The Legitimacy of Credit Rating Agencies in the Bond Market

254 Pages·2017·2.81 MB·English

The Legitimacy of Credit Rating Agencies
in the Bond Market

Hsueh Chen-hua

Department of Sociology
Tunghai University
June 2017

A dissertation submitted for the degree of
Doctor of Philosophy
Table of Contents

TABLE OF CONTENTS………………………………………………………...... I
LIST OF TABLES AND FIGURES ………..…………………………………….. VI
GLOSSARY……………………………………………………………………..... VII
ABSTRACT……………………………………………………………………..... VIII
DECLARATION………………………………………………………………...... X
ACKNOWLEDGMENTS………………………………………………………… XI

CHAPTER 1: INTRODUCTION…………………………………………….... 1
1.1 STORIES AFTER 2008 FINANCIAL CRISIS…………………………… 1
1.1.1 Settlements of Banks……………………………………………………….. 2
1.1.2 Aftermaths about Credit Rating Agencies..………………………………… 6
1.1.3 Settlements of Credit Rating Agencies…….……...………………………... 10
1.2 RESEARCH QUESTIONS……………………………………………….... 17
1.3 RESEARCH PURPOSES…………………………………………………... 18
1.4 POTENTIAL CONTRIBUTIONS………………………………………..... 19
1.5 STRUCTURE OF THE THESIS…………………………………………… 20

CHAPTER 2: LITERATURE REVIEW……………………………………..... 21
2.1 GENERAL REVIEW………………………………………………………... 21
2.2 A HISTORICAL PERSPECTIVE………………………………………...... 25
2.3 MANIFESTATION OF THEORETICAL CONCEPTS..……………......... 31

CHAPTER 3: METHODOLOGY……………………………………………… 36
I
3.1 CASE STUDY METHOD…………………………………………………… 37
3.2 CRITICAL DISCOURSE ANALYSIS……………………………………... 38
3.3 INTERVIEWS……………………………………………………………...... 39

CHAPTER 4: FROM COMMERCIAL TO FINANCIAL CREDIT………… 41
4.1 THE FORMATION OF CREDIT………………………………………….. 41
4.1.1 The Meaning of Credit……………………………………………………… 41
4.1.2 Credit between Fifteenth and Eighteenth Centuries……………………........ 44
4.2 COMMERCIAL CREDIT…………………………………………………... 47
4.3 PUBLIC CREDIT…………………………………………………………… 54
4.4 FINANCIAL CREDIT………………………………………………………. 64

CHAPTER 5: CASE STUDY OF BANKING FAMILIES…………………..... 67
5.1 THE MEDICI………………………………………………………………... 67
5.1.1 Background………………………………………………………………...... 68
5.1.2 Banking Business…………………………………………………………… 70
5.1.3 Credit and Information……………………………………………………… 71
5.1.4 Summary…………………………………………………………………….. 74
5.2 THE FUGGER……………………………………………………………...... 75
5.2.1 Background……………………………………………………………….…. 77
5.2.2 Banking Business…………………………………………………………… 78
5.2.3 Credit and Information……………………………………………………… 81
5.2.4 Summary……………………………………………………………………. 84
5.3 THE BARING………………………………………………………………... 85
II
5.3.1 Background……………………………………………………………….... 86
5.3.2 Banking Business…………………………………………………………… 87
5.3.3 Credit and Information……………………………………………………… 88
5.3.4 Summary……………………………………………………………………. 93
5.4 THE ROTHSCHILD……………………………………………………….. 94
5.4.1 Background……………………………………………………………….... 95
5.4.2 Banking Business…………………………………………………………… 96
5.4.3 Credit and Information……………………………………………………… 99
5.4.4 Summary……………………………………………………………………. 105

CHAPTER 6: DEVELOPMENTS OF THE BOND MARKET……………… 109
6.1 FUNDAMENTAL CONCEPTS OF BONDS……………………………..... 109
6.2 KEY DEVELOPMENTS OF BONDS……………………………………… 112
6.2.1 Bond Trading in Italian City-States……………………………………......... 113
6.2.2 Development of Bonds in Netherlands……………………………………… 115
6.2.3 Development of Bonds in Britain…………………………………………... 118
6.2.4 Development of Bonds in the U.S……………………………....................... 121
6.3 EURO-DOLLAR AND EUROBOND MARKETS……………………....... 124
6.3.1 Euro-dollar Market as an Off-shore One…………………………………..... 125
6.3.2 Historical Background of Euro-dollar Market………………………………. 126
6.3.3 Eurobond…………………………………………………………………..... 129
6.4 MARKET EXPANSION……………………………………………...…....... 131
6.4.1 Factors for Market Expansion………………………………………………. 131
6.4.2 Some Trends in the Current Market………………………………………… 136
III
CHAPTER 7: DEVELOPMENTS OF CREDIT RATING AGENCIES…….. 141
7.1 INFORMATION MATTERS……………………………………………...... 143
7.1.1 Information in Research…………………………………………………….. 145
7.1.2 Information in Trading Context……………………………………………... 147
7.1.3 Information as Core of Credit Rating……………………………………….. 149
7.2 DEVELOPMENTS OF CREDIT RATING………………………………... 150
7.2.1 From Personal Information to Financial Statements………………………... 151
7.2.2 From Amateurs to Professionals…………………………………………...... 154
7.2.3 From Verbal Messages to Publications…………………………………….... 158
7.3 ESTABLISHMENT OF CREDIT RATING AGENCIES……………......... 162
7.3.1 Establishment of Dun & Bradstreet………………………………………..... 163
7.3.2 Establishment of Big Three………………………………………………..... 166
7.3.3 Ratings from Big Three……………………………………………………... 172
7.4 LEGALLY DEFINED CREDIT RATING AGENCIES…………………... 174
7.4.1 Rating Requirements from OCC…………………………………………..... 175
7.4.2 Capital Requirements from SEC……………………………………………. 177
7.4.3 Identifications from NRSRO……………………………………………....... 179
7.5 DOMINANCE OF BIG THREE………………………………………….... 182

CHAPTER 8: DISCUSSIONS AND CONCLUSIONS……………………….. 187
8.1 DOMINANCE OF CREDIT RATING AGENCIES………………............. 187
8.1.1 Practical Impacts from Credit Rating……………………………………..... 188
8.1.2 Dependence from Investors……………………………………………….... 191
8.1.3 New York City as the Core of CRA………………………………………… 192
IV
8.2 LEGITIMACY OF CRA’S…………….......................................................... 199
8.2.1 Traditional Legitimacy of Dominance……………………………….……... 199
8.2.2 Legal/Rational Legitimacy of Dominance………………………..………… 208
8.3 CHANGES IN FORMS OF THE SOCIETY……………………………… 215
8.4 LIMITATIONS AND FUTURE DIRECTIONS ..……................................. 221
8.5 CONCLUSIONS ..…….................................................................................... 226

NOTES…………………………………………………………….……................ 231
REFERENCES………………………………………………………………….... 243
APPENDIX Interview Questions……………………………………………….... 260
V
List of Tables and Figures

Number Page
Table 1. Payments of Settlements between DoJ and Banks after 2008 Crisis 5
Table 2. Payments of Settlements of CRAs after 2008 Crisis 16
Table 3. Commercial Credit vs. Financial Credit 64
Table 4. NRSROs in Some Years 180
Table 5. Breakdown of Credit Ratings by Category in 2015 183
Table 6. Percentage of Total Reported NRSROs’ Revenue in 2015 184

Figure 1. Milestone of $100 Trillion in World Bond Market 132
Figure 2. Volume of International Bonds between 1970 and 1977 133
Figure 3. Railway Mileages between 1850 and 1990 166
Figure 4. Stock Prices of Moody’s 185
Figure 5. Portions of Different Types of Securities rated by CRAs 186
Figure 6. Population Growth in the U.S. between 1790 and 1920 195
Figure 7. Territory Expansion in the U.S. between 1790 and 1920 195
Figure 8. Occupational Distribution of Jewish, 1621-1977 225
Figure 9. Explanation for Claim Making 228
VI
Glossary

CalPERS The California Public Employees’ Retirement System
CDO Collateralized Debt Obligation
CDS Credit Default Swap
CMBS Commercial Mortgage-Backed Securities
CRA Credit Rating Agency
DoJ The U.S. Department of Justice
Fitch Fitch Ratings Inc.
MBS Mortgage-Backed Securities
Moody’s Moody’s Investors Service Inc.
NACM National Association of Credit Men
NRSRO Nationally Recognized Statistical Rating Organizations
OCC Office of the Comptroller of the Currency
RMBS Residential Mortgage-Backed Securities
SEC The U.S. Securities and Exchange Commission
S&P Standard & Poor’s Global Ratings
The Fed The U.S. Federal Reserve System

VII
Abstract

The world has suffered from a recession since the 2008 financial crisis which
made countless investors worldwide lose a huge amount of money. After this trauma,
some legal settlements were made between governmental organizations and banks or
credit rating agencies. Credit rating agencies remain influential and even grow more
powerful although collapses or reshuffles happened to several gigantic investment banks.
The puzzles of the dominance of credit rating agencies, particularly in the bond market,
triggered this research.
While most researches focus on the impacts of credit rating agencies from a
business or a marketing viewpoint, this thesis targets at the legitimacy of credit rating
agencies from a historical and sociological perspective. Besides, while researchers who
discussed the historical background of credit rating agencies tend to treat the
establishment of The Mercantile Agency in 1841 as the inception, this thesis, by
contrast, claimed that the origin of credit rating agencies needs to be traced back to a
much earlier era—at least three centuries before that—since some banking families had
started to deal with credit in essence.
The main research methods consist of case study, critical discourse analysis and
interviews. In this thesis, four cases of banking families—the Medici, the Fugger, the
Baring, and the Rothschild—were studied in terms of the way they handled credit and
then were compared with what is carried out nowadays by credit rating agencies, mainly
the Big Three—Standard & Poor’s, Moody’s and Fitch. Theoretically speaking, Max
Weber’s arguments about legitimation of domination—both traditional legitimation and
legal/rational legitimation—were adopted to explore the legitimacy of credit rating
agencies via critical discourse analyses. In addition, via interviews with bond traders,
VIII
the connection between academic discussions in this thesis and practical experiences in
the trading context is thus enhanced.
This research found that, first, after the comprehensive review of the four banking
families in terms of credit and information, what they conducted actually was similar to
what credit rating agencies function in the modern era. Yet, no term such as credit rating
was used back to several centuries ago, partially owing to the linguistic unavailability.
Thus, the origin of credit rating agencies is argued in this thesis to be as early as the
fifteen century instead of the nineteen century claimed by most researchers. Second, the
creation of credit rating agencies should not be taken for granted; their long-term
historical background and rational developments contribute to their legitimacy as well
as dominance in the global financial market. Last but not least, the developmental
process of credit and credit rating agencies unveils the changes in forms of the society,
shifting from a traditional society into a modern society based on specialization and
professionalism.
With this thesis, it is expected that readers can get access to credit rating agencies
with historical understanding and rational judgment. Furthermore, the trust on credit
rating agencies can truly be regained.

Key words: credit, rating, credit rating agency, legitimacy, dominance

IX