Rating the Ratings: How Rating Agencies Dismiss Kantian Ethics
Last week in the Wall Street Journal, there was an article about how bonds of Exxon Mobil and Johnson and Johnson are trading with yields below those of comparable Treasurys. This is an indication that investors believe these Exxon and J&J bonds are safer than US Treasurys. The article indicated that if this trend continues, the country could face its second credit-rating downgrade following Standard & Poor’s cut below triple-A last year (McGee). After reading this article, I began questioning how credit rating agencies evaluate credit scores. How ethical and reasonable is this process? I understand that value of having a letter rating to give investors’ confidence in what securities they are about to involve themselves with, but how does one define that security of debt by a simple letter? I will research the history and background of credit-rating agencies and identify the ethical reasoning of these scores with Kant’s deontological theory.
History and Background
Credit ratings offer investors information from a third party that assists them in determining whether issuers of debt and securities will be able to meet their debt obligations with respect to those securities. Credit ratings are usually evaluated on a letter scale: AAA, AA, A, BBB, BB, B, CCC, CC, C, D. The lower the letter rating is, that higher chance of the investment defaulting. Credit rating agencies provide investors with objective analyses and of companies and countries that issue securities (Gagliano).
The ideas of giving securities a rating started in the 1900s with John Moody. In 1900, John Moody published “Moody’s Manual”. The manual contained straightforward statistics and general information about all the stocks and bonds from various businesses and industries. After the stock market crash of 1907, Moody released a second publication in 1909 entitled “Moody’s Analyses of Railroad Investments” which added more analysis of the previous securities information and provided a value of the stocks (Kiviat). Moody and his railroad bonds analysis led not only to one of the most used tools in the investments world, but also led to the creation of more agencies ready to critique and grade any debt from corporations accounts payable to countries’ ability to pay debts.
The next publishing came from Henry Varnum Poor when he started to sell his publishing of bond ratings entitled “History of Railroads and Canals in the United States” to investors in 1916. Later Poor would collaborate with Standard Statistics in 1941 to become what we know today as Standard and Poor. Another big player in the creating of credit ratings was John Knowles Fitch when in 1924; Fitch introduced the AAA through D rating system that has become the basis for ratings throughout the industry today. It later became the global measure of rating securities and bonds.
Even with all these publications coming out, the use of these private rating agencies was not truly warranted until the market crash in the 1930s. Investors and federal regulators made use of these private rating agencies and their evaluations of the securities and debts of the third party issuers until the 1970s. In the 1970s, these rating agencies found that they could make a much larger profit if they changed their practices by charging issuers of investment products to be given a credit rating. After the rating agencies new business model, the Securities and Exchange Commission in 1975 issued a list of “nationally recognized statistical ratings organizations” for issuers to use since the SEC made it a necessity to have a credit rating if you want to issue investments. Today there are a total of three NRSRO’s: Standard & Poor’s, Moody’s, and Fitch Group. The increased demand for ratings services by investors and securities issuers combined with increased regulatory oversight has led to growth and expansion in the credit ratings industry (Kiviat).
The Great Recession
One of the case studies we went over in class (Subprime Meltdown) gives great insight to how the Great Recession came into existence. Let me take the time to inform the reader that my knowledge of financial jargon is slim, so I will try my best to explain what information I took away from the case. From the Subprime case, the basis of the recession came from the creation of CDOs in the early 2000s. Collateralized debt obligations are investment products that bundle different loan debts, both corporate or consumer, and sell these bundles, or trenches, to investor who then can collect on the debt. Legal CDO entities were held and created by investment banks where they could bundle all their mortgage-backed securities into a CDO. Private label MBSs were obligations to packages of mortgages and then distributed to the borrowers who received the interest and principal of those mortgage loans into different classes of bond “trenches” (Gagliano).
Although all three of the rating agencies had the capacity to evaluate MBSs, issuers never purchased ratings from all 3. In 2000, Moody’s was criticized for being too tough and conservative with their rating methods and that they did not properly reflect the market’s products. At that time of criticism, Moody’s only rated 39% of all issuers while the S&P had 87%. However, after much PR and creating better relations with issuers, Moody’s issued a new set of rating guidelines and in 2001 had 64% of issue deals (Rotemberg).
The evaluation of the CDOs was a complex formula for investors and left them unsure in their own due diligence of the level of risk. Rating agencies kept consistently grading these bonds at their highest AAA rating allowing investors to know these investments were at the highest level of safety. Because of the MBSs that had high ratings to begin with were being held within these secondary mortgage market investments, the CDOs were assumed to be safe products. NSRO’s were simply rating bundles that already had been rated. The creation and demand of sub-prime mortgages and CDOs increased after the AAA ratings by investment banks and mortgage brokers in the 2000s. Quantity and short-term benefits fueled the growth of the CDO market. Investors were not concerned with the quality of the CDOs since the quantity was where the profits came from (Jarrow). The rating agencies led normally savvy investors, such as Merrill Lynch and Bear Stearns, not to do their own due diligence on these products which would later result to the Great Recession.
In 2007 began the increase of foreclosures backed by subprime mortgages. As these mortgages started to default at a fast rate, it became harder to see CDOs and MBSs even if they still had the AAA rating. When the rating agencies started to get heat for their ratings during the subprime boom, they resisted to believe they misrepresented the ratings. On September 2007, Vickie Tillman, VP of S&P, made a testimony in front of a Senate panel saying “Our reputation and our track record are the core of our business”. Moody’s and S&P’s argument was that historical default rates on highly rated MBSs were lower than those on the same rated corporate bonds. They also made the argument that they employees that assign the ratings have no role in the discussion of the fees with the issuers of the products. The also blamed the quick downgrading of ratings in late 2007 was caused by the poorly written subprime mortgages in 2006 (Rotemberg).
The Ethics of Rating
When seeing how the rating agencies conducted their SEC granted powers leading up to and after the Great Recession, one must consider where their motives lied in the midst of the downward falling ratings in 2007. In the Kantian approach to business ethics, we have to who did the rating agencies have a duty to and what duty do they owe them (Bowie)? The rating agencies were granted a license of sorts by the SEC to basically do a job the SEC did not want to do anymore (Partnoy). So these NRSROs are now governmentally approved and then became the official arbiters of what is safe for long-term investing. Many different industries, such as mutual funds and insurance companies, have strict regulations that rely on the rates that these NRSROs create. So to answer the first part of the Kantian question, the rating agencies have a duty to the industries that legally rely on the accuracy of the ratings of certain investments. The duty that they owe the particular industries that rely on ratings is proper allocation and evaluation of investment products.
Another part of Kantian ethics is the Categorical Imperative. This is the deontological argument that your duty must be universal, respectful, and the ability to make a rational, informed decision. The rating agencies abused their authority to rate investment products. They allowed the mass creation of CDOs even when the rate agencies could not completely calculate the complexity of what these products were. The NRSROs also took advantage when creating more of a business for themselves. Since issuers were making more CDOs that needed to be rated, the rating agencies had more products to receive fees from the issuers. Since the NRSROs dominate the world of rating, it is difficult to decide if what they were doing was universal since at the time it was benefiting the issuers who now had AAA rated CDOs. It is easier to say that in the long run they were not respectful to the big banks whose normally conservative investors were misled and they were also not able to make a rational, informed decision since the formula in calculating the CDOs was over their heads. In general, the rating agencies during this Great Recession did not follow the Kantian business ethics.
In the past, there have been times when corporate bonds have been perceived as safer investments over US Treasurys. None of the incidences, however, last long enough to see an immediate impact. It would be interesting to see if the US will fall a second time, representing the idea that America’s ability to pay back its debts has become an even riskier idea. The Treasury has an unlimited printing press and will always be demand historically, so are rating agencies becoming very conservative after the questioning of their methods during the Great Recession? I think that the rating agencies are trying to make up for their lack of credibility and are fearful that people will eventually try to find a new way of grading. An NPR article came out after the first rating downgrade of the US. They interviewed Frank Partnoy, the author of FIASCO: Blood in the Water on Wall Street, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, and The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals. Partnoy’s response about the new Dodd-Frank law was this:
“The challenge has been for regulators to come up with some substitute. … There’s some pressure for a proposal that I’ve advocated for a while, which is to rely on market prices, to look at the markets as one reference point for deciding whether or not something is creditworthy so that you reflect information and wisdom from a variety of market participants.”
Instead of punishment to rating agencies, we should find an alternate way of rating investments in a way that is universally acceptable with rational and informed decision making.