A look at the emergence of credit scores

Business News | 19 Aug |

Bond credit ratings first appeared in the United States at the beginning of the 20th century. Capital markets had already existed for about 3 centuries. Countries such as Holland, England, and the United States possessed all the key components of a modern financial system: developed public lending, stable currency, banking system, central bank, and securities markets.

Credit Rating Invention

However, the first credit ratings for bonds were assigned by John Moody in the United States only in 1909. For most of the four-century history of modern capital markets, the issue of ratings as assessments of risk has been largely theoretical. Most bonds were sovereign, that is, issued by countries and governments that were able and willing to fulfill their obligations which investors already trusted.

When many countries in Europe and around the world adopted constitutions and representative forms of government during the 19th century, international bond markets grew in size and geographic scope. But at the time, it was mainly a sovereign debt market. Private businesses in Europe covered their external financing needs with bank loans and equity issues.

The United States was in a different position. Their economic structure was continental, the scale of infrastructure projects was quite large, and private enterprises were larger than in any other country in the world.

The U.S. Capital Requirements

The apparent need for the US capital of the 19th century was driven by the need to build railways to unify economically divided states. Despite some government support, most US railroads were organized and capitalized as private corporations.

Until the middle of the century, railroad corporations were relatively small and could finance construction and operations with banks or loans that you can get from organizations like https://directloantransfer.com/payday-loans-online/ and share issues. However, after 1850, when the railroad companies began to grow, their capital requirements also increased. They began to expand into uninhabited and undeveloped areas where the number of local banks and investors willing to finance them was limited.

The solution to the problem of financing US railroads was to develop a giant US railroad bond market: both domestic and international. The corporate bond market which was essentially a railroad bond market in its early decades can be seen as an American financial innovation that subsequently spread around the world.

Ranked Innovation by John Moody

By the time John Moody began assigning ratings to bonds, the US corporate bond market was several times larger than any other country. In a sense, John Moody’s rating innovation was a fusion of functions previously carried out by credit bureaus, the financial press, and investment bankers. It is not surprising that throughout the history of the emergence and development of rating agencies, many of them have gone through the stages of mergers with large credit bureaus and publishing giants.

A striking example is the 1962 acquisition of Moody’s Investors Service by the largest credit bureau Dun & Bradstreet. Thus, the closely related credit bureau and bond rating businesses came together under the same corporate roof. Although, they operated as independent entities. In 2000, Moody’s was sold to Dun & Bradstreet and is now owned by its own managers.

In addition, companies that were previously specialized business press often entered the rating business. This was a natural development on the basis of financial and operational information that they collected and sold. For example, the history of Standard & Poor’s began (when in 1916 the company Poor which publishes statistical compilations on the American railways) began to deal with ratings. In 1941 it merged with another information and rating company Standard Statistics forming one of the largest rating agencies in the world. In 1962, S&P was bought by publishing giant McGraw-Hill.

Developing Credit Ratings in Emerging Markets

During the 1990s, global financial markets became a particularly significant source of debt finance for many developing countries. As a result, the policy of forming portfolios of leading institutional players in these markets has had a decisive influence on the scale and structure of capital flows to emerging markets, as well as on the terms and conditions of financing in these markets. In this regard, most market participants believed that credit rating agencies, (primarily global ones) have a significant impact both on the cost of raising debt capital and on the willingness of the largest institutional investors to invest in certain types of financial instruments.

A developing country’s sovereign rating has often been seen as a prerequisite for issuing Eurobonds. In addition, the role of ratings in emerging markets is driven by rating-related regulatory requirements for investors or internal investor risk management practices based on the use of credit ratings.

Therefore, the 1990s were marked by a rapid increase in the number of ratings assigned to emerging market governments. Both Moody’s and Standard & Poor’s experienced an almost sevenfold increase in the number of sovereign ratings assigned to developing countries in terms of their foreign currency issues.

The fastest growth in the number of assigned ratings was characterized by the period from 1993 to 1997 when more and more emerging market governments began to enter the global markets with bonds and the volume of portfolio investments in emerging markets according to the IMF grew from $ 117 billion to 286 USD billion.

In the early 1990s, only 11 governments of developing countries (7 Asian countries and 4 countries of other territories) had ratings. Moody’s average rating for Asian countries in the early 1990s was A3, and it rose to A2 at the end of 1994. However, when the Asian crisis began, the average rating of these countries dropped sharply reaching Baa2 (still investment grade) at the end of 1998. The average rating of non-Asian countries in the early 1990s was B1 (below investment grade), and it gradually increased to Ba2.

After this event, uncertainty appeared in the financial markets in Russia and Brazil which led to a decrease in their average rating to the level of Ba3. Governments that received ratings in the mid-1990s generally started at the lower investment grade (Baa3). Then their ratings gradually improved until there was a significant decline caused by the spread of the Asian crisis.

The sovereign ratings of developing countries were followed by an increase in the number of ratings assigned to companies in these countries. However, most developing countries showed a low level of concentration of rated firms with the exception of fast-growing economies such as Korea and Indonesia and large countries such as China, Brazil, Argentina, and Chile.

In parallel with the growing spread of sovereign and corporate ratings in developing countries, there is growing dissatisfaction among the investment community with the quality of credit ratings from global rating agencies. Rapid and significant adjustments to the sovereign credit ratings of many emerging markets during the Asian financial crisis sparked widespread criticism of the activities of global credit rating agencies in emerging markets.

Critics accused global agencies of the fact that improvements in the sovereign and corporate ratings of developing countries in the early to mid-1990s and their rapid deterioration in 1997-1998. They introduced a cyclical element in global capital flows. First, accelerating their inflows, and then, after the development of the Asian crisis, promoting a sharp outflow.

The rating agencies could neither prevent the crisis nor accurately reflect its fundamental economic causes and prerequisites. It was also suspected that agencies were overly sensitive to short-term developments, especially during the crisis. The resulting sharp changes in ratings increased the panic in the market and contributed to the faster spread of the crisis to other regions.

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