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All credit ratings not created equal

RICE U. (US) — At least one of the Big Three credit rating agencies exaggerated scores of private debt compared to public bonds during the last 30 years, research shows.

The study, published by the Social Sciences Research Network, 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, especially in light of the recent downgrade of U.S. debt by Standard & Poor’s.

Researchers found significant differences in examining credit ratings assigned by Moody’s Investors Service from 1980 to 2010 and comparing the frequency at which different assets that received the same letter grade defaulted.


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,” says John Hund, business professor at Rice University.

The study 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 credit scores are not comparable across asset classes,” Hund says. “Debt from different types of issuers with the same ratings has different default rates and different patterns of ratings changes.”

Municipal and sovereign bonds have been rated more harshly and structured products more generously when compared with traditional corporate bonds, according to the study that 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 write. “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 says 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. 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.”

A consistent ratings system is vital to the future financial health of the United States, Hund says.

“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.”

Jess Cornaggia of Indiana University and Kimberly Cornaggia of American University contributed to the study.

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