By David Lesmond, associate professor of business
In the recent economic downturn, a downturn precipitated by an explosion of so-called toxic debt, one of the most striking discoveries was the inability of credit-rating agencies to properly assess credit risk, the chance that a bond will default. But an overriding question emerges: Were we really caught by surprise or was there already evidence in the market that credit rating agencies such as Moody’s could not accurately assess risk?
To try to answer that question, colleague John Hund and I analyzed emerging market debt in 16 countries at both the corporate and sovereign level over a nine-year period from 1997 to 2006, long before the current economic crisis unfolded. We found that credit ratings on emerging market debt had no association with the underlying yield spread of the bond, the yield that the bond pays over the prevailing Treasury Bill rate. This was true for both the level of the yield spread and the change in the yield spread over time.
Why were we so slow in picking up this problem with credit rating agencies? Our research suggests that the market is extremely efficient at predicting impending credit downturns and it embodies this risk by increasing the liquidity costs—the bid-ask spread of the bond—faster than the agencies react by reducing credit ratings. Our study shows that once we control for the effect of liquidity costs on the bond, the credit ratings have no association with the underlying yield spread.
More damaging evidence is shown in relation to changes in yield spreads. Credit rating agencies react quickly and correctly to improving credit conditions, but the agencies are horribly slow to respond to deteriorating economic conditions and extremely hesitant to reduce the credit ratings of firms or counties. In fact, the lack of changes in ratings practically obviates the use of credit ratings for emerging market debt. The conventional wisdom that credit ratings matter in yield spreads proves to be uncommonly false.
“Credit Ratings and Liquidity in Emerging Debt Markets” was awarded the Best Paper Prize at the Second Emerging Markets Conference at the Cass School of Business in London and at the 2009 Weiss Conference at the Wharton School in Philadelphia.
