Credit rating inflation: The United States might sink all the way to double-A.

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July 14 2011 7:19 PM

Why Are Credit Ratings So Inflated?

If you get a B, you're screwed.

President Barack Obama in a debt meeting with congressional leaders on July 13, 2011  . Click image to expand.
President Barack Obama in a debt meeting with congressional leaders on July 13

Moody's Investor Service threatened this week to downgrade the United States' credit rating if lawmakers don't raise the nation's $14.3 trillion debt ceiling. That would take the United States from the highest-possible rating of Aaa to a second-best score of Aa. Meanwhile, countries at the very brink of financial disaster, like Ireland and Greece, still earn credit ratings in the B- and C-ranges. Have credit grades always been so inflated?

Yes. John Moody became the first to synthesize companies' creditworthiness into a single rating in 1909, when he published his Analyses of Railroad Investments. Moody's original rating system grouped bonds into 13 categories ranging from "Aaa" to "E." The middle grades—corresponding to companies that could pay interest on their bonds, but just barely—were Caa, Ca, and C. By 1924, three companies—Poor's Publishing, Standard Statistics, and Fitch's Publishing—had all joined the business of rating corporate bonds and, later, sovereign bonds, too. Like Moody, the companies each used an idiosyncratic system of letter grades in their reports. Poor's, for instance, used to top off its scale with a trio of super-ratings denoted as A*****, A****, and A***. By the late 1930s, the ratings systems had converged to the point where A's (sound investments), B's (somewhat speculative investments), and C's (very speculative, high risk investments) all meant roughly the same thing to each agency. So a B rating, which might look pretty decent on a schoolchild's report card, reflected somewhat poorly on its holder even then.

At the same time, government regulations began distinguishing "investment grade" bonds, which were Baa/BBB or higher, from chiefly speculative bonds (aka "junk bonds"). The institutionalization of the ABC rating system partly explains why we don't see many alternative ratings systems today. (One exception to the rule is the independent rating firm, Rapid Ratings International, which uses a 100-point system.)

Though ratings firms now use similar scales—ranging from a C or D at the low end to triple-A at the high—for rating investments, each applies those ratings separately to sovereign debt, corporate bonds, and other financial instruments. The letter grades don't tell you about the absolute creditworthiness of an investment so much as how safe it might be compared with others of the same type and in the same year. In other words, creditworthiness is graded on a curve.

Has it gotten any easier to score high grades over the years? There's some evidence that Moody's and Standard & Poor's loosened their grading standards, especially for mortgage-backed securities and other complex financial instruments, in the early 2000s in response to greater competition from Fitch. One analysis concluded that S&P actually became more conservative—in its corporate-bond ratings, at least—between 1985 and 2009. According to that study, a company worthy of an AAA rating in 1985 would have garnered only an AA- rating in 2009.

Bonus Explainer: Which came first, letter grades for students or letter grades for corporate bonds? Students. The earliest record of a letter-grade system comes from Mount Holyoke College in Massachusetts in 1897. As with the Moody system that was developed 12 years later, the highest grade was an A and the lowest was an E. By around 1930, however, the E had been replaced by an F on most college campuses. (Read more on the history of letter grades in schools in an Explainer column from 2010.)

Got a question about today's news?  Ask the Explainer.

Explainer thanks Bo Becker of Harvard Business School, James H. Gellert of Rapid Ratings International, and Sergey Chernenko of Ohio State University's Fisher College of Business.

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