John Moody published the first Manual of Railroad Securities in 1909. This manual consisted of ratings on 200 railroad companies and their securities. Moody took this complex bond data and simplified it down into a single letter rating ranging. Investors jumped at the chance to purchase a list of these securities broken down by risk, cutting down on some of the work these investors would have to do. Over 100 years later, Moody’s Investors Service now does $2.7 billion in revenue and clears $690 million in net income each year. Together with Moody’s, Standard and Poor’s Financial Services, a subsidiary of McGraw Hill Company, and Fitch Group, jointly owned by The Hearst Corporation and Fimalac SA, are responsible for over 95% of all ratings issued by certified rating agencies.
These credit rating agencies, or CRAs, have a task that is simple by description, but complex by nature. “The purpose of credit rating agencies is to help pierce the fog of asymmetric information by offering judgments…about the credit quality of bonds that are issued by corporations, US state and local governments, ‘sovereign’ government issuers of bonds abroad, and (most recently) mortgage securitizers. (White 2010)” In short, CRAs judge the probability of a bond’s default through numerous factors while employing complex models, and assign a level of risk associated with that bond.
For the hundred years following rating agencies’ creation, they have been riddled with problems of perverse incentive, inaccurate information, and a monopolistic nature. The 2008 crisis merely exacerbated their issues and has called for change. My white paper proposes solutions that can potentially be supported by both sides of Congress. Without immediate and effective solutions, credit agencies can easily be a contributing factor to the next financial crisis as well.