News Column

Moody's is Lax in Rating the Bonds of Companies in Which Its Top Shareholders are Heavily Invested, Study Finds

July 24, 2014



SARASOTA, Fla., July 24 -- The American Accounting Association issued the following news release:

Should a credit-rating agency be a public company, with all the commitments to shareholders -- as distinct from commitments to clients and the public-at-large -- that this status entails?

When Moody's, the U.S.'s second largest credit-rating agency, became a public corporation in 2000 upon being spun off by Dun and Bradstreet, there was no objection from regulators. Except for some public grumbling in the wake of the 2007 world financial crisis -- when former employees of Moody's charged the company with having traded its reputation for short-term profits -- the public-ownership issue has been largely quiescent.

That could change, though, as a result of a paper to be presented next month at the annual meeting (in Atlanta, Aug. 2-6) of the American Accounting Association, the largest organization in the world devoted to accounting research.

Examining in detail Moody's bond ratings between 2001 and 2010, and comparing them to ratings of the same bonds by the nation's largest rating agency, Standard & Poor's (which is not a free-standing public company), the study finds a tangible bias favoring firms in which Moody's two largest shareholders, Berkshire Hathaway and Davis Selected Advisors, have a substantial stake of 0.25% or more. Between them, Berkshire Hathaway and Davis own almost one fourth of Moody's stock, and together they had large stakes in an average of 62 companies in the decade covered by the study.

A collaboration of Shivaram Rajgopal of Emory University and Simi Kedia and Xing Zhou of Rutgers University, the study finds, after controlling for a variety of factors which might affect rating levels, that Moody's ratings are almost a half notch higher than those of S&P on more than 900 new bonds issued by the favored firms over the course of a decade. The boost of a half notch in ratings for those issues, the authors estimate, amounts to an interest savings for the issuing firms of almost a half million dollars per bond per year.

In contrast to this finding, the authors "do not find evidence of favorable treatment by Moody's toward the large investees of its post-IPO long-term large shareholders (i.e., Berkshire Hathaway and Davis Selected Advisors) prior to its IPO."

Further, in probing whether Moody's favorable treatment toward its owners is observed in its rating of outstanding bonds as well as new issues, the researchers find that "Moody's is slower than S&P by 71 days in downgrading bonds related to its long-term large shareholders," namely Berkshire Hathaway and Davis.

The professors find an analogous pattern in the rating of commercial mortgage-backed securities (CMBS's), which were the fastest-growing segment for credit-rating agencies during the sample period of 2001 through 2010. "Though Moody's is on average tougher than S&P," they write, it "is significantly less tough on related tranches" -- that is, CMBS's issued by the financial firms in which Berkshire Hathaway and Davis were heavily invested. Meanwhile "over all, there is no evidence that a laxer S&P is relatively easier toward related tranches." In other words, S&P showed no favoritism toward CMBS's issued by firms in which Goldman Sachs (which had large ownership stakes in S&P's parent company, McGraw-Hill) was heavily invested.

As would be expected, the study goes to considerable lengths to test the strength of its findings. Suppose, for example, the differences noted between the ratings of S&P and Moody's are due to the nature of the raters' analyses (such as differing importance assigned to leverage or stock-price volatility) rather than to the bias of Moody's? To guard against any such misreading, the authors control for these and diverse other factors that are likely to affect credit ratings.

In addition, they compare Moody's ratings to those of Fitch, the nonpublic firm that is the U.S.'s third largest credit-rater, and find a pattern of Moody's favoritism similar to that which emerges in comparisons to S&P.

The professors also assess possible rating favoritism at S&P, which, while not a free-standing public company, like Moody's, is a subsidiary of publicly traded McGraw-Hill. "We find one shareholder, Goldman Sachs, who is classified as a long-term large shareholder of McGraw-Hill for three quarters over the sample period," they write. "S&P gives favorable ratings to the new bond issues, though not to outstanding bonds, of large investees of [Goldman Sachs]." Compared to bias of direct ownership seen in Moody's, "the evidence suggests some, though much weaker, effect of indirect ownership on credit ratings."

"S&P is no Mother Theresa," comments Prof. Rajgopal. "But its biases are less extensive than those of Moody's."

In conclusion, the authors note that "the SEC and the EU have recently expressed concerns about potential conflicts of interest faced by ratings agencies with regard to the interests of their large owners. We provide evidence to suggest that these concerns are not misplaced."

Asked to elaborate, Prof. Rajgopal demurs, observing that detailed recommendations are beyond the scope of the study. But he does express agreement with an assessment of the current situation made by Stanford University'sMary Barth, currently the president of the American Accounting Association, in commenting on a paper of hers on securitization published in the journal The Accounting Review. "In the end," she said, "there are two principal ways to think about these [credit-rating] agencies. One is they are as important as banks and insurance companies and have to be as closely subject to regulation as those institutions are. The other is that agencies deserve to have the same freedom of speech as a broker who advises you to buy some particular stock, but let the buyer beware. Either alternative could make sense, but right now we seem to have neither."

To which Prof. Rajgopal adds that what gives this issue special urgency is the quasi-regulatory role of credit ratings. "The regulatory capital requirement for banks and insurance companies varies with the credit ratings of the securities they hold," he says, "and money-market funds can hold only a minimal number of securities that are not rated. Laxity arising from market pressures stemming from public ownership of these agencies represents a threat to the entire financial system and has the potential to seriously erode market confidence."

The paper, entitled "Does it matter who owns Moody's?" will be among hundreds of scholarly presentations at the American Accounting Association meeting, which is expected to draw more than 3,000 scholars and practitioners to Atlanta, Georgia, from August 2 to 6. The AAA is a worldwide organization devoted to excellence in accounting education, research, and practice. Journals published by the AAA and its specialty sections include The Accounting Review, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Auditing: A Journal of Practice & Theory, and The Journal of the American Taxation Association

[Category: Accounting]

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