Rating Firms Inflated Credit Grades to Match Rivals, Report Says

Standard & Poor’s and Moody’s Investors Service inflated their grades on securitized debt prior to the financial crisis to match each other’s opinions to avoid losing business, according to a University of Texas finance professor.

Collateralized debt obligations rated AAA by both companies defaulted more often than securities with the same grade from one firm, according to a paper dated Jan. 25 from John Griffin at the University of Texas at Austin. The study examined 2,790 CDOs, which bundle bonds or loans and slice them into securities of varying risk and return, issued from 1997 to 2007.

“Our results are consistent with rating agencies going beyond their models due to competitive pressure,” Griffin and co-authors Jordan Nickerson and Dragon Tang, wrote in the paper. “Under pressure from investment banks, the rating agency with the more stringent standard will need to stretch their standards to match their more lenient competitor.”

Inflated grades on bonds backed by subprime mortgages helped ignite the worst financial crisis since the Great Depression when their values plummeted five years ago. Analysts were pressured to give their stamp of approval to complex investments in a “race to the bottom” to win lucrative business from Wall Street banks, the U.S. Senate Permanent Subcommittee on Investigations said in an April 2011 report.

“Analytic independence has always been a core principle of S&P’s ratings process,” Ed Sweeney, a spokesman for the company in New York, wrote in an e-mailed statement. “We have long had policies in place to manage potential conflicts of interest, including a separation of analytic and commercial activities.”

Michael Adler, a Moody’s spokesman, declined to comment.

To contact the reporter on this story: Matt Robinson in New York at Mrobinson55@bloomberg.net.

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net.

Bloomberg reserves the right to remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.