V O LU M E 2 2 | N U M B E R 3 | S U MMER 2 0 1 0

Journal of
APPLIED CORPORATE FINANCE
A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Fixing the Financial System

Excerpts from 8 The Squam Lake Group

The Squam Lake Report: Fixing the Financial System

The Financial Crisis: Causes and Lessons 22 Kenneth E. Scott, Stanford Law School and the
Hoover Institution

Convertible Securities and Bankruptcy Reforms: 30 Charles I. Plosser, Federal Reserve Bank of Philadelphia
Addressing Too Big to Fail and Reducing the Fragility of the Financial System

Thoughts on The Squam Lake Report: Reengineering the 34 Kenneth A. Posner, North American
Financial System to Better Withstand Extreme Volatility Financial Holdings, Inc.

Statement of the Financial Economists Roundtable 40 Financial Economists Roundtable

Reforming the OTC Derivatives Markets

Derivatives Clearing Mandates: Cure or Curse? 48 Craig Pirrong, University of Houston

Bond Rating Agencies: Conflicts and Competence 56 Martin Fridson, BNP Paribas Asset Management, Inc.

Rethinking “Strength of Incentives” for Executives of Financial Institutions 65 John McCormack, Morgan Stanley, and Judy Weiker,
Manewitz Weiker Associates

Speed Bankruptcy: A Firewall to Future Crises 73 Garett Jones, George Mason University

Banking System Bailout—Scandinavian Style 85 B. Espen Eckbo, Tuck School of Business at

Dartmouth College

Replenishing the Banking Sector: Managing Bank Capital in the Post-Crisis World 94 Ajay Khorana and Matt Perlman, Citigroup

Lessons from the Global Financial Crisis 112 Brian Kantor and Christopher Holdsworth,
(Or Why Capital Structure Is Too Important to Be Left to Regulation) Investec Securities, South Africa
Bond Rating Agencies: Conflicts and Competence
by Martin Fridson, BNP Paribas Asset Management, Inc.*
B
T
he search for culprits in the financial crisis of
2008 has placed the bond rating agencies on the
docket, along with subprime mortgage brokers,
AIG, and the government-sponsored enterprises,
Fannie Mae and Freddie Mac. Critics depict Moody’s Inves-
tors Service, Standard & Poor’s, and Fitch Ratings as enablers
of the firms that created, distributed, and recklessly invested
in excessively risky structured finance deals that blew up and
brought the global financial system to the precipice. Accord-
ing to this narrative, the imprimatur of the agencies’ Triple-A
ratings1 was the essential ingredient in the lethal Kool-Aid
imbibed by financial institutions prior to the debacle. That
was when it still seemed plausible that ultra-safe investments
could be constructed from “low-doc,” “no-doc,” and “ninja”
loans.2
These criticisms are by no means unfounded. Indeed,
it would be impossible to defend the agencies’ pre-debacle
ratings of mortgage-related collateralized debt obligations
(CDOs) on the basis of the instruments’ subsequent credit
performance. According to Chairman Phil Angelides of the
U.S. Financial Crisis Inquiry Commission, 89% of the invest-
ment grade mortgage-backed securities ratings that Moody’s
awarded in 2007 were subsequently reduced to speculative
grade. This was a level of instability surely not contemplated
by buyers of debt instruments characterized as high- to
medium-quality. Moody’s chairman Raymond McDaniel
has argued that the massive downgrading resulted from an
unprecedented downturn in housing prices that few would
have imagined.3 Warren Buffett, chairman of major Moody’s
shareholder Berkshire Hathaway, has noted with validity
that many financial market participants besides the rating
agencies failed to foresee the drop.4 Most other commenta-
tors, however, have been less forgiving. They charge that the
agencies’ CDO due diligence was lax and that their rating
standards were objectively flawed, failing to consider scenarios
that were within the range of reasonable expectation.
* The author thanks Kristen Mahoney and Vince Kong for their editorial and research
assistance. Any errors or omissions are his responsibility.
1. See Figure 1 for Moody’s and Standard & Poor’s rating scales. “Triple-A” refers to
the Moody’s Aaa and the Standard & Poor’s AAA categories.
2. These terms applied, respectively, to mortgages that required minimal documenta-
tion by the borrower, that required no documentation by the borrower, and that approved
a borrower with no income, no job, and no assets.
56 Journal of Applied Corporate Finance • Volume 22 Number 3
Explaining the Rating Agencies’ Performance
The agencies’ harshest critics contend that the overly rosy
assumptions embedded in the ratings were not a function
of incompetence, but of an ethical lapse. Ratings were too
liberal, the severest detractors maintain, because the agen-
cies profited by systematically overrating CDOs. The critics
charge that Moody’s and S&P fattened the issuers’ profits by
awarding higher ratings, resulting in lower borrowing costs
than their securities deserved.
At the root of this corruption of the ratings process, say
the most vehement critics, was the issuer-pay model. By way of
explanation, the agencies derive their revenue primarily from
the debt issuers, whose interest is in having the ratings be as
high as possible. Investors, on the other hand, desire accurate
ratings in order to make informed buy and sell decisions. They
contribute a comparatively minor portion of rating agencies’
revenues by paying for publications, conferences, and train-
ing. In the critics’ view, this mix of revenue sources inevitably
skews the agencies’ judgment in favor of the issuers.
Senator Al Franken (D., Minnesota) has drawn an
analogy from the field of education to describe the conflict
of interest created by the issuer-pay model:
[I]magine your child came home from school one day saying
that their [sic] chemistry teacher was offering an A to anyone
who wanted to skip the final exam and instead pay $100. You
don’t need to know anything about chemistry to understand that
this system of rewards is harmful. Not only is the teacher making
easy money, but nobody is holding the student accountable for
doing good work.5
Aggravating the issuer-pay conflict, as Franken explains it, is
the ability of issuers to shop around for the best rating, play-
ing the agencies off against one another.
Franken’s school analogy features a counterpart to the
rating agency (the teacher) and the issuer (the student), but
3. Frye, Andrew and Matthew Leising. “Buffett Says Moody’s Chief Shouldn’t Be
Singled Out.” Bloomberg News, June 2, 2010.
4. Chow, Lisa. “Buffett Defends Credit Ratings Agencies at Congressional Hearing.”
WNYC News, June 3, 2010.
5. See Franken, Al. Statement on Introduction of a Credit Rating Agencies Amend-
ment, March 3, 2010. Al Franken: U.S. Senator for Minnesota (website). http://franken.
senate.gov.
A Morgan Stanley Publication • Summer 2010
includes no character who corresponds to the investor. Let us
complete the loop. College admissions officers rely on school
grades for decision-making, much as bond buyers rely on
ratings. Expanding further on the parallel to the ratings
business and focusing on private education, the school derives
much of its revenue from its students. Many prep schools
compete to attract students and their tuition dollars. It would
therefore seem to follow from Franken’s reasoning that grade
inflation is rampant at the likes of Brearley, Collegiate, and
Phillips Exeter, leading to flawed decisions by the college
admissions officers. In reality, investigation will show that A’s
are not dispensed indiscriminately at these elite academies.
Numerous other industries furnish examples of well-
controlled conflicts. For instance, it is not proverbial that
advertisers receive kid-glove treatment from the newspapers
to which they provide the majority of revenues. That ought to
be the case, however, by the logic of rating agency critics who
assert that the issuer-pay model is unavoidably corrupting.
Somehow, newspapers manage the advertiser-related conflict,
proudly maintaining a church-state separation between their
business and editorial departments.
To critics who regard the rating agencies’ adoption of
the issuer-pay model in the 1970s as the financial equivalent
of Eve eating the forbidden fruit, the obvious solution is to
return to the investor-pay model. But this remedy overlooks
the infeasibility nowadays of generating sufficient revenue
to support a staff of analysts by selling access to the ratings.
Nobel economics laureate Paul Krugman comments, “We
can’t go back to the days when rating agencies made their
money by selling big books of statistics; information flows too
freely in the Internet age, so nobody would buy the books.”6
United States Secretary of the Treasury Timothy Geithner
has this to say about the issuer-pay model: “…I don’t see a
practical, viable alternative.”7 Senator Franken proposed a
modified issuer-pay model in which the mandates to rate
would be assigned by a self-regulatory body, but his amend-
ment to the Dodd-Frank bill for financial regulatory reform
did not survive the legislative process.
Not all of the critics, to be sure, ascribe rating agencies’
shortcomings to sinister motives. One observer, along with
several other commentators, instead blames the “mess” of credit
ratings on the Comptroller of the Currency’s 1936 requirement
that banks rely on the ratings of Moody’s, Fitch, Standard, and
Poor’s (the last two later merged) to determine whether a bond
represented a satisfactory investment.8 Another critic points to
methodological flaws in structured finance ratings, including
reliance on excessively short default histories of mortgage-
6. Krugman, Paul. “Berating the Raters.” New York Times, April 25, 2010, p. A23.
7. Standard & Poor’s, Meeting Investors’ Needs through Quality, Transparency, and
Independence (Undated).
8. Berman, Dennis K. “The Credit Raters: How We Got Here.” WSJ.com, May 25,
2010.
9. Myers, Randy. “Ratings Disaster.” CFO Magazine, June 1, 2010. [Electronic ver-
sion]
Journal of Applied Corporate Finance • Volume 22 Number 3
backed securities and failure to consider the possibility of
simultaneous default waves throughout the United States.9
And a third simply castigates the agency without seeking to
explain their failings: “An arriving Martian would find it hard
to understand why anybody gives any credence at all to S&P
and its rivals Moody’s or Fitch.”10 Like countless others who
have lambasted the agencies, this last critic mentions their
handling of Enron prior to its December 2001 bankruptcy
filing as self-evident proof of their incompetence.
In this article, I start by addressing the argument that the
issuer-pay model by its nature ensures that the ratings will be
inaccurate, as well as the broader criticism that the ratings are
not useful, whatever the cause of their alleged inaccuracy may
be. The analysis begins by describing contrasting conditions in
two market segments, corporate bonds and mortgage-related
CDOs, that could cause efforts to control conflicts of interest
to have dissimilar outcomes. Next, I present evidence that
the agencies have managed the issuer-pay conflict success-
fully in certain segments of their rating business, resulting in
substantial rating accuracy at an aggregate level. At the individ-
ual-company level preferred by most rating agency critics, this
study challenges the critics’ assertion that the investment grade
ratings held by Enron until shortly before its 2001 bankruptcy
proved that the agencies were incompetent.
Managing Conflicts: Corporate Bonds versus CDOs
As the preceding private school and newspaper examples
suggest, business activity is not hopelessly hamstrung by the
many potential conflicts of interest that inevitably arise in
a market economy. In practice, reliance on reputation gives
providers of goods and services strong incentives to control
the conflicts. Structural factors and cultural norms determine
the probability that efforts to control a particular conflict
will succeed.
A preparatory school would be unable to send its gradu-
ates to top-tier colleges, making it impossible to attract
tuition-paying students, if its grading system were known
to be excessively lenient. Similarly, a newspaper that either
blatantly promoted or conspicuously refrained from criti-
cizing its advertisers would lose readers to rivals with better
reputations for honest reporting. The resulting drop in circu-
lation could undermine the newspaper’s ability to generate
advertising revenues. In a similar way, rating agencies are able
to charge issuers for ratings only if their ratings are credible
enough to influence investors in deciding whether to buy
those issuers’ bonds. The agencies therefore have a strong
incentive to preserve the integrity of their ratings.11
10. Dixon, Hugo. “Caveat Emptor.” Breaking Views, April 28, 2010. Collected in
Reinventing Finance, Reuters, New York: 2010.
11. This incentive exists whether the agencies operate in a vigorously competitive
market or in an oligopoly created by a government seal of approval for selected rating
organizations. In the latter case, an agency that neglects the quality of its ratings risks
losing the benefit of its official status.
A Morgan Stanley Publication • Summer 2010 57
Figure 1 Rating Scales
Quality Moody’s Standard
& Poor’s
Investment Grade
Aaa AAA
Aa AA
Lowest
A A
Risk
Baa BBB
Ba BB
Speculative Grade
B B
Highest
High Yield or
Risk
Caa CCC
Ca CC
C C
D a convention of requiring ratings by both Moody’s and
In the corporate segment of the ratings business, the
agencies face no great temptation to compromise that integ-
rity. Suppose a corporation needs to raise capital in the bond
market. Going to market without ratings is generally not
a viable option.12 The company ordinarily must follow the
market convention, which at a minimum means obtaining
both a Moody’s and a Standard & Poor’s rating for its offer-
ing, although the company may also seek a rating from Fitch
or another agency.13 Because the norm is to obtain ratings
by both Moody’s and S&P, investors would look askance at
an offering rated by only one of the two leading agencies.
They would suspect that the issuer ducked the other agency
because it had reason to believe that agency would assign a
lower rating.
Under these conditions, the issuer cannot play the
agencies off against one another to obtain a higher rating
than it deserves. Moody’s and Standard & Poor’s will receive
revenue regardless of the ratings they assign. The two agencies
effectively have a captive market and stand to gain nothing
by shading their ratings in the issuer’s favor.14 On the other
hand, awarding a rating that appears too high (whether at the
time or in retrospect) could have a cost, in the form of lost
reputation. Therefore, making a good faith effort to assign
the correct rating is an easy choice for the agencies.
Staying within this analytical framework, it appears that
when a rating agency rates a mortgage-related CDO, it may
have greater difficulty controlling the conflict that arises
12. During the 1990s boom in issuance by telecommunications companies, a num-
ber of issuers that surely would have been rated in the bottom tier of the speculative
grade category (Caa by Moody’s or CCC by Standard & Poor’s, generically referred to as
“Triple-C”) went to market without ratings. Under applicable reserving rules, some inves-
tors could more easily buy nonrated bonds than they could buy Triple-C issues. Over the
years, such specialized circumstances have affected a tiny minority of issues.
13. Some critics of the rating agencies protest that ratings should not be necessary
and that investors should rely entirely on their own credit analysis. Be that as it may,
ratings are not going to disappear from the bond market any time soon. This report fo-
cuses on the agencies’ performance in the context of an expectation that they will remain
a fixture of the debt markets for the foreseeable future.
58 Journal of Applied Corporate Finance • Volume 22 Number 3
from the issuer-pay model. To begin with, the issuer is not
an existing company with a new need for capital. Rather, the
prospective offering has come about because an underwriter
has structured a financing around a pool of mortgages. The
deal is contingent on selling the senior tranche to investors
who will accept a comparatively low yield in exchange for a
very high level of perceived safety. Therefore, if the bankers
are not fairly confident of being able to obtain a Triple-A
rating on the senior tranche, they will not even bother to
commence work on the deal. In that case, the CDO will not
be created and the rating agencies will receive no revenue.
A second factor differentiates the corporate and CDO
markets, in terms of the dynamics of the rating process.
The structured finance market does not have quite as strong
Standard & Poor’s. If an underwriter pushes the limits on
leverage and initially gets rebuffed by one agency in its quest
for a Triple-A, it may be able to exert pressure for a better-
than-fair rating by implying it will go to a different agency
in future deals.
Unlike the conditions surrounding the rating of corpo-
rate bonds, the dynamics of mortgage-related CDOs do raise
the possibility that the agencies can gain by lowering their
standards. Reputation is valuable in rating CDOs, just as
in rating corporates, but the temptation is greater to sacri-
fice the long-term value of reputation for near-term profits.
This analysis does not prove that a breakdown in control
over conflicts of interest was the cause of the poor ratings
performance of CDOs in the 2000s, but that is a plausible
interpretation.
The essential point is that the issuer-pay model does not
inexorably subvert the ratings process. Much depends on
the context in which the issuer pays. The following section
presents evidence that in sectors other than mortgage-related
CDOs, Moody’s and Standard & Poor’s have controlled
potential conflicts effectively and maintained the integrity
of their ratings. The evidence deals with rating accuracy, as
judged by default experience and the market’s independent
assessment of risk.
Ratings and Default Rates
It is common to hear bond investors argue that a particular
company is under- or overrated, but such judgments can never
rise above the level of opinion. The risk that a bond issuer
will fail to meet its obligations is not observable; the finan-
14. The implication that the corporate ratings business is a duopoly seemingly up-
holds rating agency critics who contend that a lack of competition produces poor-quality
ratings. In reality, the situation likely would be worse with a larger number of competi-
tors. Issuers would have greater opportunities to shop for ratings. The least successful
agencies would stand to gain market share by being more prone than the industry leaders
to award the highest ratings. In any case, calls for increased competition must differenti-
ate between quality and pricing. A firm that earns a superior risk-adjusted return through
less-than-perfect price competition has an incentive to maintain its position by maintain-
ing quality. This effect is observable among consumer goods companies that achieve
partial monopolies through brand recognition.
A Morgan Stanley Publication • Summer 2010
Figure 2 One-Year Default Rate by Rating 1983–2009
35
Mean Annual Percentage of Issuers
30
25
Migrating to Default
20
15
10
0
Aaa Aa1 Aa2 Aa3 A1 A2 A3
Source: Moody’s Investors Service.
cial ratios employed in determining credit ratings are mere
proxies. On the other hand, the ex post incidence of default
is an objective fact.15 It is therefore possible to determine
beyond dispute whether, for example, the issuers rated Triple-
A by the agencies truly constitute a lower-risk category than
the Double-A issuers. In short, measuring the accuracy of
bond ratings is properly an aggregate exercise, notwithstand-
ing practitioners’ insistence that such-and-such a company is
obviously misrated.
Figure 1 depicts the letter-grade rating scales employed by
Moody’s and S&P. The agencies divide the Aa/AA to Caa/
CCC categories into three subcategories, e.g., Aa1, Aa2, Aa3
and AA+, AA, AA-. Moody’s Ca and C categories include
issues in or near default, while S&P reserves its D category for
defaulted issues. Market participants and certain regulations
divide outstanding bonds into investment grade (Baa3/BBB-
or higher) and speculative grade (Ba1/BB+ or lower).
A graph of Moody’s alphanumeric ratings versus one-year
default incidence (like the one provided in Figure 2) should
lay to rest any notion of gross inaccuracy in corporate bond
ratings. (Note that the unit of account is issuers, rather than
issues.) During the observation period, no issuer has defaulted
within one year of being rated Aa2 or higher. At the other
extreme, one-year default rates are 27.00% on issuers rated
Caa3 and 33.23% on issuers rated Ca-C. The rise in the
default rate is monotonic16 throughout the rating scale except,
and then only trivially, in the Aa3 to A3 categories, where
one-year default rates are all in the barely noticeable 0.05%
to 0.06% range. Far from suggesting that ratings provide no
15. In a negligible number of instances, the rating agencies disagree about whether
to classify a bond exchange as a default. These are transactions in which bondholders
agree to a reduction of their coupon or principal, or an extension of their original matu-
rity, to help the company avoid a bankruptcy that they believe would leave them even
worse off. The general rule is to classify an exchange as a default if bondholders accept
terms that are inferior to their original agreement and if they to do so under distressed
conditions. On rare occasions, the latter judgment is sufficiently subjective to produce a
Journal of Applied Corporate Finance • Volume 22 Number 3
Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca-C
Rating
useful information about risk, the graph depicts fairly refined
risk categories.
Note also that over multi-year periods, even the highest
category experiences a small incidence of default. For the
period 1970-2005,17 Moody’s reports defaults—subsequent
to being downgraded to higher-risk categories—by 0.08%
of Aaa issuers.
Figure 3 confirms that that the agency has given investors
due warning by downgrading companies as they approached
default. Over the period 1983-2009, the average defaulting
company was rated close to Ba3 five years before default but
in the B3-Caa2 range one year before default. So much for the
canard that the agencies fail to monitor issuers after assigning
initial ratings!
Stability of Triple-A Ratings
Downgrading of Triple-A companies, if it occurs in response
to escalating credit risk, is an indication that the rating agen-
cies are fulfilling their mission. On the other hand, a very
high level of downgrading at that lofty tier suggests that the
agencies are correcting an earlier, pervasive overrating of
Triple-A bonds. This is the essence of the common complaint
about the agencies’ CDO ratings in 2008. Specifically, as
documented in Figure 4, Standard & Poor’s downgraded a
dramatically higher percentage of Triple-A structured finance
CDO tranches in that year than in previous years of economic
stress. The 2008 downgrade rate of 69.64% towered above
2001’s 5.88% and 1991’s 0.00%.
Critics not implausibly infer from this evidence that
difference of opinion.
16. Each member of a monotone increasing sequence is greater than or equal to the
preceding member; each member of a monotone decreasing sequence is less than or
equal to the preceding member. See www.thefreedictionary.com
17. The shorter observation period in Figure 2 results from the fact that Moody’s did
not introduce its numerical modifiers until 1983.
A Morgan Stanley Publication • Summer 2010 59
 Figure 3 Mean Rating Prior to Default (Defaulting Issuers of 1983–2009)

Ba3

B1

B2

B3

Caa1

Caa2

Caa3

Ca
60 55 50 45 40 35 30 25 20 15 10 5 0
Months prior to default

Source: Moody’s Investors Service

Figure 4 AAA Downgrade Rates in Stress Years between 2001 and 2008 the agencies lowered their standards,
causing many CDO tranches to receive undeserved Triple-A
Percent (%) 1991 2001 2008
ratings. The subsequent wave of downgrading, according to
80 the critics, represented a correction of the original overrat-
ing, rather than a response to increased risk. Moreover, claim
Structured Finance CDOs

70
60 the agencies’ severest critics, the initial overrating arose from
50 conflict of interest inherent in the issuer-pay model, rather
40
than honest mistakes.
30
20
Rating agency officials have argued, on the contrary, that
10
their CDO ratings were based on the best information avail-
0 able at the time. “We certainly believed that our ratings were
appropriate when they were assigned,” Moody’s chief execu-
8 tive officer Raymond McDaniel testified at a Financial Crisis
7
Inquiry Commission hearing on the rating agencies.18 In his
U.S. Public Finance

6
view, the agencies acted in good faith when they rated vast
5
4
numbers of CDO tranches Triple-A, but they could not have
3
foreseen the magnitude of the subsequent housing market
2 downturn.
1 Whichever narrative ultimately emerges as the accepted
0 history of the 2008 CDO experience, we can be certain of one
thing: The wholesale downgrading was not the consequence
20
of either a lowering of standards or a systematic error in risk
18
16 analysis that cut across all sectors of the debt market. Figure
14 4 shows that in some asset categories, the incidence of Triple-
Financials

12
10
A downgrading was lower in 2008 than in previous years
8 of economic stress. Only 0.25% of AAA-rated U.S. public
6 finance issuers were downgraded in 2008, far below the 7.55%
4
2
rate of 1991. Of the AAA financial companies, 11.54% were
0 downgraded in 2008, somewhat higher than 2001’s 8.42%
but lower than 1991’s 18.18%. Standard & Poor’s relied on
Source: Standard & Poor’s the issuer-pay model to generate revenue from rating bonds

18. See Chow (2010), cited earlier.

60 Journal of Applied Corporate Finance • Volume 22 Number 3 A Morgan Stanley Publication • Summer 2010
Figure 5 Risk Premiums by Rating (June 30, 2010)
2000
Option-Adjusted Spread (Basis Points)
1800
1600
1400
1200
1000
800
600
400
200
0
AAA AA+ AA AA- A+ A A-
Source: BofA Merrill Lynch Global Research
in these categories, yet the outcomes were very different from
what was observed in structured finance CDOs.
Market View of Rating Accuracy
Despite evidence of aggregate-level rating accuracy, such as
provided in Figures 2 and 3, many corporate bond market
participants regularly disparage the agencies. This behavior
is particularly pronounced among the investment bankers,
portfolio managers, and analysts who specialize in high yield
(speculative grade) bonds. They characterize the agencies’
analysis as superficial, rigid, and slow to respond to changes
in companies’ riskiness. High yield investment managers are
at pains to discourage the notion that they rely in any way on
ratings when making investment decisions.
Market participants insist that ratings do not reflect credit
risk, but the impact of their collective investment decisions
tells a different story. Figure 5 plots Standard & Poor’s ratings
against the mean option-adjusted spread (OAS)19 for bonds
with those ratings, as of June 30, 2010. OAS, a standard
measure of risk in bond analysis, reveals that the market
considers CCC- bonds riskier than CCC bonds. They, in
turn, are judged by the market to be riskier than CCC+
bonds, and so on up the rating scale.20
Like the preceding graphs, Figure 5 deals with aggregate
data. It is by no means the case, for example, that on June
19. Option-adjusted spread (OAS) is a measure of a security’s extra yield over the
yield of a comparable Treasury security after accounting for any options (calls, puts) or
sinking funds.
20. The one non-monotonic observation, the greater spread on the AA+ category
than on the AA category, is a statistical aberration. On the measurement date, a single
issuer, General Electric, accounted for 84% of the AA+ category’s market value. The
weighted average spread on GE bonds was 174 basis points. The rating group’s only
other major issuer, Berkshire Hathaway, with 14% of the rating category’s market value,
had a spread of +88 basis points, placing it properly in-between AAA (+84) and AA
(+109).
21. The dispersion of spreads within each rating category refutes a possible objection
to this analysis, namely, the effect of matrix pricing. Because most corporate issues trade
Journal of Applied Corporate Finance • Volume 22 Number 3
BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC-
Standard & Poor's Rating
30, 2010, every A+ bond had a spread of 151 basis points, the
mean for that category.21 Indeed, the range of spreads within
a rating category may overlap the range of adjacent and even
non-adjacent categories.
It is incorrect to infer, as some critics do, that the imper-
fect mapping of spreads to ratings demonstrates that the
ratings are proven wrong by the market. For one thing,
many of the market professionals who make such statements
are practitioners of active management. That is, they assert
that market valuations are frequently incorrect. It is there-
fore inconsistent for them to assert, in the case of a disparity
between ratings and market spreads, that it must be the rating
that is wrong.
Several other factors explain divergences between market
spreads and ratings. For one thing, the spreads show more
gradations of risk than the agencies build into their rating
scales. These gradations allow the market to adjust an issue’s
risk premium upward or downward on a very short-term
basis. The agencies do not attempt to revise their ratings as
frequently as the market finetunes its opinions, that is, from
one minute to the next. In addition, market spreads reflect not
only differences in issues’ default risk,22 but also differences in
their secondary market liquidity and supply-demand factors.
For example, a period of disproportionately large issuance
in a particular industry may cause that industry’s bonds to
infrequently, many of the prices (and therefore the yields and spreads) provided by pric-
ing services are valuations rather than transaction prices. Ratings are among the factors
employed in the valuation models, so if not for the dispersion of spreads within rating
categories, one might argue that the correspondence between ratings and spreads is an
artificially induced effect of matrix pricing. In any case, matrix pricing is infeasible in the
speculative grade category because of the wide range of spreads observed within each
rating group. For speculative grade issues, pricing services rely on a combination of
transaction prices, trader bids and offers, and traders’ estimates derived from recent
market activity.
22. Default risk subsumes both probability of default and severity of default, i.e., the
expected percentage loss of principal in the event of default. The agencies address both
components in determining their ratings.
A Morgan Stanley Publication • Summer 2010 61
Figure 6 Price Change by Rating (1997–2009, Annually)
Price Change Differential: CCC minus BB+B (%)
60
50
40
30
20
10
0
-10
-20
-30
-40
-50
-60
-60
Source: BofA Merrill Lynch Global Research
trade, at least temporarily, at wider spreads than other bonds
of equivalent default risk and liquidity.
Finally, Figure 5 does not reflect rating outlooks or watch-
listings. An outlook indicates whether the agency expects the
future direction of the rating to be higher, stable or lower. A
watchlisting states that a rating may change upon resolution
of a material, known uncertainty. For example, suppose an
unfavorable verdict in a legal case would have adverse implica-
tions for an issuer. By watchlisting its rating, the agency gives
investors fair warning. Investors will adjust spreads on the
issuer’s bonds according to whatever probability they assign
to the adverse outcome. That will cause the spread to move
out of line with the rating, which will not change unless
and until an unfavorable verdict is announced. In such a
case, it is disingenuous for critics to contend that the agencies
have failed to reflect heightened risk in their ratings. Note
that the alternative of lowering the rating on the possibility
of an unfavorable verdict, then returning it to the previous
level upon news of a favorable outcome, would generate loud
protests from bond investors who consistently urge agencies
to avoid excessive rating volatility.
In summary, a complete and fair picture seems to show
that the market participants who deride the rating agencies
actually agree with their judgments to a greater extent than
they acknowledge. More important to investors’ performance
than static prices, however, are changes in prices. Therefore,
another worthwhile question about the market’s view of
rating accuracy is whether ratings provide useful informa-
tion concerning price risk. To define that term, Bond Group
X has greater price risk than Bond Group Y if Group X falls
23. The composition of this index is revised monthly to reflect the entrance and exit
of issues through such factors as upgrading, downgrading, default, new issuance and
retirement. Annual price changes represent linked monthly returns, rather than the be-
ginning- to end-of-period aggregate price change of a static universe of bonds.
62 Journal of Applied Corporate Finance • Volume 22 Number 3
-50 -40 -30 -20 -10 0 10 20 30 40 50 60
Price Change: High Yield Index (%)
by more than Group Y in a falling market and rises by more
than Group Y in a rising market.
Dealing once again at an aggregate level, Figure 6 offers
evidence that the ratings can be helpful inputs to decisions
involving security selection in a rising or falling market.
The horizontal scale measures annual price changes on the
Merrill Lynch High Yield Master II Index.23 The vertical
scale measures the difference in price change between the
lowest-rated tier (CCC) and its higher-rated complement
within the speculative grade tier (BB+B).
The plot points in Figure 2 are concentrated exclusively in
two quadrants—northeast (CCC rose more than BB+B in a
rising market) and southwest (CCC fell by more than BB+B
in a falling market). In no years within the observation period
did the CCC segment rise by less than the BB+B segment in
a rising market (northwest quadrant) or fall by less than the
BB+B segment in a falling market (southeast quadrant). By
the definition given above, the result supports the hypothesis
that the rating categories constitute valid price risk classes.
What About Enron?
This study has focused so far on analysis of aggregate data,
arguing that it is the only valid method of measuring rating
accuracy. Rating agency critics, in contrast, have long empha-
sized individual cases, oblivious to the pitfalls of relying on a
single, potentially anomalous observation. A generation ago,
the critics continually harped on the 1976 bankruptcy of
mass merchandiser W.T. Grant. In recent years, their poster
child has been Enron, which held investment grade ratings
at Moody’s and Standard & Poor’s until shortly before its
A Morgan Stanley Publication • Summer 2010
December 2, 2001 default. As it turns out, the Enron case is
not even an outlier case of rating agency failure that is some-
how anomalous and therefore misleading; it is not a case of
rating agency failure at all.
True, Moody’s and Standard & Poor’s maintained
bottom-rung investment grade ratings (Baa3 and BBB-,
respectively) on the energy trading company until November
28, 2001. The reason was that Dynegy, a competing company
then rated Baa3 by Moody’s and BBB- by Standard & Poor’s,
had indicated an interest in purchasing Enron for at least $23
billion. There was general agreement that despite Enron’s
problems with several dubious investment partnerships, an
acquisition by Dynegy would justify continued investment
grade ratings. Accordingly, the agencies watchlisted Enron
for downgrading to speculative grade, but clearly signaled
that the continuation of investment grade ratings was contin-
gent on consummation of the Dynegy deal. When Dynegy
abandoned its acquisition proposal on November 28, the
agencies promptly downgraded Enron not just to a margin-
ally speculative grade rating, but to B2 and B-.
The media crucified the rating agencies for failing to
downgrade Enron to speculative grade sooner than November
28, with nary a mention of the watchlistings. Investors who
ignored the agencies’ warnings and held Enron paper right
up until the default added their voices to the condemnation,
hoping thereby to shift the blame for their losses. Imagine,
however, that Moody’s and S&P had dropped their ratings
to Ba1/BB+ while the Dynegy offer was still on the table
and Dynegy had decided to go ahead with the deal. In that
scenario, the agencies would have been obliged to upgrade
Enron to investment grade a short while after downgrading
it to speculative grade. The very same investors would have
howled in protest. “Our investment guidelines forced us to
sell Enron when you lowered it to speculative grade,” they
would have said. “Now, in order to remain exposed to a name
that has a large weighting in our performance benchmark, we
have to buy Enron bonds back at higher prices. Why did you
not leave your ratings where they were?” In short, the agencies
faced the prospect of intense criticism over Enron whether
they reduced its rating or left it intact, yet both actions could
not have been wrong.
With the benefit of hindsight, critics faulted the rating
agencies for failing to detect the accounting fraud that came to
light after Enron’s bankruptcy filing. This criticism reflected
in part a mistaken notion that the agencies enjoyed unlimited
access to the books of the companies they rated. Prevail-
ing securities regulations permitted, but did not require,
companies to make nonpublic disclosures to rating agencies.
Moody’s and S&P received no more of an inside look than
24. Hubbard, Russell, Jim Kennett, and Margot Habiby. “Dynegy Calls SEC’s Probe of
Enron ‘Financial Noise.’” Bloomberg News, November 12, 2001.
25. Stein, George and Jennifer Ryan. “Dynegy Expected to Acquire Enron; Moody’s
Cuts Ratings.” Bloomberg News, November 9, 2001.
Journal of Applied Corporate Finance • Volume 22 Number 3
Enron allowed them. Considering that an inside look would
have revealed massive illegalities, as well as Enron’s notorious
aversion to transparency, it is fair to assume that any nonpub-
lic disclosures to the rating agencies were minimal.
Enron’s prospective acquirer, which probably got as close
a look as anyone other than Enron’s auditor, did not initially
perceive a fraudulent enterprise on the verge of collapse. As
late as November 12, Dynegy chairman Chuck Watson
commented, “What we found when we looked under the
hood is that the core of Enron was still there and working as
well as ever.”24 From the outside, as well, experts saw Enron,
excluding the sketchy partnerships, as a thriving enterprise.
The manager of a large mutual fund focusing on utilities
chimed in, “It’s a wonderful acquisition for Dynegy. They’ll
take the best businesses at Enron and make them hum and
sing.”25 Enron’s management may not have been as good as
it claimed at generating legitimate profits, but it was adept at
concealing its fraudulent activities.
In the years since Enron’s bankruptcy, the false notion
has arisen that certain analysts more rigorous or more astute
than the rating agencies’ teams spotted the fraud well in
advance of the bankruptcy. A popular version of this story
is that scrappy little Egan-Jones Ratings Co. beat its larger,
lumbering competitors to the punch. The kernel of truth in
this account is that Egan-Jones cut Enron to the top rung
of speculative grade, BB+, on October 26, 2001, or 37 days
before the bankruptcy filing. As Figure 2 indicates, that
rating implied less than a 1% probability of default within
one year. Surely Egan-Jones would have made a deeper cut
if it had had an inkling of the true precariousness of Enron’s
financial situation.
Renowned short seller James Chanos of Kynikos Associ-
ates did an admirable job of spotting Enron as an overvalued
stock. He has stated, however, that until the summer of 2001
he suspected Enron of nothing worse than overstating its
earnings. Chanos thought the stock would go down, but not
that it would decline to pennies a share.26 Off Wall Street
Consulting Group made a good call by recommending a short
sale of Enron in May 2001, when it was trading around $59.
The analytical firm removed its SELL, however, when the
stock reached $26, not a change it likely would have made if
it had foreseen the bankruptcy. Similarly, a student group that
helped to manage an investment fund for Cornell Univer-
sity astutely sold its Enron shares on December 1, 2000, but
maintained a long-run NEUTRAL rating on the stock, an
opinion that hardly suggested the expectation of a Chapter
11 filing a year and one day later. There was also excellent
analysis by BNP Paribas analyst Daniel Scotto, who issued an
urgent SELL on Enron’s stock and bonds in August 2001, and
26. Nocera, Joe. “Tipping Over a Defense of Enron.” New York Times, January 6,
2007, pp. C1, C8.
A Morgan Stanley Publication • Summer 2010 63
McCullough Research, which in November 2001 detected
inconsistencies in Enron’s financial statements. No examples
have come to light, however, of analysts concluding long
before Moody’s and S&P dropped Enron to speculative grade
that the company would collapse in a notorious accounting
fraud. In short, the critics’ favorite demonstration of rating
agency incompetence turns out to be an empty bag.
Conclusion
Financial market observers and participants, not least the
rating agencies themselves, agree that the rating of mort-
gage-related collateralized debt obligations in advance of the
financial crisis of 2008 produced unsatisfactory outcomes.
There is no such consensus on the causes of the misfire or
proposals for altering the rating process to prevent a recur-
rence.
Many critics of the agencies focus on the influence of
the issuer-pay model, yet the agencies have performed credit-
ably, under the same fee arrangement, in segments other than
structured finance. This outcome is not surprising in light of
a careful consideration of the incentives created by the issuer-
pay model. In any case, there is no practical alternative to
the issuer-pay model, although safeguards could conceivably
64 Journal of Applied Corporate Finance • Volume 22 Number 3
be added for situations in which the associated conflicts of
interest appear especially difficult to manage.
Notwithstanding market participants’ claims that ratings
poorly reflect credit risk, market prices and price changes
tend to uphold the ratings’ validity, at an aggregate level. The
rating agencies’ critics, however, generally prefer anecdotal
evidence. They typically present the Enron case history as
their trump card, considering it a self-evident example of
rating agency failure. The standard narrative, however, omits
the fact that Moody’s and Standard & Poor’s watchlisted the
energy trading company to warn investors that its investment
grade rating was contingent on a proposed acquisition by an
investment grade competitor. Deeper downgrading would
have been in order if the agencies had uncovered Enron’s
financial reporting fraud, which became apparent after
the company’s bankruptcy filing. There is no factual basis,
however, for the notion that nimbler, less conflicted analysts
detected the fraud long before Enron went bust.
martin fridson is Global Credit Strategist for BNP Paribas Asset
Management, Inc., a member firm of BNP Paribas Investment Partners.
A Morgan Stanley Publication • Summer 2010
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