The recent downgrade of U.S. debt by Standard & Poor's reignited the debate over whether ratings agencies can be trusted to fairly assess different types of debt. A new study could add fuel to the fire: Professors at Indiana University, American University and Rice found that, over the last 30 years, at least one of the big three agencies, Moody's Investors Service, inflated the credit scores of private debt relative to public bonds.
Even more damning is their conclusion that assets that generated greater proceeds for the ratings agency were rated more leniently than less lucrative securities. "Ratings optimism (leniency or inflation) increases in the revenue generation by asset class," wrote the authors. "The evidence overwhelmingly suggests that while ratings of structured products were significantly more generous (optimistic) than those assigned to corporate issues, those assigned to municipals and sovereign issuers were significantly less generous (more pessimistic)."
Although S&P, Moody's and Fitch use different letter systems to gauge the health of various types of bonds, each applies its own individual criteria across asset categories. So when Moody's says a collateralized debt obligation, a corporate bond and a sovereign issue are all rated AA, the implication is that the three types of bonds are equally healthy.
But professional investors have long been dubious of the ratings' commonality, according to Joe Balestrino, the chief fixed income strategist at Federated Investors, an investment management firm with $355 billion in assets. "There are inconsistencies or discrepancies from one asset class to another," he says. "Munis are the most glaring example."
For decades, Moody's used a separate scale for municipal debt, which gave the bonds the appearance of being underrated. The agency argued that sophisticated investors understood that municipal issues were less likely to default than similarly rated corporate issues.
Public officials disagreed. In 2008, Conn. Attorney General Richard Blumenthal sued the big three ratings agencies, citing several internal studies that suggested the companies were aware that municipal bonds were defaulting at a much lower rate than private issues. Bill Lockyer, the treasurer of the state of California, led a campaign to force the agencies to modify their scales.
Eventually, Moody's -- and Fitch Ratings, which also used different criteria for munis -- caved. In 2010, both agencies recalibrated their municipal ratings systems so that they better corresponded to their corporate rating scales, which resulted in upgrades for thousands of public bonds. S&P maintains that its general ratings scale does not discriminate against municipal debt.
But the study's findings go beyond municipal bonds. "The fact remains that sovereigns are getting the shaft relative to corporates, and corporates are getting the shaft relative to structured products," says Jess Cornaggia, one of the authors of the paper. (Though the study only used data from Moody's, Cornaggia says the results likely apply to S&P and Fitch, which tend to produce similar ratings).
Cornaggia and his co-authors looked at the credit ratings Moody's assigned between 1980 and 2010, then compared the frequency at which different assets that received the same letter grade defaulted. They found large disparities. For example, while just 0.49% of municipal bonds and 0% of sovereign bonds that received an "A" rating defaulted, the rate was 1.83% for analogous corporate bonds, 4.92% for financial bonds and 27.2% for structured products.
