All credit ratings are not created equal
New study by Rice,
American and Indiana universities shows inflation of credit scores

BY AMY HODGES
Rice News staff

A recent study by researchers from Rice University, American
University and Indiana University found that over the last 30 years, at least
one of the big three ratings agencies exaggerated credit scores of private debt
compared with public bonds. The study comes following the recent downgrade of
U.S. debt by Standard & Poor’s and 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. 

	JOHN HUND

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 and compared the
frequency at which different assets that received the same letter grade
defaulted. Their findings revealed significant differences. Zero percent of
sovereign bonds and 0.49 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 analyzed
the rate at which different types of assets had their ratings downgraded or
upgraded and found a connection between this data 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 said. “Debt from different
types of issuers with the same ratings have different default rates 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 study said. “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 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 present system of ratings have
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,” Hund said.