Credit rating companies are distorting capital markets byassigning the same debt ranking to countries from Italy to Thailandand Kazakhstan, according to BlackRock Inc., the world's biggestmoney manager.

While 23 countries share the BBB+ to BBB- levels assessed byStandard & Poor's, the lowest investment grades, up from 15 in2008 at the beginning of the financial crisis, their debt to grossdomestic product ratios range from 12 percent for Kazakhstan to 44percent for Thailand and 126 percent for Italy, InternationalMonetary Fund estimates show. The cost of insuring against adefault by Italy, ranked BBB+, over the next five years is almosttriple that for Thailand, which has the same rating.

For BlackRock, which oversees $3.7 trillion in assets, themeasures are so untrustworthy that the firm is setting up its ownsystem to gauge the risk of investing in government bonds. Thisyear, the market moved in the opposite direction suggested bychanges to levels and outlooks 53 percent of the time, datacompiled by Bloomberg show.

“The rating agencies were very, very slow to the game,” BenjaminBrodsky, a managing director at BlackRock International Ltd., saidin a Nov. 23 interview from London. “They all came after the fact.For us, this is not good enough.”

Since S&P cut the U.S. to AA+ from AAA on Aug. 5, 2011,yields on the benchmark 10-year Treasury note have fallen to 1.79percent from 2.56 percent. After France was downgraded on Jan. 13,10-year yields fell to 2 percent from 3.08 percent.

Ratings companies, the arbiters of creditworthiness and thelikelihood of default by governments and companies in the $46trillion global debt market, are coming under more scrutiny fromregulators and investors.

When S&P downgraded the U.S., a Treasury official said thecompany had made a $2 trillion error. France's top central bankersaid Moody's Investors Service's ranking is wrong. Russia's deputyfinance minister said S&P and Fitch Ratings exaggerated itsweaknesses relative to higher-rated countries.

A court in Australia found Nov. 5 that S&P misled investorsduring the financial crisis that began in 2007. Regulations beingwritten under the U.S. Dodd-Frank law may ban government entitiesfrom using ratings to price bonds.

Moody's said on Dec. 17 that it plans to change the methodologyfor sovereign rankings, putting more importance on economic growth.The unit of New York-based Moody's Corp. is seeking market feedbackto help its system become more transparent and “forward-looking,”according to the statement.

Argentine Risk

BlackRock started compiling its own Sovereign Risk Index tomeasure countries' creditworthiness in June 2011. The latestquarterly update in October rates Spain, Ireland and Italy similarto Argentina and Venezuela, among the 10 most risky countries.S&P puts Argentina, which defaulted on its debt in 2001, at B-,six levels below Spain. Venezuela is B+, six grades below Italy andIreland.

The New York-based fund manager sorts countries based on theirwillingness to pay debts, their access to external funding, thestrength of their finance industries and fiscal metrics such asdebt-to-GDP, according to Brodsky. The index shows Malaysia andRussia rank similar to the U.S., while the Philippines is noriskier than France and the U.K.

“Ratings should be evaluated on the basis of their correlationover time with defaults, not with short-run movements in marketprices,” John Piecuch, a spokesman for S&P, wrote in an e-mailresponse to questions from Bloomberg on Dec. 6. “Ratings and marketindicators of creditworthiness often diverge, because they aregenerated by fundamentally different processes and can be driven byvery different factors.”

The number of countries rated in the BBB category grew asS&P cut European nations such as Spain that are mired in thethree-year-old debt crisis and promoted developing nations,including Colombia, from below investment grade. Those ranked A- orabove shrunk to 43 from 52 since 2008, according to data compiledby Bloomberg.

Gary Jenkins, founder of Swordfish Research Ltd. based outsideof London, said analyzing sovereign credit is becoming moredifficult as policy makers and politicians increase intervention inmarkets.

“It's not like analyzing cash flows and gearing,” Jenkins, aformer head of fundamental credit strategy at Deutsche Bank AG,said by phone from Amersham, England on Nov. 16. “When it comes toEuropean sovereigns they have no more real insight into what mayhappen than anyone else does. It is educated guesswork. That's allit is.”

Bond spreads have moved in the opposite direction from what thecompanies suggested in 53 percent of rating or outlook changes forcountries from France to South Korea since February, according todata compiled by Bloomberg. Over the past 38 years, yields havegone the opposite way about half the time for more than 300issues.

U.S. and French bonds have rallied since the countries werestripped of their top grades.

The companies “quite accurately rank sovereign credit risk” and“they should not be expected to be consistent with specific defaultprobabilities,” according to an IMF study published in October2010. All 14 sovereign defaults between 1975 and 2009 had beenrated non-investment grade one year prior to the event, accordingto the study.

Most of the “useful informational value” in their assessmentcomes from their outlook changes, rather than the actual upgradesor downgrades, according to the IMF report.

The companies say they assign ratings based on their assessmentof the countries' ability and willingness to pay obligations,examining criteria such as debt levels, economic growth andpolitical and regulatory stability.

Moody's Review

The review by Moody's of its rating performance since 1983 showsthat the system has proven to “powerfully” rank-order sovereigndefault risks, according to the company's Dec. 17 report. Nogovernment has defaulted on its debt within a year of holding aninvestment-grade rating, according to the report. Countries ratedCaa and C, the lowest ranking, had a default rate of 28 percent,compared with 0.6 percent among those in the Ba category, which isthe highest speculative grade, the report said.

“There's nothing in the sovereign statistics to suggest that weare missing credit risk, under- or overestimating sovereign risksin any direction,” Bart Oosterveld, the head of the sovereign riskgroup at Moody's in New York, said in a telephone interview on Dec.6. “Our track record of accurately ranking default risks forsovereigns is really quite good.”

Among the countries in the BBB category that have credit defaultswaps available, investors are betting that the probability of themmissing interest-rate payments by 2018 varies from 23 percent inSpain to 8 percent in Thailand, according to data compiled byBloomberg.

While S&P has downgraded Italy twice since September 2011,the country is still rated the same as Kazakhstan and Thailand.Italy's economy probably contracted 2.1 percent this year, comparedwith growth of 5.4 percent in Thailand and 5.2 percent inKazakhstan, according to economists surveyed by Bloomberg.

Credit default swaps show Europe's fourth-largest economy ismore risky. The cost to insure Italian debt for five years morethan doubled since the end of 2009 to 267 basis points, or 2.67percentage points, compared with 87 basis points for Thailand and139 for Kazakhstan, according to data compiled by Bloomberg. Thecontracts pay the buyer face value in exchange for the underlyingsecurities or the cash equivalent if a borrower fails to adhere toits debt agreements.

“Rating agencies tend to be a lagging indicator rather thanleading indicator,” said Neil Shearing, chief emerging marketseconomist for Capital Economics Ltd., in a telephone interview fromLondon on Nov. 19. “The danger is giving too much weighting torating agencies' opinion.”

Regulators remain divided about how to create a better system.The Dodd-Frank Act, signed into law last year to overhaul financialregulation, requires government agencies to replace ratings withanother standard for creditworthiness, without providing details.Basel III international banking standards rely on rankings to gaugerisk.

In Europe, governments have criticized the companies asdowngrades of Portugal, Spain, Italy, Ireland and France amid theregion's debt crisis risked raising borrowing costs and hamperingefforts to restore stability.

Bank of France Governor Christian Noyer said at a Nov. 30 pressbriefing in Hong Kong that Moody's was wrong in its reasoning forrevoking the nation's Aaa rating on Nov. 19, saying the companymade a “factual mistake” judging exposure to the debt crisis.

S&P Cuts

After S&P cut its rating on U.S. debt to AA+ from AAA inAugust 2011, John Bellows, then acting assistant secretary foreconomic policy at the U.S. Treasury, spotted what he thought was amistake in S&P's math. There was no “justifiable rationale” forthe downgrade, Bellows wrote on a Treasury blog post. S&P saidits decision wasn't affected by the “change of assumptions.”

Governments, banks and companies pay for assessments of theircreditworthiness. S&P, a New York-based unit of McGraw- HillCos., Moody's and Fitch generate about $4 billion in annual revenuewith 3,054 analysts ranking 2.52 million securities worldwide,according to data compiled by the Securities and ExchangeCommission and Bloomberg.

They also rate borrowers that haven't asked or paid for them.Fifteen of 128 sovereign ratings at S&P, including the U.S.,U.K., France, Switzerland and Argentina, are designated as“unsolicited,” according to a company report dated Dec. 5.

The companies postponed cutting the European countries to junkstatus because doing so would deprive them of much-needed capital,according to Sean Egan, president of Egan-Jones Ratings Co. inHaverford, Pennsylvania. Some investors, such as pension funds andinsurance companies, are barred by regulators from holdinghigh-risk, non-investment grade assets.

“If there are huge incentives for maintaining higher than normalratings, then that will be the industry behavior,” said Egan in aphone interview on Nov. 19. “If a rating company is not rewardedfor being timely and accurate, why in the world they should betimely and accurate?”

Egan-Jones, which competes with S&P, Moody's and Fitch torate securities, charges investors, rather than bond issuers, forits opinion on the securities.

“We believe that the marketplace should be open to all businessmodels, provided that all conflicts of interest are identified,disclosed and either eliminated or managed,” Daniel J. Noonan, aspokesman at Fitch in New York, wrote in an e-mail Dec. 6. “In thecase of the issuer-pays model, we think that the potential forconflicts of interest is understood and well managed.” Fitch is aunit of Paris-based Fimalac SA.

Rating companies have been slow to recognize improvements inemerging markets, according to David Robbins, who manages a $5.7billion emerging-market debt fund at TCW Group Inc.

“Many emerging-market countries, certainly by their creditfundamentals, are under-rated compared to developed markets,”Robbins said in a telephone interview from New York on Oct. 22.“The relative credit quality improvement of the emerging marketversus developed market probably won't be over until 2015.”

Russia's Deputy Finance Minister Sergei Storchak said in Junethe country should be upgraded at least two steps, a level thatwould put it above Ireland and Italy. Russia cut its debt to 11percent of GDP this year from 40 percent in 2002, while Italy'sdebt increased to 126 percent from 105 percent, according to theIMF data.

“The issue is the entire finance industry chooses to rely onwhat is clearly the stuff that doesn't pass the smell test,” JanDehn, a London-based strategist at Ashmore Investment MangementLtd., which oversees $68 billion of emerging-market assets, said ina phone interview on Dec. 3. “As long as these perceptions exist inthe markets, then you will have misallocation of capital.”

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