How did ratings agencies become so powerful? Trains and recessions, that’s how

IT’S BEEN OVER a week now since Standard & Poor’s did the hitherto-unthinkable and decided to downgrade its rating of the United States of America, stripping it of its AAA rating for the first time in its history.

The ripples from that seismic event have been felt around the world – with markets around Earth all showing incredible volatility this week as stock prices went down, then up, then down, and then up again.

But one of the questions that’s been asked about the downgrade – including by many senior figures in the States, who are questioning the logic of the move, is how ratings agencies managed to manoeuvre themselves into such a domineering position in the first place.

It’s a fair question – if countries can live or die by the ratings of an agency (remember: 18 months ago, Ireland was an AAA country!) then it’s only right to ask how they became such a big deal in the first place.

The answer, it turns out, is all to do with the Transcontinental Railroad.

American broadcaster NPR has been doing some digging and learned that the ratings agencies only really came into existence in the latter half of the 19th century, when it was decided to expand railways from small, inter-city things to larger transnational projects.

At that time, if someone was putting up the money to build a railroad, they knew exactly who they were giving it to – they only lived one or two towns away. It would be feasible for a lender to go out and meet the railway’s constructor to check out whether the investment was a worthwhile one.

That all changed when railroads went trans-continental. Suddenly, investors were being asked to put up money for projects on the other side of the country – places they couldn’t physically visit to scope out in advance of an investment. They simply didn’t know the people they were giving money to.

That’s where Henry Poor came along. In 1860 he published a book containing nothing but the financial details of every railway and canal boat operator in the US – simplifying the process of figuring out which operators were worth investing in.

Poor’s company existed in a vacuum all of its own until 1906, when Luther Lee Blake set up his own Standard Statistics Bureau – which essentially covered everything that Poor’s didn’t, ranking everything from corn to timber.

In 1909 John Moody, brought out his own similar data on a broader range of goods, while in 1913 John Fitch set up shop right in the centre of New York City just as the stock markets began to emerge as a formal method of buying and selling ownership in a company.

In 1941, Standard and Poor’s merged to form… well, Standard & Poor’s, and that’s were the three major ratings agencies came from.

But how did they gain such a prominence? That’ll be the fault of the Great Depression in the 1930s- a move which caused the US government to act very much like our own government did in 2008, when it started taking a greater interest in the activity of the banking sector.

With banks suffering massive losses because of the number of companies going out of business – and because all of their collateral was now essentially worthless – the government introduced new rules on the nature of the assets banks could invest in.

Among those rules were the requirement that every prospective investment be vetted – and ranked by a ratings agency.

From then on, the ratings agencies flourished – and grew into the substantial behemoths that we know today.

Earlier: US markets watchdog investigating alleged insider trading at S&P >