Credit-rating companies like Moody’s Investors Service and Fitch Ratings routinely award higher rankings to debt issued by banks and corporations that pay them the most, a conflict of interest that Congressional may be unable to do anything about.
According to a study by scholars at Indiana University in Bloomington, American University in D.C., and Rice University in Houston, the bonds of cities and countries are “rated more harshly” when they pay about half as much than issuers of less creditworthy debt.
A study of Moody’s showed that Sovereigns with an A rating had no defaults over a 30-year period, while corporate bonds with A ratings went into default in 1.8% of cases and securities backed by debt defaulted 27.2% of the time. Research shows that profit may influence credit rankings.
In 2008, the government described the ratings companies as “key enablers of the financial meltdown” for misleading investors. And yet Moody’s, Standard & Poor’s, and Fitch still dominate scoring for the $43 billion global debt market that has been in the spotlight since the recession, particularly in the euro zone.
“There’s a problem here of conflicts, credibility and competence,” said Phil Angelides, a former California State Treasurer and chairman of the Financial Crisis Inquiry Commission. “The current model is tragically broken, it needs to be abandoned,” said Angelides in an October 14 interview.
Ratings agencies provided inaccurate assessments of toxic mortgage securities packaged by banks that paid them. Those toxic securities have contributed to $2.1 trillion in losses and writedowns by institutions around the world since Lehman Brothers’ collapse three years ago, according to a report by the Senate Permanent Subcommittee on Investigations.
While regulators are aware the system is flawed, they are divided about how to improve it. The Dodd-Frank Act requires government agencies to replace ratings with another standard for creditworthiness, but doesn’t provide a solution for how to do so. The Basel III international banking standards rely on rankings to gauge risk.
A spokesman for Moody’s disagrees with the study’s methods and findings. “It attempts to draw broad conclusions about the comparability of Moody’s ratings over time by relying disproportionately on the ratings performance of U.S. housing-related securities during the financial crisis,” said Michael Adler. Fitch spokesman Daniel Noonan said “we broadly disagree with the conclusions of this study, which did not examine Fitch data.”
S&P’s criteria are “developed and applied independent of any commercial considerations,” according to spokesman Edward Sweeney, who also laid out a host of reasons why corporate ratings might change.
However, Senator Carl Levin (D-Mich.) said the study is consistent with government findings on conflicts of interest at ratings companies. Levin endorses a proposal to create a new government board to make assignments as put forward by Senators Al Frank (D-Minn.) and Roger Wicker (R-Miss.).
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Rankings are considered important because they allow investors “to compare credit risk across jurisdictions, industries and asset classes,” said Farisa Zarin, the managing director for global regulatory affairs at Moody’s. Moody’s revenue from grading company debt and financial borrowers rose 26% last year to $843 million from 2009, compared to a 10% increase to $272 million from grading public securities.