In the recent past I have written about the the quantitative and qualitative elements that influenced Moody’s early success as a publicly traded company. I have also covered Gotham’s analysis of the company’s spin out from Dun & Bradstreet in 2000 (an early banger on the blog). I have followed the company on and off for years, but I once again find myself both owning shares (please see the latest portfolio update in the Discord server), and intrigued with its modern context.
If you’re subscriber, it’s a virtual certainty that you are attracted to high quality businesses, with extreme durability, that produce cash now and growth in the future. Moody’s (along with its counterpart S&P Global) is one of the world’s great businesses. It has been operating for over 100 years. It has been able to grow profitably for much of that time. The capital light nature of its core ratings offering has meant that it has produced healthy dividends for investors over time while having very few needs for internal reinvestment. Part of that excess cash has been used to build a software and analytics business, which now produces significant revenues itself (more on that later). Wars, famine, upheavals, plagues, and even being caught selling poisoned product during the heady days preceding the GFC has not even altered their franchise status. They persist, sometimes despite themselves, offering essentially the same service they did 100 years ago.
The explanation for Moody’s unusual market position is relatively straightforward. John Moody began John Moody & Company in 1900 which began by producing an embryonic version of the mythical Moody’s Manual. Despite a financial pinch that caused Moody to sell the business in 1907, he returned in 1909 with a new publishing company that solely focussed on rating the bonds of railway companies. This later expanded to industrials, and then to all corporate bonds, and finally to all state and municipal bond issues. By 1924 Moody’s rated the entire U.S. bond market using a letter grading system inspired by earlier systems from mainland Europe.
If you can conceive of the early market for ratings as a two sided marketplace, then Moody’s initial business model was to focus on the investor side of the equation (corporate and government issuers being the other side). This approach was derived from the fact that the early value of a credit rating was found in its technical utility: it provided a useful shorthand for investors to assess credit-worthiness at glance. Subscriptions from these investors funded the company initially. Overtime the clout that Moody’s had with investors translated into a veritable toll booth. This kind of success inspired imitators, all of whom exist in some form to this day: Poor's (established 1916), Standard Statistics Company (established 1922). and the Fitch Publishing Company (established 1924).
The financial upheavals of the Great Depression, and the subsequent explosion in financialization post-World War II, further entrenched the position of the ratings agencies. This came in the form of increased regulation from the U.S. government, and in the demand for corporate transparency from an ever growing class of investors. By the 1970s Moody’s had such an entrenched position that they began charging issuers for the privilege of having their own bonds rated. It is at this juncture that the first element of Moody’s standard-based moat becomes clear - the reason why issuers pay for ratings is that without them they face significantly higher borrowing costs in the market. This is augmented by the fact that not just any rating will do - the government only recognises a fistful of firms with the designation Nationally Recognized Statistical Rating Organizations (NRSROs), and investors sanctify the legitimacy of a Moody’s rating (along with S&P) with a lower borrowing cost than those issues with a rating from another firm. Standards gain exponential recognition (and subsequent lock-in) with the addition of every new party to a transaction. In the modern context, a credit rating is a common language for no less than 4 separate parties - investor, issuer, governments, and regulator (although the latter two can often be the same). It is one of the purest expressions of a naturally occurring monopoly, and in this case it is reinforced by government sanction.
The 1970s and 1980s saw the expansion of US-style financialization across Europe, and then later to Asia. The 1990s and 2000s saw an explosion in structured finance, and later mortgage backed securities. These key themes of internationalisation and ever morphing financialization (characterised by ever greater levels of indebtedness globally) remain key drivers of the business today - however, it is interesting to note that about 2/3rds of Moody’s Investor Services (MIS) revenue is derived from the US home market.
Like all great businesses, Moody’s has been rocked by controversy, scandal, and government interference and investigation. The transition to an issuer-payer model is the main source of perceived conflicts of interest. To the casual observer it would seem unusual for an issuer to get a truly independent rating when he is the one paying for it. The alignment of interests between credit rating agency and issuer, leaves the investor somewhat on his own. This dynamic was on full display during the dark days of the GFC - many investment grade ratings were shown to be worth less than the paper they were delivered on. The fact of the matter is that ratings are much more reactive than they are predictive, and that is symptomatic of tensions that permeate market economies, not of ratings themselves. A sad but unavoidable truth is that from time to time financial, and regulatory infrastructure fails the public - but never for long.
While Moody’s enjoys a quasi-government sanction, it also enjoys constitutional protections that ameliorate legal liability that would have otherwise bankrupted it many times over.
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