There are some simple lessons for tracking credit quality, according to new research: watch independent ratings agencies before the big ones like Moody's, but if you watch the big ones focus keep an eye out for the word "negative."
A recent study by researchers at the University of Michigan and Stanford University has found that changes in credit ratings by noncertified agencies like Egan-Jones Ratings Co happen on average 237 days before the ratings changes by the certified agencies, in this case Moody's Investors Service.
A 1973 law by the Securities and Exchange Commission approved for certain regulatory requirements just a handful of ratings agencies: Moody's, Standard & Poor's and Fitch Ratings.
The paper by Catherine Shakespeare and Mark Soliman sought to look at whether the concentration of this power among a few participants weakens incentives for certified ratings agencies "to produce high-quality ratings." For the study, the researchers compared Egan-Jones with Moody's.
Egan-Jones provided a copy of the paper to reporters on Thursday and has lobbied extensively for the government to open up the ratings process to others besides the big three.
In addition to the heads-up on ratings actions, the study found that based on stock returns, the ratings by Egan-Jones were "more closely associated with information in the marketplace, suggesting the noncertified agency leads the rating process and is more timely."
Then comparing changes in credit spreads on corporate bonds to the ratings of Egan-Jones and Moody's, the paper found that the noncertified agency ratings "are more accurate and timely."
"Taken together, our findings indicate the lax competitive environment of the bond rating industry may induce biases in bond rating reports, resulting in less-informative rating changes," the report concluded.
That said, a separate study from the Bank for International Settlements in its quarterly review discovered that markets - the credit default swaps market in particular - are not all-knowing when it comes to anticipating likely ratings changes.
"Credit ratings do convey information to market participants. Even announcements that are anticipated by earlier movements in spreads seem to contain additional pricing-relevant information," according to authors Marian Micu, Eli Remolona and Philip Wooldridge.
After trying to control for factors like general market reaction in credit spreads and other rating agency announcements, the BIS found credit default swaps react most to the ratings agencies issuing reviews to downgrade a rating and outright downgrades.
"The impact is significant even when rating events are anticipated by an earlier widening of credit default swap spreads," the report said.
This result held up even when other ratings agencies made announcements before the rating event. "Both the first and credit ratings seem to contain pricing-relevant information.