The false equivalence of credit ratings

July 15, 2014

In a new report, Janney Capital Markets analyst Tom Kozlik calls out Standard & Poor’s for credit ratings on local governments that he says are too liberal. Kozlik claims that S&P is inflating ratings. I think his analysis is solid, but inconclusive given the size of his claim. Kozlik opens the door to more critical analysis of the comparability of ratings.

The Bond Buyer wrote:

Since S&P updated its criteria, it is more common for issuers to have ratings from S&P that are multiple notches higher than their ratings from Moody’s. ‘This leads us to believe that ratings shopping will continue, perhaps at an even faster pace than before,’ Kozlik wrote.

Ratings are opinions. There is nothing in federal law or the SEC rules that says one rater must be as conservative as another. Credit rating firms are free to analyze bond issuers however they want, as long as they disclose the methodology. Kozlik seems to believe, like most of the market, that raters should assign alphanumeric ratings in a standardized way to signal risk on an equal scale.

Issuers obviously want the highest rating possible so they can borrow money at the lowest cost. Investors want the opposite — for issuers to get critical ratings so they can get paid higher interest rates. Issuers often “shop” their ratings to find the best one.

There are ten raters that are officially “recognized” by the SEC to assign ratings. Four of these firms assign ratings for muniland (Fitch, Kroll, Moody’s and S&P).

Kozlik’s new report, “Are S&P’s Local Government Ratings Too High?” covers three areas that he believes shows that S&P gives inflated ratings:

  • He plots data showing that S&P has higher upgrade-to-downgrade ratios than Moody’s.
  • He details an instance where the two raters diverged in their assessment of a specific issuer in which S&P left out important information.
  • He alleges that issuers hide their lowest ratings and don’t include them in official statements and other investor communications.

If Kozlik is right, has S&P broken any rules? No, because credit ratings, according to law, are merely “opinions” that raters assign to bond issuers.

Kozlik’s analysis focuses on S&P’s methodology for U.S local government general obligation (GO) bonds, which it revised in 2013.

Kozlik admits that S&P said upfront that its revised local GO criteria would improve its muni ratings. S&P’s upgrades are happening at a time when local governments are under increasing fiscal stress and ratings should be going down instead of up.

It is up to market watchers to do more analysis and use transparency to highlight where the raters are diverging from each other. Raters are required to publish complete sets of historical rating data in machine readable form that allow researchers or market participants to mash up ratings between firms and with trade data. Analyzing this data is the best way to look at systemic rating issues.

Kozlik’s work is laudable for shining a light on rater performance. But I think it also highlights that ratings are not scientific and that raters are free to define how they look at issuers. This only demands more analysis.

In the end, investors have to determine how useful ratings are for themselves. As David Litvack, Managing Director at U.S. Trust, Bank of America Private Wealth Management wrote to me about credit ratings: “We have always believed independent research is essential for investing in any fixed-income security.”

Further:

Nuveen: Rating Change Data Reveals Moody’s and S&P Divergence

One comment

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I should have included these in the post from S&P:

The press release from their local GO methodology revision:

https://drive.google.com/file/d/0BwUldNJ -sOg_RTJMYm1hRS1ldkU/edit?usp=sharing

And S&P’s open source local GO ratings platform:

https://www.spratings.com/credit-tools/u s-local-government-scenario-builder

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