Credit-rating companies routinely award higher rankings to debt issued by banks and corporations that pay them the most, a conflict of interest that may escape Congressional efforts to change the way they do business.
Bonds from countries and cities that pay about half as much as issuers of less creditworthy debt are “rated more harshly,” according to a study by scholars at Indiana University in Bloomington, Washington, D.C.-based American University and Rice University in Houston. Sovereigns rated A had no defaults over a 30-year period, compared with 1.8 percent of corporate bonds and 27.2 percent of securities backed by debt such as mortgages and loans assigned that ranking, the study of Moody’s Investors Service data said.
The research shows that profit may influence credit rankings after a government panel described the rating companies as “key enablers of the financial meltdown” in 2008. New York-based Moody’s, Standard & Poor’s and Fitch Ratings still dominate scoring for the $43 trillion global debt market, pressing borrowers from Spain to California to address fiscal imbalances to avert downgrades that may raise taxpayers’ financing costs.
“There’s a problem here of conflicts, credibility and competence,” said Phil Angelides, a former California State Treasurer and chairman of the Financial Crisis Inquiry Commission, which Congress asked to examine causes of the crisis. “The current model is tragically broken, it needs to be abandoned,” he said Oct. 14 in a telephone interview.
Credit rating companies provided inaccurate assessments of toxic mortgage securities created by the banks that paid them, contributing to $2.1 trillion in losses and writedowns by institutions worldwide after the collapse of Lehman Brothers Holdings Inc. three years ago, according to a report by the Senate Permanent Subcommittee on Investigations. S&P was criticized by President Barack Obama and Berkshire Hathaway Inc. Chairman and Chief Executive Officer Warren Buffett for its Aug. 5 downgrade of U.S. debt from AAA to AA+.
Regulators remain divided about how to create a better system. The Dodd-Frank Act, signed into law last year to overhaul financial regulation, requires government agencies to replace ratings with another standard for creditworthiness, without providing a solution. The Basel III international banking standards rely on rankings to gauge risk, Mark Van Der Weide, a senior associate director at the Federal Reserve, said during a Subcommittee on Oversight and Investigations meeting on July 27.
No Easy Answer
“That people have been focused on it for three years and haven’t come up with an answer tells you it’s not an easy answer,” Gary Witt, a former Moody’s managing director who’s an assistant professor of statistics and finance at Temple University in Philadelphia, said Oct. 25 in a telephone interview. “There’s just not a good alternative.”
The report, titled “Credit Ratings Across Asset Classes: A=A?,” was co-written by Jess Cornaggia, assistant finance professor at Indiana University’s Kelley School of Business, with his wife, Kimberly J. Cornaggia, an associate professor at American University’s Kogod School of Business and John E. Hund, an assistant finance professor at Rice University’s Jones Graduate School of Business.
“We disagree with the study’s methods and findings,” said Michael Adler, a spokesman for Moody’s. “It attempts to draw broad conclusions about the comparability of Moody’s ratings over time by relying disproportionately on the ratings performance of U.S. housing-related securities during the financial crisis.” Fitch spokesman Daniel Noonan said “we broadly disagree with the conclusions of this study, which did not examine Fitch data.”
S&P’s criteria are “developed and applied independent of any commercial considerations,” said spokesman Edward Sweeney. The majority of U.S. corporate ratings are speculative-grade, while American state and local government debt is usually ranked investment grade, he said. “Transitions in corporate ratings can happen for a variety of reasons, including changes in the conditions and prospects for the company, regulatory changes, merger and acquisition activity and changes in corporate strategy or financial policy,” Sweeney said.
Senator Carl Levin, Democrat of Michigan, said the study is consistent with government findings on conflicts of interest at credit-raters. He endorses a proposal to create a new board to parcel out assignments to the companies that was put forward by Senators Al Franken, Democrat of Minnesota, and Roger Wicker, Republican of Mississippi. That measure is for bonds backed by assets such as mortgages and loans.
‘Influence His Calls’
“It’s no surprise that if an umpire knows who pays his bills it will influence his calls,” Levin said Oct. 25 in an e-mailed statement. The U.S. Securities and Exchange Commission “should adopt the Franken-Wicker approach on using an independent intermediary to assign initial credit ratings.”
Rankings are meant to be consistent to allow investors “to compare credit risk across jurisdictions, industries and asset classes,” Farisa Zarin, the managing director for global regulatory affairs at Moody’s, said in a Feb. 18 e-mail to the SEC and posted on the regulator’s website.
Moody’s revenue from grading company debt and financial borrowers rose 26 percent last year to $843 million from 2009, according to filings. That compared with a 10 percent increase to $272 million from giving grades to public securities.
“We take strong exception to the implication that commercial considerations play any role in our credit ratings,” Adler said. “The commercial and analytic aspects of our business operate separately. Commercial considerations do not and never have influenced our ratings process.”
S&P, which is owned by McGraw Hill Cos., doesn’t provide that level of revenue detail. The New York-based firm said sales rose 10 percent last year to $1.7 billion and profit increased 7 percent, driven in part by record high-yield corporate bond issuance.
Fitch, a unit of Paris-based Fimalac, said revenue grew 6.3 percent to 488 million euros ($678 million) in 2010 from a year earlier, without disclosing the breakdown of contributions.
The university research, which analyzed Moody’s revenue, default data and rating changes across security classes over the 30 years ending in 2010, found that initial assessments of bonds backed by assets such as mortgages were the least accurate and more likely to be downgraded than sovereign or municipal debt, whose grades were more often raised.
“Credit-rating inflation is correlated with the asset classes that generate the most revenue for the raters,” said Jess Cornaggia, who has presented research at the SEC and the Commodity Futures Trading Commission.
While the study was based on Moody’s data, it would find about identical results with data from S&P and Fitch because each firm’s grades closely track each other, Cornaggia said in an Oct. 14 e-mail.
“Extrapolating performance from one rating firm to another is not appropriate,” S&P’s Sweeney said.
Moody’s and Fitch began rating the creditworthiness of U.S. state and local government bonds the same way they do corporate debt in 2010. S&P has insisted its ratings are comparable and no across the board adjustments are needed.
Bond ratings for municipalities, which typically pay the least, are the most accurate, a measure within the study showed. Those bonds, whose issuers usually have the power to tax constituents, have a 0.44 accuracy ratio, where a higher number means a stronger relation between lower credit ratings and higher defaults. The ratio was 0.4 for company securities, 0.36 for sovereign debt, 0.3 for bank and financial companies and 0.16 for securities backed by assets such as credit cards and mortgages.
Corporate debt, with a median initial rating of Baa2, has a 30 percent chance of being lowered and a 20 percent likelihood of being upgraded, according to the study, which analyzed Moody’s revenue, default data and rating changes across different types of securities. Sovereign borrowers with a median Aa3 ranking are three times more likely to be raised than cut.
The comparability of long-term grades across assets is a “core aspiration” for Fitch, its chief credit officer John Olert said, according to a March 7 report e-mailed to the SEC.
When S&P assigns a rating symbol, its intent is to show roughly the same opinion of creditworthiness, “irrespective of whether the issuers are a Canadian mining company, a Japanese financial institution, an Illinois school district, a British mortgage-backed security, or a sovereign nation,” S&P president Deven Sharma said Feb. 7 in a letter to the SEC.
Moody’s charges about $250,000 to grade a $500 million corporate bond, while S&P charges $248,000, according to a Jan. 28 report by JPMorgan Chase & Co. If Tennessee sold that amount, it would pay Moody’s $115,000 for a rating, said Mary-Margaret Collier, its director of state and local finance.
While Moody’s and S&P provide rankings to countries including France, Germany and the U.K. for free -- known as unsolicited grades -- products such as mortgage-backed securities cost the most to be rated.
The Senate investigations subcommittee headed by Levin blamed the rating firms for putting revenue ahead of accurate assessments, helping fuel the crisis by “masking the true risk of many mortgage-related securities.”
S&P collected as much as $750,000 to grade pieces of a collateralized debt obligation, which bundles mortgages or loans and slices them into securities of varying risk, before the credit market meltdown in 2008, according to the panel’s April 13 report.
It’s “just another demonstration of the fact that ratings have historically been skewed by the parties that are compensating the raters,” Byron Georgiou, a commissioner on the crisis panel and former legal affairs secretary for California, said Oct. 12 in a telephone interview from Las Vegas. “You can frequently demonstrate the accuracy of ratings by following the money.”
Moody’s, S&P and Fitch haven’t lost influence among investors. Moody’s reduced Spain’s credit rating for the third time since June 2010 on Oct. 18 following similar actions by S&P and Fitch, after all three companies had downgraded Italian debt as Europe’s debt crisis spread. Even as governments criticized the downgrades, yields on the debt rose to about record levels.
S&P’s cut of the U.S. credit rating to AA+ in August triggered a loss of $9.7 trillion in market value from global equities last quarter. Government debt returned 6.4 percent, the most since the three months ended December 2008.
S&P’s U.S. Downgrade
A Bloomberg survey of 1,031 subscribers found that 57 percent of U.S. investors agreed with S&P’s decision, compared with about 75 percent of those in Europe and Asia. While most of those polled backed S&P’s downgrade, 35 percent of investors said that overall the grades given by rating firms aren’t reliable. Only 1 percent called them very reliable, 18 percent fairly reliable and 45 percent just somewhat reliable.
Buffett, the world’s most successful investor, said the U.S. should be “quadruple-A.” John Bellows, acting assistant Treasury secretary for economic policy, said S&P had made a $2 trillion “mistake” in its math and then changed the rationale for its decision to politics instead of financial metrics. Moody’s and Fitch have affirmed their AAA grades on the U.S.
Differing performance and variance in initial ratings is a “warning flag,” showing the system of assigning credit ratings is still influenced by profit, said Angelides, whose Financial Crisis Inquiry Commission was created by a law in May 2009 to examine the causes, domestic and global, of the financial and economic crisis in the U.S.
“Until you break this link of who pays for the ratings and who benefits from those ratings, then we’re going to continue to have a very fundamental problem in our ratings system,” he said. “Not all ratings are created equal.”