The professors also analyzed the rate at which different types of assets had their ratings downgraded or upgraded and found a similar pattern. After five years, 27% of A-rated corporate bonds were downgraded, versus 6% of municipal bonds and just 3% of sovereign issues. Unsurprisingly, a whopping 53% of CDOs were downgraded.
Moody's dismisses the research. "We disagree with the study's methods and findings," says Michael Adler, a spokesperson for Moody's. "It attempts to draw broad conclusions about the performance and comparability of Moody's ratings over time by relying disproportionately on ratings volatility stemming from the financial crisis, a period in which Moody's' ratings changes reflected the unprecedented decline in credit quality for U.S. housing related securities."
When structured products tanked during the crisis, ratings agencies defended the securities' high scores by arguing that they were too opaque to evaluate. The study's authors reject that idea. If the opacity defense were true, they wrote, then simple pools of mortgages or credit card receivables ought to have received less inflated ratings than complex corporate issuers with off-balance sheet debt and synthetic leases. But structured products routinely received more liberal grades, irrespective of their complexity.
The professors concluded that ratings inflation corresponded not to opacity, but revenue. "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," they wrote.
The findings corroborate the theory that the agencies' much-critiqued business model, in which bond sellers pay for their own ratings, poses a conflict of interest. Though the professors don't outright accuse the ratings agencies of running a pay-for-play scheme, the implications are clear: Issuers with bigger pockets received more generous scores.
Cornaggia says it's too soon to tell if municipal bonds are finally receiving a fair shake. But he points out that the industry's business model is the same. As a result, he says, the impetus that may have induced agencies to plump ratings for higher-paying customers hasn't gone away.
Such practices impact institutional buyers like pensions and insurers, which are often restricted to buying highly rated debt. Because these investors can shop across assets, they have an incentive to buy bonds with fatter yields--even if, unbeknownst to them, those bonds' ratings were inflated. As a result, Cornaggia says, taxpayers, who pay out interest rates on public bonds, suffered.
As part of the Dodd-Frank Act, the SEC is looking at a number of topics related to the ratings agencies, one of which is standardization. The SEC posted a request for comments that asked, amongst other things, whether ratings were "comparable across asset classes."
Farisa Zarin, a managing director at Moody's, wrote in response that the agency's ratings are used "to compare risk across jurisdictions, industries and asset classes, thereby facilitating the efficient flow of capital worldwide."
Cornaggia says his study refutes the agency's claim that its ratings are universal. "What we've shown is that's not the case," he says.
