All credit ratings not created equal

Sep 15, 2011

At least one of the "Big Three" credit ratings agencies exaggerated credit scores of private debt compared to public bonds during the last 30 years, according to a new study by researchers from Rice University, American University and Indiana University.

The recent downgrade of U.S. debt by Standard & Poor's makes the study timely, and the research adds to the current debate surrounding regulatory reliance on credit ratings and the current Securities and Exchange Commission proposal to standardize credit ratings across asset classes.

For the study, "Credit Ratings Across Asset Classes: A ≡ A?," business professors John Hund of Rice, Jess Cornaggia of Indiana and Kimberly Cornaggia of American examined credit ratings assigned by Moody's Investors Service from 1980 to 2010. They compared the frequency at which different assets that received the same letter grade defaulted, and they found significant differences. Zero percent of sovereign bonds and .49 percent of municipal bonds that initially received "A" ratings defaulted, compared with 1.83 percent of corporate bonds, 4.9 percent of financial bonds and 27.2 percent of structured bonds.

"Professional investors have been uncertain about the Big Three's ratings similarities, and our findings show that their hesitation is justified," Hund said.

The researchers also found a connection between the rate at which different types of assets had their ratings downgraded or upgraded and the different asset classes. After five years, 27.4 percent of A-rated corporate bonds, 17.8 percent of financial bonds and 33.3 percent of structured bonds were downgraded, versus only 3.3 percent of sovereign bonds and 6.1 percent of municipal bonds.

"Contrary to statements by the Big Three credit raters, our research demonstrates that are not comparable across asset classes," Hund said. "Debt from different types of issuers with the same ratings has different default and different patterns of ratings changes."

The study also shows that municipal and sovereign bonds have been rated more harshly and structured products more generously when compared with traditional corporate bonds. The authors found an inverse correlation between ratings standards and revenue generation among the asset classes.

"We find ratings optimism (leniency or inflation) increases in the revenue generation by asset class," the researchers wrote. "Revenues generated from structured finance products are significantly higher than those generated from corporate issuers which are, in turn, higher than those generated from sovereign issuers and municipalities."

Hund said he hopes that the study will shed new light on the current ratings system and will motivate organizations to do independent research rather than simply rely on what credit agencies are saying.

"In the past several years, some investors have depended on credit agencies to guarantee their decisions as 'safe,' and the current ratings system makes it difficult to determine which are the riskier securities," Hund said. "Ultimately, it's up to investors to know the difference, but the present system of ratings has left many with a false sense of security."

Hund said a consistent ratings system is vital to the future financial health of the United States.

"The foundation of our financial system is understanding credit risk, but we need to re-examine the credit ratings process and the ratings agency's role in that process in order to ensure that the foundation is solid for the future."

Explore further: Economist probes the high cost of health care

More information: papers.ssrn.com/sol3/papers.cf… ?abstract_id=1909091

add to favorites email to friend print save as pdf

Related Stories

People more likely to overestimate their credit quality

Jun 02, 2008

A new study published in the Journal of Consumer Affairs examined consumers' self-assessments of their credit rating and found that respondents were more likely to believe they had average or above average credit and those ...

Corruption is Expensive, But Who Pays the Bills?

Mar 25, 2008

One often must look no further than today’s headlines to find examples of personal failure, corporate financial woes and political corruption. But how does political integrity affect the bottom line? A University of Missouri ...

Recommended for you

Economist probes the high cost of health care

16 hours ago

When Zack Cooper arrived at Yale as assistant professor of public health and economics, he gained access to a first-of-its-kind dataset. Working with the non-profit Health Care Cost Institute, Cooper and ...

Cash remains king in Chile but its days could be numbered

Mar 26, 2015

For more than a year now, Chileans have endured a crisis of cash access. Despite global moves toward new forms of payment such as contactless and mobile transfers, the crisis in Chile highlights the continuing ...

Will you ever pay off your student loan?

Mar 25, 2015

Would-be participants of higher education must be given full and transparent advice before they accumulate debts as students that follow them into the workplace, according to a report published in the International Journal of ...

User comments : 0

Please sign in to add a comment. Registration is free, and takes less than a minute. Read more

Click here to reset your password.
Sign in to get notified via email when new comments are made.