human folly, in this case, wasn’t new, it just occurred on a much bigger scale.
The inter-connectedness of the financial markets will continue to make them susceptible to collusion. Knowing this, we need is a capital market ratings system that avoids collusion through stricter guidelines and clear rules of corporate conduct. Not tolerating conflicts of interest is a key step towards achieving this.
*Lindblad. C. 2011. Over rated. Bloomberg BusinessWeek, November 28 —December 4: 51 —52.
**1975 SEC designation as NRSRO, a quasi-government organization leading to birth of issuer-payer model; 1975 Securities Acts Amendment Repeal of Glass Steagall Act 1999; SEC rule change for voting and disclosing proxy votes; 2002 SOX Act
Cynthia Clark is assistant professor of management at Bentley and director of the Geneen Institute for Corporate Governance. Her research was conducted with Sue Newell, Cammarata Professor of Management and director of Bentley's PhD program.