Passing Judgement: A History of Credit Rating Agencies
Part 1: Formation
Credit rating agencies can be useful institutions as ideally they allow lenders to know the likelihood of a borrower repaying loans or if they should even be loaned to at all In the current era, though, such agencies now have global power and can effect economies the world over, most notably with the 2007 financial crisis where bundled mortgages that were junk received AAA ratings.[1] Given that, it would be prudent to understand their history, how they operate, and the effects that they have had historically and currently, especially as a new financial crisis may be looming.[2]
Credit scores began to form somewhat in the 1800s due to the risks of borne by creditors. This led to several attempts to standardize creditworthiness.. One of the most successful experiments occurred in 1841 with the formation of the Mercantile Agency, founded by Lewis Tappan. Tappan wanted to "systematize the rumors regarding debtors' character and assets,"[3] utilizing correspondents from around the nation to acquire information, report back, and then organize and disseminate that information to paying members. Yet, this was done in response to the Panic of 1837, an economic calamity that would have wide-reaching effects not only for Tappan, but the nation as a whole.
The First Bank of the United States
Before delving into the Panic of 1837, there needs to be an examination of The Bank of the United States [BUS], as it set in motion events that would create the Panic.
Alexander Hamilton was the Treasury Secretary under President Washington at the time the idea of a national bank was being floated, with a report being done on the matter in 1790. He supported the creation of a government bank on the grounds that it would allow for the US to ascend economically and therefore politically on the international stage.[4] This didn't come out of thin air, however, there was some precedent regarding such a bank, found in the Bank of North America, established in Philadelphia in 1781.
Hamilton was primarily concerned with the fact that the Bank of North America "had made money for its investors and [had] operated under a charter granted by the Continental Congress, whose funds had made its establishment possible,"[5] yet, there were severe issues with the bank that would be a foreshadowing of the problems to come decades later, mainly regarding speculation. While the bank enjoyed support from businessmen, farmers were staunchly opposed to it as not only were they forced to deal with high interest rates on loans, which could range from 16 to as high as 96 percent annually, but there was also criticism of the bank being rather flagrant in loaning out money for land speculation.
In Congress, debates began over the question of creating a national bank. James Madison, representing Virginia's 15th district, argued that the entire idea was unconstitutional as he couldn't find anywhere in the Constitution which allowed Congress to grant charters or borrow money. Strangely enough, he had previously proposed an amendment to the Article of Confederation which explicitly noted implied powers. His amendment read
A general and implied power is vested in the United States in Congress assembled to enforce and carry into effect all the articles of the said Confederation against any of the States which shall refuse or neglect to abide by such determinations.[6] (emphasis added)
This was a rather serious about face on the issue for Madison.
Massachusetts Congressman Fisher Ames countered those who were against the bank by echoing the findings of Hamilton's report, "that the bank would improve commerce and industry, [insure] the government's credit, [and aid] in collecting taxes." He "saw no purpose in the power of Congress to borrow if the agency of borrowing was not available and if the power to establish such an agency was not implied."[7]
Opposition to the bill proved in vain and it passed Congress and was signed by President Washington, being approved for a 20 year charter, until 1811.
During its initial run, the bank's purpose was to "make loans to the federal government and [hold] government revenue."[8] (This was all in the context of a gold and silver-backed currency system.) When state banks were presented with notes or checks from BUS, state banks would exchange the amount noted in gold and silver, something rather unpopular due to making it more difficult for state-based banks to issue loans.
Many in the business community supported the BUS on the grounds that it kept state banks in check by preventing them from making too many loans "and helping them in bad times by not insisting on prompt redemption of notes and checks."[9] New businesses would finance themselves by borrowing money from the BUS and when economic hardships occurred, the businesses would have some breathing room as the government didn't demand repayment on scheduled times.
After the bank's charter expired in 1811, the push to create another bank would be caught up with the War of 1812 and the financial circumstances that it had placed the country in.
The Second Bank
In the first year of the War of 1812, the US saw $7 million of foreign investment leave and about a 161% increase in the amount of bank note circulation (from $28.1 to $45.5 million) due to the increase in state banks (from 88 to nearly 200).[10] The US was seeing large amounts of inflation in a war that had just begun.
Businesses were generally concerned about the amount of inflation and lack of a stable currency to the point that some began to become intimately involved with arguing for a renewal of the BUS, among them David Parish, Stephen Girard, John Jacob Astor, and Jacob Barker. There was also the politician John C. Calhoun, the Congressional Representative of South Carolina's sixth district, who would become involved with creating a second national bank.
In addition to financiers and politicians, there was Alexander James Dallas, the United States Attorney for the Eastern District of Pennsylvania and friends with Treasury Secretary Albert Gallatin. Dallas had help to coordinate a meeting in April 1813 between Parish, Astor, Girard, and Gallatin which resulted in them closing out a deal in which the financiers formed a syndicate and purchased $9,111,800 of government bonds at $88 a share, which allowed the government to obtain the $16 million it needed to continue funding the war.[11] Still, many businessmen were concerned about the general economic situation of the country so heartily pushed for the creation of a second BUS.
Initially, there was a bit of stumbling about. In January 1814, Calhoun proposed a poorly received scheme in which the bank would be set up in Washington D.C. and that each state would be able to buy into it voluntarily, with the number of bond subscriptions corresponding with each state's respective representation in the House, as a way of getting around those who saw the BUS as unconstitutional.
Seeing Calhoun's failed attempt only made Barker push harder for the establishment of a national bank, arguing such in the National Intelligencer, a daily newspaper read by many in the nation's capital. This pushed Astor, Parish, and Girard to discuss the situation in greater detail via correspondence and, after writing up an outline, they began to quietly disseminate it among other capitalists and urging Congressional representatives to take up the cause.
In April 1814, the Madison Administration, realizing that the impossibility of raising $25 million for the war effort, reluctantly gave in to the creation of a second BUS, with the House passing a motion with a 76 to 69 vote..[12] Shortly after this was announced, Parish and Astor corresponded with one another, with Parish noting that the time to increase the pressure on politicians was ripe.
Both men followed through, but kept their contacts quiet until they knew that the administration was all in. Parish contacted Dallas who offered his services as to defend the constitutionality of the Bank, doing so in the form of writing letters to Senators as well as Acting Treasury Secretary William Jones, who had become such after Gallatin went to help aid in establishing a peace treaty with the British.
Dallas, in part, wrote that the constitutionality of the bank was disputed "only by a few raving printers and rival banks"[13] and that it should be established. However, within one week of the aforementioned House motion, rumors began to circulate that Britain was looking to negotiate an end to the war. This provided an opening for Madison, who only passively supported the implementation of the Bank, the opportunity to withdraw his support, as did the House promptly afterward.
In February 1813, Acting Treasury Secretary William Jones, working on behalf of the President, offered Dallas the full position of Treasury Secretary, which he declined on the basis of it being too much of a financial sacrifice to do so. The situation changed however in 1814, as with knowledge of Astor's plan to base the new bank's capital in real estate, Dallas contacted Secretary of War James Monroe to say that he was now interested in the position, if it were still available and in letters with Jones pushed heavily for the creation of a national bank to predict and collect revenue.
While this conversation was going on, Jones "predicted that the government would have a deficit of almost $14,000,000 by the end of 1814, declared that $5,000,000 more revenue must be provided if the war were to continue through 1815, but made no recommendation as to sources of additional revenue."[14] This was quickly followed by his resignation. Realizing that Dallas was one of the few people who were on good terms with both his administration and the business community, Madison submitted Dallas' name for Treasury Secretary on October 5, 1814, with Congress ratifying his nomination the following day.
Immediately after Dallas got into the position, he began to plan for the creation of a national bank that was similar to its predecessor, but with some significant differences: it would be chartered for 30 years, operate out of Philadelphia, and it's capital would be $50 million of which $20 million would be owned by the government with the rest being up for grabs. In addition, the government would choose only 5 of the banks 15 directors, the remainder being chosen by those private individuals holding government stocks.
When presented before the House Ways and Means Committee, though, there were some minor changes made to accommodate the financial and political realities, with the proposal that the bank be charted for 20 years, $6 million of the bank's capital being in coins, and that the bank would immediately loan the government $30 million. Dallas moved to garner support not only with the House Committee, but also talking to a special Senate committee on the matter of the bank along with Parish and Girard going to Congress to lobby in favor of it.
Strangely enough, one of the bank's biggest opponents was Congressman John C. Calhoun, who devised his own plan that he thought would unite both sides.
The Calhoun plan called for the creation of a national bank with a capital base of $50 million, one-tenth of which was to be paid in specie and the remainder in new treasury notes. [...] To satisfy the Calhoun supporters, the bank would have to pay in specie at all times, and would not be required to make loans to the government. To gain the support of the Federalists, the government was prohibited from participating in the direction of the bank, and there was to be no provision that subscriptions be made only in stock that was issued during the war.[15]
It would seem that the situation had come to an impasse, yet Dallas had a trump card: maturing Treasury bonds. He announced to Congress "that the government would have $5,526,000 due in Treasury notes on January 1, 1815, with at most $3,772,000, including unavailable bank deposits to meet them."[16] This convinced the Senate to pass the bill, but it failed in the House due to the anti-bank elements, led by New Hampshire Congressman Daniel Webster, pushed back heartily against the bill and killed it.
On February 13, 1815, news reached Washington that the US and Britain had signed a peace treaty at Ghent, Belgium the past December. The ending of the war allowed the differences between Treasury Secretary Dallas and Congressman Calhoun to thaw as there was now not a need to try to unite everyone, but rather push forward with the bank. The two men got together and hammered out an outline and plan for the bank, which soon passed in Congress and was signed into law on April 10, 1816, with the bank being chartered for 20 years.
The Death of the Second Bank
The bank was set to expire in 1836. Yet it was when the Bank was nearing the end of its life, did a struggle occur over its renewal, led by Andrew Jackson.
In his earlier years, Jackson had a business situation involving paper currency go south, leaving him with a bad taste in his mouth. In 1795, Jackson sold 68,000 acres to a man named David Allison in hopes of establishing a trading post, taking his promissory notes as payment and then using the notes as collateral to buy supplies for the trading post. When Allison went bankrupt, Jackson was left with the debt of the supplies.[17] It would take him fifteen years to finally return to a stable financial situation.
There were also deeper reasons for his anti-bank stance than personal animosity. Jackson was among those people who thought that banking
was a means by which a relatively small number of persons enjoyed the privilege of creating money to be lent, for the money obtained by borrowers at banks was in the form of the banks' own notes. The fruits of the abuse were obvious: notes were over-issued, their redemption was evaded, they lost their value, and the innocent husbandman and mechanic who were paid in them were cheated.[18]
This mistrust of banks would put him in a direct, confrontational path with the BUS and its president, Nicholas Biddle.
Nicholas Biddle was a former Pennsylvania state legislator who became President of the BUS in 1823. Considered a good steward of the bank, he ensured that it "met its fiscal obligations to the government, provided the country with sound and uniform currency, facilitated transactions in domestic and foreign exchange, and regulated the supply of credit so as to stimulate economic growth without inflationary excess."[19] However, he was also undemocratic as he "not only suppressed all internal dissent but insisted flatly that the Bank was not accountable to the government or the people."[20] Actions such as these simply reinforced Jackson's disdain for the institution.
Jackson became vehemently anti-Bank in 1829 when Biddle, attempting to gain Jackson's friendship, proposed a quid pro quo deal. The Bank would purchase the remaining national debt, thus eliminating it, something Jackson greatly wanted done and in exchange, the bank would be re-charted years earlier than expected. An early re-charting would allow for stocks to grow and thus provide a major increase in the dividends of the shareholders.[21] Instead of seeing this as an olive branch though, Jackson viewed it as the institution attempting to utilize bribery and corruption to ensure its continued existence, turning Jackson wholly against the Bank.
It was in 1832 where both these individuals would come to a head over the continued existence of a federal bank.
The National Republicans, a group that split off from the Democratic Party due to anti-Jackson sentiment, nominated a Kentucky Senator by the name of Henry Clay as their presidential candidate in 1831. Convinced that he could utilize the issue of the Bank to beat Jackson, Clay convinced Biddle to seek renewal of the Bank's charter in 1832 rather than 1836.
Clay did have some backing as the House' and Senate's respective financial committees issued reports in 1830 "finding the Bank constitutional and praising its operations[.It should be noted that] Biddle himself had drafted the Senate report[and the] Bank paid to distribute the reports throughout the country."[22] Clay supporters and allies pushed a bill through in both the House and Senate which would reauthorize the bank, but on July 10, 1832, Jackson vetoed the bill, with the Senate failing in an attempted override.
The Bank was now no more, but what of the Treasury surplus?
After the re-chartering of the Bank of the United States was successfully vetoed, Jackson decided to take the Treasury surplus and split it up among certain favored banks, 'pet banks' as they came to be known. However, such a term isn't fully accurate as while funds did go primarily to banks that were friendly to the administration, "six of the first seven depositories were controlled by Jacksonian Democrats,"[23] there were also banks that whose officers were anti-Jackson that received funds such as in South Carolina and Mississippi.
This divvying up of the Treasury's surplus funds would set the stage for the Panic of 1837.
Panic of 1837
Due to the massive cash influx, people began to set up their own banks, hoping to get a slice of the government pie. From 1829-1837, the number of banks increased by 56%, from 329 to 798. Many of these new banks were wretched, being "organized purely for speculative purposes [with] comparatively little of the capital required by law [actually being paid and] many of the loans [being] protected by collateral of fictitious or doubtful value[.]"[24]
This led to a fight between banks for deposits and meant that large amounts of money was going all over the country, with no regard for if those funds were being put in places with viable markets and stable economies, where the money could be leant out with confidence that it would be invested and repaid.
With the debt being paid off in January 1835, a surplus created due to rising cotton prices, and an increase in public land sells,[25] and newly collected tax money being sent to banks, it created a situation where these banks were effectively getting an interest free loan which they could make money off of by lending at interest.
Such lending practices would have major repercussions in the western US. Due to the Indian Removal Act of 1830, huge swaths of land were opened up to settlers to come and claim, but it was also open to speculators. These individuals would go westward and purchase large amounts of land to sell to new coming settlers at massively marked up rates. They found themselves empowered by the banks as due to the Treasury giving funds to state banks, banks loosened their lending policies, thus giving speculators the access to credit needed to buy up much of the land. So much had the west become infested by speculation that one Englishman went so far as to say "The people of the West became dealers in land, rather than its cultivators."[26]
There also existed the problem of professional land agents who worked for capitalists in the East. These agents would go out west, charging some type of fee, whether it be a share of the transactions to take place or a flat five percent fee, and purchase land for their employers, in some cases not even physically seeing the land and basing it off of books. This land would then be rented out and in the meanwhile, further money would be made by loaning funds to frontiersmen at rates ranging from 20 to 60 percent.
This real estate bubble was heavily impacting the nation's currency. The recognized currencies were gold and silver coin, known as specie. Seeing as how there wasn't enough of such coinage to go around, paper money supplemented the money supply, which was technically redeemable for specie. Effectively, the US dollar was backed by gold and silver.[27] Due to the moving of money from the US Treasury to state banks which in turn loaned it to western speculators, there was a major increase in the paper money supply to the point that it there wasn't enough specie to back it and created inflationary concerns, thus prompting the Specie Act of 1836 in an attempt to curtail the problem.
To this end, the Specie Circular of 1836 was introduced which "required that only gold or silver be accepted from purchasers of land, except actual settlers who were permitted to use bank notes for the remainder of the year."[28] The entire structure, which was based on paper currency and credit, came tumbling down, with land speculation halting almost immediately.
The credit collapse caused a run on the banks as the citizenry, "alarmed by the money stringency, by the numerous failures in the great commercial centers, by reports that the country was being drained of its specie by the English, and convinced by the Specie Circular that the paper money which they held would soon become worthless,"[29] led people to go to banks and redeem their paper money for specie. Due to so many people wanting specie, banks didn't have enough to meet demand and suspended all such payments.
All of this caused the Panic of 1837 to come about which shattered credit markets as the nation fell into a painful recession, primarily due to the aforementioned lending policies where literally anyone could get a line of credit given to them.
It was in the aftermath that led to the creation of some of the first credit reporting agencies.
Credit Reporting
Early 19th merchants relied mainly on personal ties to decide with whom to conduct business as many of them would travel from the west and south to eastern coastal cities and purchase goods from the same people again and again. As trade and the economy increased, merchants began to want to give lines of credit to people they didn't know and in order to get some information on the creditworthiness of these individuals, they "would turn to traveling salesmen to appraise those asking for loans, however, this proved to be a problem as the salesmen, wanting to increase his sales, would paint bad creditors as good, thus allowing for loans to be given."[30] This led some businesses to, in searching for less biased reports, seek out information from agents whose only job was credit reporting. Baring Brothers was the first to do this in 1829 and were followed by another international banking house, Brown Brothers, both of whom developed systematic credit reports.[31]
The first person to start up an agency where the only objective was credit reporting was Lewis Tappan, "an evangelical Christian and noted abolitionist who ran a silk wholesaling business in New York City with his brother Arthur."[32] Coming out of the Panic of 1837 almost bankrupt, Tappan decided to launch the Mercantile Agency in 1841 in order to create a national system of credit checking, which utilized both residents and credit agents to judge a person or company's creditworthiness.
Tappan began the work of his agency by sending a circular to lawyers and others in faraway locations, inviting them to become his correspondents with the hope of "[securing] sufficient data regarding the standing of traders in other cities, towns, country hamlets, and trading posts to enable New York City wholesalers to determine what amount of credit, if any, could safely be accorded."[33]
There were credit problems for New York wholesalers. They would generally give a line of credit to local distributors to distribute their product(s) in a given area. Rather than asking for cash payment for the goods, wholesalers gave distributors a discount price and the wholesaler would be reimbursed with the money made from the difference of the discounted and regular pricing, which included an interest rate and covered the wholesaler for risk.
In order to get the risk correct, wholesalers relied on agents reports to their employers about the financial trustworthiness of local borrowers, but they could be deceived as the agent could be falsify information regarding the employer or both the agent and shop could conspire against the creditor.
Tappan's Mercantile Agency gave a slight fix to these problems in the form of being a de facto surveillance system on borrowers by being an independent source of information from which creditors could gauge the reliability of borrowers. Correspondents would send bi-annual reports to the Tappan's New York office in early August and February, ahead of the spring and fall trading seasons, which were then copied into large ledgers. Those who subscribed to the ledgers would call the Mercantile Agency's office to inquire of a current or potential recipient, where the clerk would read the report aloud.[34]
While this helped, there were major weaknesses in the system as the "correspondents [many of them part-time] relied on their general, personal knowledge of businessmen and conditions in the town or area of their responsibility,"[35] which was subject to being influenced by gossip and rumor. During the 1860s changes were made which increased professionalism by bringing on paid, full-time reporters and by the 1870s most major cities had full-time reporters. Methods also changed and was based on direct interviews and financial statements that were signed by lendees, the latter improving greatly in the 1880s after the courts ruled that such individuals could be charged with fraud if they knowingly provided false information to credit reporters.
The industry would evolve with the ushering in of the 20th century, which would see the origins of the current three major ratings agencies: Moody's, Standard and Poor's, and Fitch Group.
Endnotes
[1] Matt Krantz, "2008 crisis still hangs over credit-rating firms," USA Today, September 13, 2013 ( https://www.usatoday.com/story/money/business/2013/09/13/credit-rating-agencies-2008-financial-crisis-lehman/2759025/ )
[2] Larry Elliot, "World economy is sleepwalking into a new financial crisis, warns Mervyn King," The Guardian, October 20, 2019 ( https://www.theguardian.com/business/2019/oct/20/world-sleepwalking-to-another-financial-crisis-says-mervyn-king )
[3] Sean Trainor, "The Long, Twisted History of Your Credit Score," Time, July 22, 2015 ( https://time.com/3961676/history-credit-scores/ )
[4] H. Wayne Morgan, "The Origins and Establishment of the First Bank of the United States," The Business History Review 30:4 (December 1956), pg 479
[5] Ibid, pg 476
[6] Sheldon Richman, TGIF: James Madison: Father of the Implied-Powers Doctrine, https://www.fff.org/explore-freedom/article/tgif-james-madison-father-of-the-implied-powers-doctrine/ (July 26, 2013)
[7] Morgan, pg 485
[8] Jean Caldwell, Tawni Hunt Ferrarini, Mark C. Schug, Focus: Understanding Economics in U.S. History (New York, New York: National Council on Economic Education, 2006), pg 187
[9] Federal Reserve Bank of Minneapolis, A History of Central Banking in the United States, https://www.minneapolisfed.org/about/more-about-the-fed/history-of-the-fed/history-of-central-banking
[10] Raymond Walters Jr., "The Origins of the Second Bank of the United States," Journal of Political Economy 53:2 (June 1945), pg 117
[11] Walters Jr., pg 118
[12] Walters Jr., pg 119
[13] Ibid
[14] Walters Jr., pg 122
[15] Edward S. Kaplan, The Bank of the United States and the American Economy (Westport, Connecticut: Greenwood Press, 1999) pg 50
[16] Walters Jr., pgs 125-126
[17] The Leherman Institute, Andrew Jackson, Banks, and the Panic of 1837, https://lehrmaninstitute.org/history/Andrew-Jackson-1837.html
[18] Bray Hammond, "Jackson, Biddle, and the Bank of the United States," The Journal of Economic History 7:1 (May 1947), pgs 5-6
[19] https://lehrmaninstitute.org/history/Andrew-Jackson-1837.html
[20] Ibid
[21] Daniel Feller, "King Andrew and the Bank," Humanities 29:1 (January/February 2008), pg 30
[22] John Yoo, "Andrew Jackson and Presidential Power," Charleston Law Review 2 (2007), pg 545
[23] Harry N. Scheiber, "The Pet Banks in Jacksonian Politics and Finance, 1833-1841," The Journal of Economic History 23:2 (June 1963), pg 197
[24] Vincent Michael Conway, The Panic of 1837, Loyola University, https://ecommons.luc.edu/cgi/viewcontent.cgi?article=1469&context=luc_theses (February 1939), pg 21
[25] https://lehrmaninstitute.org/history/Andrew-Jackson-1837.html
[26] Paul Wallace Gates, "The Role of the Land Speculator in Western Development," The Pennsylvania Magazine of History and Biography 6:3 (July 1942), pg 316
[27] Robert Samuelson, "Andrew Jackson Hated Paper Money As Is," Real Clear Markets, April 27, 2016 ( https://www.realclearmarkets.com/articles/2016/04/27/andrew_jackson_hated_paper_money_as_is_102137.html )
[28] Gates, pg 324
[29]Conway), pg 22
[30] James H. Madison, "The Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America," Business History Review 48:2 (Summer 1974), pg 165
[31] Madison, pg 166
[32] Josh Lauer, "From Rumor to Written Record: Credit Reporting and the Invention of Financial Identity in Nineteenth-Century America," Technology and Culture 49:2 (April 2008), pg 302
[33] Lewis E. Atherton, "The Problem of Credit Rating in the Ante-Bellum South," The Journal of Southern History 12:4 (1946), pg 540
[34] Madison, pg 167
[35] Madison, pg 171