Last month was a quiet watershed in debt capital market history, reversing the decades-old, untrammeled legal privilege of rating agencies to express their credit views.
Superficially, the cases were very different—one in Hong Kong involving emerging market corporate research, another in the state of California involving a highly structured money market type investment—but both featured substandard credit information and spillover volatility into related, non-credit markets. The essence of the California case was whether ratings are automatically protected by the American Constitution, even if negligently produced. In a nutshell, the California courts said “no.” The essence of the Hong Kong case was whether its securities regulator, the SFC, had jurisdiction over credit research published by the agencies it licenses. In a nutshell, the Hong Kong Tribunal said “yes.”
On March 9, 2016, Moody’s Investors Service agreed to pay $130 MM to settle a 2009 $1 billion lawsuit by the California Public Employees’ Retirement System (CALPERS) against Moody’s, S&P and Fitch Ratings, for willful negligence in departing from its documented conservatism in assigning high ratings to loss-making short-term paper that CALPERS invested in. Separately, on March 30, the Hong Kong Securities and Futures Appeals Tribunal (SFAT) fined Moody’s HKD 11 MM for breaching Hong Kong’s Rating Agency Code of Conduct when it published “Red Flags for Emerging-Market Companies: A Focus on China.” This was an exploratory approach piece on corporate governance lapses. It followed closely on the heels of Carson Block’s expose of Toronto-listed Sino Forest, seemingly a “me-too” move, but one that seriously disrupted the market for the Hong Kong-listed red chips referenced in it.
How ratings fail investors is a side of this business I know more about than I ever intended to. In 1976, I came to Hong Kong to teach at the Chinese University of Hong Kong before following in my Dad’s footsteps back to law school. Ironically, it was in Hong Kong’s ubiquitous wet markets that I saw firsthand how exchange improves the lives of informed parties on both sides of the trade. I learned that trading is a game where one must defend one’s face, i.e., never accept less than full value for money. Holding the “red snapper” (HKD 100 bill) I learned to speak the language of the game in Cantonese. By playing, I learned to love the game, and Cantonese. That is also how I decided against a profession where one side’s win is inevitably the other’s loss.
Back then, Hong Kong’s wet markets were a reasonable paradigm for credit markets, but in the 1980s banking changed forever. The full story of transformation is long and complex; but an important milestone was the creation of a special class of rating agency under U.S. securities law, the Nationally Recognized Statistical Rating Organization (NRSRO), which Moody’s and S&P still dominate. Ratings by NRSROs qualified asde facto credit risk measures for bank regulators to set capital levels on banks and broker-dealers in the U.S.. Under Basel, they set capital levels for the world. This goes a long way towards explaining their approximate 95% market share and Moody’s reported revenue of $3.5 BN in 2015.
Credit analysis is a subtle discipline that requires a player’s understanding of financial games. The beauty of the NRSRO system on paper was its reliance on expert judgment instead of rules. But there was trouble in paradise. Following Bretton-Woods, banks acquired a freedom to create money via lending rivaling that of the emperors of yore. Credit ratings curtailed their freedom, not to mention profits and bonuses. Senior spokespeople for the newly minted NRSROs lobbied for constitutional speech protections, which the U.S. government granted. Bit by bit, protected speech morphed into a seemingly impenetrable wall against liability, not just in the U.S. but all ratings-dependent capital markets.
Every institution that borrows, from small towns to universities to large corporations, has had to tiptoe around rating agencies: they wield the power of the downgrade. There is no “commercial court of appeal” in the form of competition because the market is sewn up. That is how NRSROs’ impenetrable legal defense created an impenetrable commercial moat.
No one in the market has ever believed a newcomer could compete shoulder-to-shoulder, and everyone has feared the association with change. More than anything else, fear and ignorance have made NRSRO’s absolute financial power self-fulfilling. This is a perspective I did not have while working as a Moody’s analyst in the 1990s, when I took the power of the brand for granted. It is something I learned when I founded a yet-to-be licensed credit rating agency in 2000. In reality, the NRSROs‘ only real absolute power is the power of intellect, which they traded away years ago for shareholder returns.
And that is why these two events are a watershed in debt capital market history. Only when the rating agency duopoly begins to be held accountable to standards of objectivity and neutrality does competition in this antiquated market stand a chance.