During the financial crisis of 2008, major credit rating agencies faced sharp criticism for failing to recognize and warn of the risks of emerging instruments like mortgage-backed securities.
Since that time, the results of a new study suggest, the agencies appear to have learned a critically important lesson: getting it wrong can seriously damage their reputations and hurt their businesses. As economic fears mount and raise default concerns, a fresh analysis of new-and-improved credit rating agencies sounds a hopeful note about the reliability of their system for investors.
“Our paper answers the question, ‘Should we continue to rely on ratings, given all the times that ratings have been shown not to be correct?”
Harvard Business School assistant professor Anywhere Sikochi and colleagues crunched thousands of ratings between 2003 and 2015 to test long-standing criticisms of credit rating agencies. High-profile failures of the agencies to predict catastrophes, like the Enron and WorldCom scandals, caused “everyone to wonder, ‘Where were the credit rating agencies?’” Sikochi explains. “Our paper answers the question, ‘Should we continue to rely on ratings, given all the times that ratings have been shown not to be correct?’”
The results suggest that the answer is yes, especially given improvements since the financial crisis, Sikochi says. The motivation to avoid high-profile failures has given way to signs that rating agencies are acting more defensively today than before the crisis, delivering more accurate and relevant ratings for investors.
The paper, published in Management Science, was coauthored by Sikochi, Samuel B. Bonsall IV and Karl A. Muller III of Penn State University; Kevin Koharki of Purdue University; and Pepa Kraft of HEC Paris.
Going beyond the numbers
Credit ratings play an essential role in global finance by assessing whether borrowers can meet their debt obligations. Agency analysts study data from financial statements to make initial assessments about bond issuers, which include companies, countries, states, and local governments.
Many analysts put their initial opinions through additional levels of scrutiny, in which they evaluate more qualitative information from sources such as interviews with management, suppliers, and partners, and an in-depth review of underlying strategic plans.
Based on both the financial data and qualitative or “soft” adjustments, analysts give an opinion about the “ability and willingness” of the issuer to repay investors who purchase debt securities, according to Standard & Poor’s. Major credit rating agencies include Moody’s and Fitch.
Deep dive into ratings
The financial crisis provided a lens through which to look at what went wrong with the ratings system and how much it has changed.“What we wanted to find out was, are there times that they actually do a good job? Do we find they provide ratings that are accurate?”
During the subprime crisis, many observers concluded that “the rating agencies are messing up all the time,” says Sikochi. “What we wanted to find out was, are there times that they actually do a good job? Do we find they provide ratings that are accurate? Do they provide ratings that are relevant? Are they using the tools at their disposal to reflect risk before that risk is reflected in the company?”
Analyzing thousands of ratings, the researchers show that the credit rating agencies are becoming more skeptical in evaluating higher-risk debt issues, slashing missed defaults by between 57 and 72 percent. A missed default occurs when an agency predicts a default that doesn’t happen or fails to predict a default that subsequently comes to pass.
They focused on the “soft” adjustments as an indicator of whether agencies were providing accurate and relevant information to investors.
Their paper asks if analysts were using their discretion “defensively” to account for signs of greater risk that might not appear on a balance sheet or cash-flow statement. In addition, the study also looked at how well agencies did in estimating potential recovery by borrowers in the event of a default.
A final question the researchers examined was whether there was evidence that the agencies assigned more experienced and highly educated analysts to evaluate debt issues with more inherent risk.
How much has changed
The results of the study indicate that credit rating agencies are more careful and comprehensive in their ratings of high-risk issues for reasons of self-preservation. The agencies are motivated to avoid high-profile failures because it undermines the confidence of customers in the credibility of their rating, Sikochi says.In the past, credit rating agencies have received extensive criticism for using the “issuer-pay” model, where the organization issuing the debt pays the agencies for their ratings. Some have argued that this creates a potential conflict of interest.
An alternative source of revenue for agencies that gets less criticism is through a “subscription” model, where investors pay a monthly fee for access to ratings.
Regarding the higher-risk issues, the study finds that agencies are overcoming the financial incentives to rate specific issues inappropriately high.
“Overall, our study suggests that as the likelihood of issuer default grows, the threat of reputational harm from discovered rating failures increasingly mitigates the rating agencies’ strategic behavior incentivized by the issuer-pay model,” the study concludes.
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Image: iStockphoto/CHUNYIP WONG