Credit-rating agencies history

Ratings of the creditworthiness of business borrowers were provided historically in the United States by two types of firms: credit-reporting agencies and credit-rating agencies. Although they performed broadly similar functions, they provided different services and are discussed separately. Early credit-reporting agencies provided information that influenced the type and amount of trade credit offered by wholesalers and manufacturers to small retailers. Creditrating agencies, on the other hand, provide standardized ratings of large borrowers who issue bonds and other marketed debt instruments.

When the Mercantile Agency was founded in New York City in 1841 by Lewis Tappan, it offered a new service to American businessmen. Before then, wholesalers, jobbers, and others seeking information about the creditworthiness of potential borrowers occasionally hired agents or sought assistance from distant correspondents who may have known something about the potential borrower’s business and personal habits. The Mercantile Agency was the first organized effort to systematically collect and collate information about thousands of scattered small businesses and provide that information to lenders in useful form. The Mercantile Agency’s efforts were novel in the mid-19th century but became a mainstay of modern business practice by the beginning of the 20th century. Despite some early legal and political concerns, the firm provided a vital economic function and became a widely accepted, nearly indispensable, enterprise. In time the Mercantile Agency faced a number of competitors—some such as Bradstreet’s represented a real competitive threat; most others did not and quickly closed.

It is generally believed that the formation of the Mercantile Agency in 1841 was a consequence of a realization on the part of many wholesalers and jobbers that the existing system was woefully inadequate. Relying on informal reports and recommendations from correspondents, wholesalers suffered significant losses as small retailers went bankrupt by the thousands during the economic downturn of the late 1830s and early 1840s. Such rapid change in the financial condition of so many businesses impressed upon merchants, especially Tappan, the need for more accurate and time information.

Tappan collected information on merchants and retailers in New York and elsewhere from reports provided by unpaid correspondents— mostly local attorneys—who ostensibly had some insights into the character and business practices of neighbors. After receiving a solicited report on the personal and business habits of merchants, clerks at the agency recorded the information in longhand in large ledgers. Subscribers to the agency’s services, considering whether to offer a small-town retailer goods on credit, could then receive the agency’s most recent report on the retailer by calling the office, where a clerk would read the report to the subscriber. The agency generated revenue by charging subscribers fees commensurate with the scale of the subscriber’s business on the assumption that larger enterprises would make more use of the service than smaller ones. Correspondents provided reports without charge because Tappan encouraged subscribers to use his correspondents as collection agents when borrowers fell into arrears.

Although Tappan may have had larger aspirations, under his leadership the Mercantile Agency principally served New York City merchants despite agreements and copartnerships with comparable firms in other cities. His partner and successor, Benjamin Douglass (1849–58), envisioned a more centralized firm providing services on a national scale. He expanded the group of correspondents to include banks, insurance companies, manufacturers, and commission merchants. Douglass also centralized direction and made branches part of the New York operation rather than semiautonomous entities. Under Douglass, the firm expanded coverage into the southern and western United States, provided some collection and direct-mail advertising services, and introduced a rating system provided in published form instead of descriptive reports available for inspection.

The last innovation was forced on the Mercantile Agency by the Bradstreet Agency, founded in 1849 by John M. Bradstreet, who in 1851 was the first to publish standardized firm ratings. Douglass and his successor, Robert G. Dun (1858–1900), initially resisted publishing the agency’s ratings, but competition by Bradstreet’s forced its hand. Dun published his first Reference Book in 1859, a practice continued long afterward. Published volumes of both firms organized rated businesses by city or town, name of businessman, type of business, and reported two code letters or numbers with one signifying the rated firm’s invested capital—the other its general creditworthiness. Dun’s earliest books rated about 20,000 businesses. By 1880, his firm rated about 800,000 and by 1900 about 1.3 million.

After 1875, credit-reporting firms matured. Routines and procedures were formalized, flow charts detailing information flows were developed, accounting practices were standardized, control was more fully centralized, pricing policies were rationalized, and new technologies were utilized. Two important innovations that significantly increased the scope and efficiency of credit-reporting agencies were the telegraph and the typewriter. The telegraph lowered the cost of collecting and disseminating information; the typewriter in collating and distributing it among branch offices. Typewriters and carbon paper quickly replaced hundreds of clerks hand-copying information longhand into bound ledgers.

Relatively little is known about the operation of either major credit-reporting firm after 1900, as no detailed history has yet emerged. Dun & Company grew increasingly international following Robert G. Dun’s death, opening 77 overseas offices. Dun’s firm merged with Bradstreet’s in 1933 to form Dun & Bradstreet. In 1962, it acquired Moody’s Investors Service and subsequently acquired a number of other firms. In 2000, Moody’s Investors Service was spun off, and the firm changed its name to D&B in 2001.

Modern credit-rating agencies play an important role in modern financial markets. Credit-rating agencies assess the default risks of corporate and governmental borrowers and issuers of other fixed-income securities, such as commercial paper, preferred stocks, bank certificates of deposit, mortgage-backed securities, and several other financial derivatives. Agencies sift through and make sense of enormous amounts of quantitative and qualitative information about borrowers to provide lenders and investors accurate and timely assessments of the risks involved in purchasing a borrower’s securities. Like the previously discussed credit-reporting agencies that developed alphanumeric codes to summarize a borrower’s likely ability to repay its obligations, credit-rating agencies developed codes to distinguish between investment-grade and lesser-grade issues.

There are currently four full-service creditrating agencies in the United States, in addition to several agencies that provide credit ratings for specific industries, such as banks and insurance companies. The earliest full-service rating agency was Moody’s Investors Service, established by John Moody in 1909. Poors Publishing Company opened in 1916; Standard Statistics Company and Fitch Investors Service in 1922. Duff & Phelps Credit Rating Agency opened in 1932 but focused on public utilities until 1982, when it expanded its ratings and became a full-service rating agency. McCarthy, Crisanti, and Maffei opened in 1975 but was acquired by Duff & Phelps in 1991. Two prominent specialized rating agencies are Thomson BankWatch, founded in 1974, which rates only financial firms, and A. M. Best, which rates the claims-paying abilities of insurance companies. Relatively little is known about the internal operations of these firms because no large-scale history has been written about any of them. Nevertheless, it is possible to piece together a basic chronology of the industry.

John Moody & Company published Moody’s Manual of Industrial and Miscellaneous Securities in 1900. Moody’s manual provided information about stocks and bonds and became quite popular. The company failed during the financial panic of 1907, but Moody formed a new business in 1909 with a new objective. Instead of collecting and publishing businesses’ accounting statistics and managerial data, his new company published a manual that analyzed each firm’s relative investment quality. He borrowed the alphanumeric rating system then in use by credit-reporting firms and became the first to offer systematic ratings. Moody’ 1909 manual concentrated on railroads, but by 1913, he included industrials and utilities. In 1914, he began including ratings of municipal bonds. By 1924, Moody’s rated nearly every outstanding corporate and municipal bond. In the 1970s, it started rating commercial paper and bank certificates of deposit. Moody’s published its first ratings of international bonds in 1981 and ratings of over-thecounter securities in 1986. The Financial Information Services division was acquired by Mergent, Inc. in 1999, which currently delivers financial services to Internet subscribers.

Although Moody’s provided the first formal credit ratings of railroads, Henry Varnum Poor was among the first to collect and publish information about the financial condition and managerial structure of railroads. H. V. and H. W. Poor’s was founded in 1867 and by 1868 was publishing, to wide acclaim, the Manual of Railroads in the United States. This and subsequent manuals provided four types of information on each U.S. railroad: line of road, rolling stock, operations and general balances, and officers and directors. In providing this information, the Poor’s provided bankers, lenders, and investors with a portrait of each railroad’s current operations and financial condition. The Poor’s company faced some early competition but had the field to itself until Moody’s published its first manual in 1909. Poor’s Publishing Company changed from simple reporting to rating in 1916. Standard Statistics Company entered in 1922, offering ratings of corporate bonds. The firms merged to form Standard &Poor’s in 1941, which was itself acquired by the publisher McGraw-Hill Companies, Inc. in 1966.

Fitch Ratings was founded by John K. Fitch in 1913 and, like Poor’s, initially published financial statistics in such volumes as the Fitch Bond Book and the Fitch Stock and Bond Manual. Between 1922 and 1924, Fitch moved into credit rating and is sometimes credited with having developed the now familiar “AAA” to “D” ratings.

Four notable factors led to the establishment and success of credit-rating agencies. The first was the growing use of the corporate form of organization and the issuance of bonded debt by railroads, public utilities, manufacturing firms, as well as state and local governments. Second, growing wealth among the middle class increased the demand for information about the riskiness of different investments. Third, existing investment banks came under fire for conflicts of interest and became less reputable certifiers of bond quality. And fourth, the First World War and the mass marketing of government bonds introduced middle America to war bonds, which increased interest in and the demand for public and private debt. With this massive growth in both the supply and demand for bonds, investors needed some way to differentiate between alternative investments by risk and return. Rating agencies provided this sorting mechanism.

Credit-rating agencies historically provided ratings of issuers without charge and generated revenues by selling publications reporting the ratings. Because the materials were easily copied, however, potential revenues were lost. An opening for changing the revenue source presented itself following the default of the Penn Central Railroad in 1970. Penn Central defaulted on its outstanding commercial paper, and concerned investors refused to roll over their holdings of other firm’s commercial paper, forcing many others into default. To assure nervous investors, issuers of commercial paper sought out and paid for objective ratings of their commercial paper issues. This new practice quickly took hold for other securities and is now standard practice in the industry.

Further reading

• Cantor, Richard, and Frank Packer. “The Credit Rating Industry.” Federal Reserve Bank of New York Quarterly Review (1994): pp. 1–26. 
• Chandler, Alfred D., Jr. Henry Varnum Poor: Business Editor, Analyst, and Reformer. Cambridge, Mass.: Harvard University Press, 1956. 
• Madison, James H. “The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America.” Business History Review (1974): pp. 164–186. 
• Norris, James D. R. G. Dun & Co., 1841–1900: The Development of Credit-Reporting in the Nineteenth Century. Westport, Conn.: Greenwood Press, 1978. 
• Sylla, Richard. “An Historical Primer on the Business of Credit Ratings,” in Richard M. Levich, Giovanni Majnoni, and Carmen Reinhart, eds., Ratings, Rating Agencies, and the Global Financial System. Boston: Kluwer Academic Publishers, 2002. 

Howard Bodenhorn