How The U.S. Gave S&P Its Power

Who gave S&P the power to kick sand in the face of the U.S. government?

Oh, right. It was the U.S. government.

"There's some ironies, shall we say, in all of this," says Lawrence J. White, a professor at NYU's Stern School of Buisness.

The story goes back to the rise of the railroads in the 19th century.

Before then, most loans were pretty simple. You loaned money to a business and, at least, you knew where the store or factory was. But putting railroads across the continent required the kind of capital that was unheard of at the time. They needed investors who were literally sending your money out into the wilderness.

"There were a lot of railroads out there," White says. "And investors wanted to know , who are the guys who are likely to pay me back?"

Enter Henry Varnum Poor. In 1860, he published a giant book of nothing but financial details of railroads. Finally, there was a way to start to make sense of the industry.

In 1909, another famous name , John Moody, jumped into the railroad reporting business, too. He was the first one to use those letter grades. He was followed by Fitch. Standard joined up with Poor.

Pretty soon, they started branching out.

"By the 1920's, the stock market is booming," White says. "There is this need for more and more information on the part of lenders, who is a good risk and who is not."

But back then, the rating of a loan was just a service that investors payed for. It didn't have the make-or-break power that it has today.

The U.S. government changed all that.

After the stock market crash of 1929 and the start of the Depression, the U.S. government started to regulate the health of the banks. Part of that was monitoring the quality of the bonds that banks invested in.

And here's the catch: The government said the bonds had to be rated by one of these private agencies, according to White.

"It was outsourced," he says. "It was delegated to this handful ... of third-party, private-sector rating firms."

For decades, the rating agencies did a pretty good job of separating the good loans from the bad, White says.

But the business started to change in the late 1960s. Instead of charging investors, the rating agencies started to take money from the issuers of the bonds. White blames the shift on the invention of "the high-speed photocopy machine."

The ratings agencies were afraid, he says, that investors would just pass around rating information for free. So they had to start making their money from the company side. Even this seemed to work pretty well for a long time.

In the scandals of the past decade, though, the rating agencies fared more poorly. They largely missed Enron's impending bankruptcy. They gave AAA ratings to too many subprime mortgage securities.

In the aftermath of the crisis, Congress even passed legislation ordering regulators to stop relying on the rating agencies as much as they used to. But it's hard to undo decades of special status, and the regulators are still trying to figure out how to stop relying on ratings.

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