Transcript
Hey, it's a business pants. Bonus episode on Thursday, September 21st. I am at mascardi. I am about to be joined by Damien rawlas and one Mr. Danielle cash. It's a bonus episode because you have a special guest. He is the author of modern credit, rating, agency, the story of Moody's, which you could pre-order pick up. Now, we had a long talk yesterday and we covered the messy history of creating ratings how rating credit ratings were formed, how it relates to ESG, and ESG ratings, how messy that is. And the real goal of regulators of ESG because spoiler it's not getting the right answer. It's not the one he is she to rule them all it is something else entirely but Daniel cash is now written the book on the history of Moody's. It's the only ones you can find and it's fantastically interesting conversation. We had with them. We actually excited some of the yesterday but here's our conversation. In full sit, with Daniel wall, he schools us all. Here's the bonus episode. All right, we're recording. We're here with Daniel Kash. Daniel, just wrote a book called The Modern credit rating, agency, the story of Moody's. It comes out this week. September 21st 22nd comes out really soon. You can pre-order it now and just to set the stage for who you're who we're talking to. Because you're way smarter than I am. You're at Aston University. Now, you led ESG ratings at Ben McLoughlin McQuay McQuay that way. Yeah, it's a lot, it's a law firm, right? Full bright scholar. Bachelor's in criminology the Masters in law and a PhD in Security's law. first of all, I don't know who does that. That sounds incredibly masochistic, but good for you and general overall, smart human. Daniel thanks for joining us. Thank you. It's really good. Really good to be here. I'm a big fan of the podcast. Are you don't have to lie at the start. We don't have to start with lies Daniel. We don't have to start. All right, so I asked you here to talk about, you wrote the book. Now, literally wrote the book on history of Moody's and I wanted to talk about credit rating agencies and some things about them. I want to juxtapose into like ESG ratings and you know, Carbon markets and things like that because you have experience in those things. But let's start at the top, I did a little bit of research back in the day, when I was at msci, about how the credit ratings came to be Mercantile agency, Lewis, Japan. And how it became done in Bradstreet and Moody's and done in Brad's treatment merge. And that's where the Moody's story and John Moody sort of fit into this. But back in the day, the credit ratings were effectively like they'd write down like how much money you have. And whether you were having a fairs and you were a Christian and whether you were like, you know, like all sorts of and it sounds just like kind of like an ESG rating mixed with. Yeah, it's like Money mixed with other stuff and it really sounds like that. I want to actually, can you kind of elaborate expand on the messy history of making? Like the start of it? Like how rating gets done in the first place? How these rating agencies happen, what a fucking disaster and mess. It is for a long time until they hit maturity. Like what's it look like? Okay, so I think when somebody asked me about credit rating agencies and they like myself, when I first looked at it they get confused at how you have an industry with so many issues yet, they're so profitable. So in terms of profit ratios that in the top five companies on the planet and people get confused of why. That is but I think the reality is when it's very I'll give you a very brief history of the kind of explained why we have them. So The. First sort of credit rating entities, as we know them were started in England. And that was through Trace society and they wanted to come together to make sure the dead members were protected against those who were trying to rip them off and the more happy. So they were collect information on local business people. When the large British Financial house was like that bearing brothers were crossing the Atlantic to try to take advantage of the growing railroad industry in the US. They struggled to extend credits. To those who they didn't know. So what they did was they would hire very influential business. People on the US East Coast. He would collate information about people coming into the likes of Boston and New York. And they were collate information on them. The first commercial like this. Yes. They're like, getting off the, the boat in Boston, and New York, and someone's there being like five foot, seven smells terrible. Like, well, I think the reality is it at the base of everything to do with credit is a simple question. How do you trust somebody? You don't know? And that's it. They, they were just take their word for the people. It was just so people. The bearing Brothers used to use. So his name was Thomas. Ward was extraordinarily influential on the East Coast. He was very well respected and it was his respect. That they utilized so people would feed information into him and he would collate it in a very, very Advanced manner for the time. It's very statistical. Um, but then yeah, that was, it was very expensive because they had to pay a lot of money and you couldn't scale it the first. Commercial rating agency was an 1835 by a small law firm in New York City. Called Griffin Cleveland and Campbell. But they They fold a pretty quickly because of the time it was a very very turbulent economic time for them. So a couple of years later, somebody called Lewis Tappan, he was very famous. If you know anything about the anti-slavery movement in the US because he was connected to the Amistad story in terms of, he provided legal council for them. He essentially created what was called, the Mercantile agent American Tile agency. That was the first ever commercial rating agency, notable characters, who worked to him, who reported to him. Include Abraham Lincoln, Abraham. Lincoln Lincoln was one of tap and reporters. And he essentially spread across the whole country. So, he formalized, the agency structure, where you would have different agencies and branches across the country. It was well received and not well, received an equal measures. So, people were calling a system of Espionage people did not like that. You could essentially those reporters around the country could essentially destroy their competitors. By reporting that they were not good to deal with, and sure bring credit to so essentially That's the basis. And then it grows and grows and grows with the growth of the railroads. I mean. You just like ESG, Matt. It's started with a woke and I mean, literally, it's like the same people and now, it's like, so should we expect eventually? This is really the question about credit rating. Which should we expect eventually that? You know, Henry Fernandez of msci. Gets a bridge named after him outside in New York for being offering woke data ratings. I think we'll expect. Yeah. All right. We won't come right. That bridge yet. And it's a very small Bridge. It's a four foot Bridge. So so it's a messy beginning and they're formalizing it and scaling it and it becomes like I think of it just it's a rooted space and a very evangelist movement because of tapping. So he was against things like he was very much into prohibition and living a very pure our lifestyle. So any business people who didn't follow that, we usually negatively rated by his family, which goes into what you're saying about this ideological background. well, so Yeah. I mean and that kind of but that does go along with like what we refer to here in the United States, is the Yankees. Like it's a, the Northeast, the New England part of the car. Yes. So it's not surprising that you will see That attitude mixed with an anti-slavery attitude. Like they seem like they're posing Viewpoint, he struggle to expand his business in the South, which is not surprising, because they didn't take too young. He telling them whether they were good, the business or not. So, that was a Essentially, the existential problem of the early rates. Oh yeah, it's funny when you say these things because I it it's not hard to think. When we talk about tapping and we talk about what we're talking about with the Yankees versus the southerners is that a lot of this still persists and kind of the same way, like the turf, war is Not So Different. You could say the current ESG ratings, right? And we used to talk about this all the time. Heavily favored, our bias towards Western companies, and if you're in Asia, right? Like you basically have the Yankees, telling the South, the same thing. And it's just Global instead of local, right? It's you have to say, thank you. The likes of me and Motley the ball. Bae, this prime minister who's really pushing the reform of Global Financial architecture which is the global North Face of the global South because If you are, let's say your opinion country. Credit rating agency, he's usually favorable towards you, but if you're not an African country, it's quite the office. Right. That's so let's talk about that because that's the methodological question and this gets to the heart of sort of My Fascination. Like the early methodologies are basically a guy in a room being like this is what I think should be good and should be bad and I imagine expands into like a committees. But how does that like, what's the first? What's the Arc of that? Like, what's the maturity Arc of starting with Lewis? Japan saying? I want to bridge named after me one day. How do I like make a methodology and scale? This to what is today considered? And and maybe wrongly so, right? Because this is what was our conversation on social? Like it's considered a highly algorithmic outcome. And credit ratings tend to be highly correlated but actually it starts with a lot of numbers that are algorithmic and it ends in still in a room in a committee, with a bunch of people raising their hands that that's the right rating and it's still a black box. What's the Ark of that? Does it? Does it like, when does it start to get out? Algorithmic, when do they start to like collect data points? When do they try to scale those things? What does that look like? Well, those depends on what you'll rating. So for example, The rating accuracy for corporate bonds is pretty high. They're rating accuracy for structured. Bonds is extraordinarily low. And their rating accuracy for Sovereign bonds as somewhere in the middle. So it depends what your rating, but the different agencies, take different approaches to it. So, I think like Moody's is often considered to be slightly more Technical and other rhythmic in its approach. When it's Finding out the data point when it dealing, with the issues who are requesting for the rating. but, Only since 2010 to 2009 that we've even know what the methodologies were before that, they were entirely non-public. So don't have to the crisis with the Dodd, Frank act in European regulations that we actually get a lock at the methodologies and at the moment in the ESG rating world because there's no regulations as we speak that will change soon but because as we speak to the regulations, only 50% of the top rating agencies actually publicized their methodologies, the other ones don't even publicize them. So it's because I mean in, In fairness, credit ratings had 150 years before they had to say what their methodologies are ESG, has been around for Arguing in modern ratio it's been around for arguably 20. Yeah yeah but in reality it's irrelevant it really irrelevant because Once credit analyst and a team of analysts. Say deal with the issue, they get the information they need, they cone the public information, they'll feed it through the methodology, they'll get the waiting at the methodology said they should get for that particular industry and then it goes into a room and a dog gets closed. And the rest is you can't know. the only thing that happens in a rating committee is that the documents get kept for regulatory investigation, but then no regulator actually details the element of those documents that they read even when they turn off to investigate. So the methodology to me in my mind is just one very small pause of a very long story because once it goes into a rating committee There's no telling what that rating may end up. It's not based on the methodology anymore, it's based on the findings of the committee. so, Has the sorry Matt has the disclosure of the methodology has that changed the industry at all or change the individual companies as it had any point of a lot of the post crisis legislation and regulation was focused on increasing competition. And all the top and since the crisis that competitions decrease because very, very quickly, they are rating. the concept of a rating is based upon, and this is what my book talks about is, So if you in the model world it's usually institutional investors who use ratings. Institutional investors have far greater resources than a credit rating age and he does on a deploy those to make sure that investing properly. They don't rely on credit ratings for their information content because it's usually very backward-looking. It's very out of date. If it for example, if Institutional Investor manager was to rely on a credit rating, they were probably be held liable for doing so because it's so out of days or so useless. The reason why they use them is because it provides a signal. And that signal is very basic to understand and keep in a Simplicity is its power. You don't need to be a genius to know, the triple layers, better than sea on a slide in scale. And that's all you need to know and that's where it's genius, comes in and that's why. It really doesn't matter if the methodology is public or how they come to a rating, because as long as you get the signal you need, you can then go invest in the product that you need to invest in. Well, I mean it doesn't matter. Except that like they are I mean that there there are in the US. Anyway, they're nationally recognized agencies right like and there's only three or four of them so they are effectively a regulated Monopoly. Well right? Like the 10 nrsv It is a still, it doesn't like the methodology doesn't matter. Feels significant given that there are there's regulations about insurance companies, what they can you know the the investment grade Pension funds, you know, Arista funds there are there are limitations to actually what signal level they can actually utilize. Well interestingly financial crisis that's being changed. So if since the financial crisis, you are not allowed to insist on a rating being used. It's called removal of racing Reliance and the whole point was that the government and the state wanted to say that well we're not telling you to use them anymore. So if you use them by every word that up to you, That on their misunderstands that they are the only form of credit worthiness. Understanding that exist in the marketplace so whether or not you insist on them being used or not, you're still going to have to use them. This, this sounds like we have this standardized tests in America for for students entering university called SATs, and it sounds almost the same. Because now most universities are saying, You know, if submit them if you want to, but it's optional but but then the idea of course is, if you don't submit them, we know you probably didn't get a great score and but the whole thing is it kind of reminds me what you're saying though, right? It's like because there's the, there's all so, Controversy with SATs because there's this, you know, the question of whether there's implicit bias, and what does the score really measure and, and blah, blah, blah? But it's weird how it's kind of, sort of the same. Don't you actually see Divergence of the scores post financial crisis? Then why are they still highly correlated given the fact that like the methodologies tend to be black box at the end of the methodology and there is no There is no regulatory need to hit a certain score in order to be investable. Why do we not see Divergence? Well, does probably two reasons the first is that the measuring observable? Of data. So if you're looking for example, the corporate strengths of a corporation you can point to specific figures on the balance sheet and such, and you really should all be looking at the same data. Whereas, when you look at ESG rating agencies, it's very subjective. If you're looking at, let's say how green a supply chain is, you may have one Fair may have access to more data than another. That's why you have more Divergence in ESG, then you do credit. And the other thing is in the credit rating age and Industry, they are very well. Functioned well designed natural oligopoly. They have been for a long time and they know if we if we produce a rating that goes too far out of work with the other two, we're going to be the outlier. So they usually only incrementally change. That's why you see for example. When S&P downgraded the United States in 2011. The other two didn't and pictures. Only just recently Suggested that they were going to change the Outlook of the United States while the other two states. Still you'll have any incremental movements where does an ESG with the likes of msci, a sustainalytics and what have you? They are not a natural oligopoly yet and that's why everybody is complaining about ESG rating agencies saying, there's too much noise because what they want. Everybody wants a natural only got only because it's natural but you can't say that no regulator on a planet would ever call for Less competition. They can only call for more why makes me sad. Why in this regard? Are we so afraid of outlier because you want? Why don't they don't tell? Why do we assume? Don't know if you want to signal, if you want to signal and you have three people. Three entities all saying, same thing that gives your signal strength that will happen in the credit rating. Well, but in the ESG rating world, The same signal gets 10 different versions and then when you go to use it, you can't rely on it and this will stems to the modern world of separator by one simple relationship which is principal and agent. so, for example, let's say all three of us have a pension We are not interested in monitoring how our pensions are governed on a daily date basis. We just want our pension, at the end of it and we want a nice and safe. The best way to do that, is you say to your pension manager, you can only invest in Triple-A, keep it nice and safe, rather than any risky Behavior. That governs. And what we call an asymmetric relationship where you don't have the information that you should have. So you use Waze a means to jump over the asymmetric Gap. Can you can you argue though that it's not principal and agent? It is really like the, like creative thinking versus process thinking in a way because having an outlier actually Like, if I, when I see the credit rating agencies and or the ESG Raider ratings and they diverge right one, I see in carbon markets, you have multiple models and they diverge, right? That just seems to be a place where you say. Why is it diverging? That's interesting that it's diverge, like, which one do I believe? Can I see the data with which you got to that conclusion? In fact, it begs questions which is a good place to be in if you're trying to make an informed decision rather than just saying. All they all agree, so I might as well go with it, right? It seems like the problem is more like humans want agreement so that they don't lose their jobs and they don't have to think or am I being human nature? Well that's it. I agree to say that's yeah that's what we all. See the questions are good and they increase it should Inspire thinking so you get to the truth of the matter but that's not how humans operate humans operate. In terms of they need shelves of food, they're securities. What's happening at the moment in ESG, there is a massive. I think I always equated to a reservoir a damn, that's blocked. And in the damage of water, you have just incredible resources that are waiting to be invested. But they can't be invested yet because the infrastructure of the bottom of the time, is not ready to let the water flow down and that's what's happening. And what in the ESG rating world, the regulations of very quietly if you know what to look for. They're forcing Oligopoly. Because they know that's the only structure that will allow for that Capital to be released but they can't overtly say it because no regulated That both terrifies me and saddens me the same but it's just amazing. I love the whole world is about movement of capital, doesn't move the well grounds to hold. And it doesn't matter. Whether it's a good example of looking at the likes of China, whether your socialist or Socratic or Democratic, it's irrelevant as long as capital moves, your system moves, if your Capital doesn't be, if your system doesn't move and you need for Capital to move as a Content as a concept that you need and infrastructure to allow it to move. And that's why credit ratings, good, bad or indifference. They're exceptionally good at allowing Capital to move. Where does ESG rating agencies at the moment are not good at allowing Capital to me because they're not. So for that. so instead of forcing this, like, Strange idea of having like a unified thought process which we know is bad for analytical and critical thinking. Anyway, when you kind of force people into her Corner, why don't we just like take the Olympic scoring method with figure skating where they talk know, I'm really I'm serious, they throw out the high and low scores. They average the other scores like why do we why do we concerning ourselves with forcing? All these these disparate agencies to think alike and have a unified? Why not just kind of amalgamate them and And kind of respect the different thought processes going on. Because, because a lot of these different thought processes from these ratings, come this goes back to our original thought about es versus West is that sometimes they come from different regions, Sometimes they come from different types of people who have a different, you know, attitude of what these scores mean and should mean. And so I feel like, doesn't that respect that process even more? As opposed to trying to find this one? I agree in. An analytical concept and analytical conversation. It's absolutely correct that we should do that. but if you think of Austrian this podcast and everybody who's listening to, it is likely to have a very Base or higher level of financial literacy, they understand simple. I don't think, you know I was you said that on me, but In in the general populace that Financial history simply doesn't exist. And when it comes to the law, the protect those consumers, they don't expect that financial literacy and that's why you can't have the system that you propose. Were you have a variety of thoughts? And you may be a marker and maybe get an average score. Because that popped out normal quote. Normal person doesn't know that doesn't understand it, it's too complex. What they want is a very simple sliding scale. The scores for my mom's money to Daniel. Because like Yeah, but can I just say though it's funny? You're saying this because you know, I'm sure you have the same in the UK with with football. But you know, Americans are obsessed with fans towards and and they do this, they do this very process daily. They, they look at ranking from all these diversions news sources, they they decide which ones they think are important. They average them together. They can do this, they are capable of this but it's funny that we and I appreciate what you're saying. I agree with you by the way that that, but the financial literacy of the average person is weak. But but it's the same principle. How not we go because this is just the boring. This is just more, but I know people who will. I mean, I'm good. Example, was a cryptocurrency. I need people, he would never ever have dealt with five until literacy at all. It comes to cryptocurrency that old, all of a sudden that invested in this that invested in that when it comes to have like 17 It comes to the normal understanding, a mortgage understanding, a basic investment to saving trade. They turn off because I don't know why. So one reason is in mice. In my spelling history, what we call business studies, in the UK was optional, 16. Plus it was never forced at like seven, eight, nine, ten. Whereas, right, if it was people would be very more, much more comfortable with understanding, what seemed to be complex Financial date. And in reality, it's not that complex, but the perceived complexity sad, but there, it's more because black go to Rotten Tomatoes, which is which Aggregates every movie review and you're gonna read all of them and like based on BET on natural language, understanding the Lord those reviews Matt don't even have a score. And yeah, yeah well I want to I want to before we end here because we're we could talk about this probably for days. Which means we're probably gonna have to have you back. There was something you said earlier about how the analysts you were talking about the team of analysts the methodology. Like in the end is can be largely irrelevant. The team of analysts getting a room, you said, quote, they deal with the issuer, right? And I want to ask about that process because there is a conversation happening. Now about carbon Target setting and science-based targets and it they talk about any ESG ratings and they talk about conflicts of interests. The issuer pays model effectively where, when you're dealing with the issue or the issue is Paige. You as a credit rating to give the rating and it's not different from a company comes to you and pays you to create a Target and then validate that Target which is effectively getting a rating and and ESG ratings. There are companies that will give a rating and then charge to consult to improve your rating, right? It's all issue or pays That seems to be at the heart of the business model of credit ratings and the Heart of the problem when it comes to like incentive streams. How bad is it in a credit rating or how natural is it? Like how, how, like, there's not another better model and I'm curious when you think of it that way, is the ESG, the carbon Target setting, all of that. Is it really that different From the way they kind of readings, do it? Very quick. History lesson issue. A started in 1969. There's two reasons why it started. The first is the Xerox machine was launched in late 60s, publicly. And that allowed. I love drivers to potentially photocopy and release the subscription for free which is called free ride riding. So essentially, they were going to be taking out of business if they didn't change. The second reason is that a company? So, in between the 30s and 60s, Donald Bradstreet was by all of these different rating companies. They had one called the national credit office, and in the 1960s, they bought Moody's in the 1960s. The national credit offers was giving out Triple A rating. What they called primary things to everybody who wanted one because they paid for it. What happened in 1970, the railroad company called Penn Central crashed, and shocked, the economy. what happened was not the national credit office was found to be really guilty by Congressional investigation and they essentially disappeared into nothingness. In their place stepped of the credit rating agencies who said, we're not like that. We're different. But they just changed their rating model to issue a pays. So we only have a five-year gap between Moody's, applying a issue, a pace model and SMP catching up. And similarly applying the issue pays model. Gap. Moody's rating went up for issuers, by two ratings on average. Because they changed their model and have four years later. SMP rating's caught up and went up two ratings on average, because they all so changed to issue. A pace. The point is rating. Inflation is the natural partner of the issue of pace model. the year pays is that you get access to information that you wouldn't normally get But it's impossible to stop the conflict of interest. It's quite literally impossible to do it. And even if you separate the analysts from the commercial people, They then go into the rating committee where the commercial person and the executives of the rating agency sit in a very same room as what our analysts and sometimes, Junior analysts. So it's impossible to change and in the ESG space It's mostly subscriber pays or what we call. Investor pays. But that's slowly changing. And once you get issue a pays in the ESG world, that will be the end of what we call the oligopoly and you have the natural Olive, goalie that all the investors want. So, That's terrifying. I so just to summarize that ratings inflation is the natural outcome of issue or pays and firewalls don't work. Meaning like any of the ESG ratings any carbon validation, any of that kind of stuff that are currently issue or pays. Are exactly the same without the oligopoly. Does that make them do you, would you say that makes them better or worse? I mean, and, you know, in a way it sounds like that might actually be worse. That's just an earlier stage of their development, that's all because the ultimate goal of a rating industry is to be an oligopoly, because once you're in it you can't leave it. It did it essentially, a job for life. So a very quick story when I was starting to make PhD, my supervisor warned me not to do it because he said you're being very specialist and you might not have a job. I said, don't worry, the credit rating agencies will keep me in business for life. I wouldn't worry about that and believe me every single day. There's a new story what they got to. So because it's the same essentially, economic rent. Taking, they've got a place in the economic system and they would draw rent from it because they can't be punished. So, I got it in my whole page, the thesis was based on this simple understanding, they bought the consultancy services from the audit companies after Ed Ron when Enron was forced to divest their consultancy. They build up this mass of consultancy business. And my whole thesis was about you can't have somebody. So Central also selling consultancy services to issue is when you have issue of pays, it's a massive conflict of interest and they're generating too much money for you to push them. Effectively. The record punishment was, so there's a settlement in 2013 for 1.3 billion. There's a settlement in 2015, for 800 million. They end five times that from just ancillary Services alone so does literally no deterrent. So, the different with the ESG is at the moment, you can't deter. And that's the difference. But if it even when the oligopoly is formed your ability to deter of operate. So that's what we saw with the financial crisis. So I'll end with this question, this is been awesome and so I'm going to end with this question which is what I'm gonna ruin it. So we we do board member analytics and management analytics. We measure the individual performance of board members and their influence and stuff like that. What you're saying. Based on your incredibly deep knowledge of this is that a we need to make a rating and rate individuals and B. We need to establish ourselves as an oligopoly. So we need to reach out to our only other and say let's go. Like let's like put press releases out against each other so that And then I need to and then I need to start accepting money from the directors and Executives themselves to write them. I like this that I just want to I want to that's a yes, no question. That's what we should do. Danielle cash. Yes, no. That's what Daniel saying, oh my feet about advice is exalted him but you will be adding twice with us. That's it, that was Daniel cash. Author of modern credit rating agency, the story of Moody's, which you can pre-order or pick up in stores. Now, I am going to do that immediately. It was a fantastic conversation. A big thanks to him for joining us. That was Damian roles. And I am, Matt Scotty. We are business fans and free flows if you like what you heard on this show. Come back tomorrow. We'll have our Friday wrap of the week and you can also go to free float, analytics.com. This shows spots are by free float, analytics.com. It's where you can get all your direct data individual performance attribution. All the things go there. Get that until tomorrow. Goodbye.