Optimal delay in downgrade by Credit Rating Agencies

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Optimal delay in downgrade by Credit Rating
Agencies

• -Krishna Kamath
• (Preliminary Incomplete)

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Motivation

• Debt is often trading at a significant discount
  by the time the downgrade actually takes place.
• Markets seem to anticipate downgrades i.e. little
  new information is conveyed by decision to
  downgrade
• Criticism of rating agencies for reacting slowly
  to changes in credit quality

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Motivation (continued)

• a great deal of evidence indicates that their
  product, information, is not particularly
  inaccurate and, to the extent that it is
  accurate, by the time it reaches investors it is
  so stale as to be useless to the investors for
  whose ostensible benefit it is produced. The
  credit rating agencies dismal performance in
  their work on Orange County, Mercury Finance,
  Pacific Gas Electric, Enron, WorldCom, and most
  recently General Motors and Ford suggest that
  credit rating agencies arent doing the job that
  the public thinks they do. A plethora of academic
  studies showing that credit ratings changes lag
  the market support this intuition. - Jonathan
  R. Macey from Yale Law School testifying to
  Congress on Nov 29, 2005
• Economist (1997, p. 70) on the Asian crisis The
  raters, firms such as Moodys Investors Service,
  Standard Poors, Duff Phelps and IBCA, are
  supposed to be the financial markets early
  warning system. Instead, the agencies have spent
  the past few months belatedly reacting to
  events.
• If you want to see a grown man cry ask him
  about Thailands 7.75 issue of 2007, rated A/A3
  back in May of 1997 Euromoney, Jan 1998

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Documented Empirical Findings in Literature

• stock prices and stock analyst forecasts predict
  rating changes (e.g. Holthausen and Leftwich,
  1986, Ederington and Goh, 1998)
• rating changes lag changes in default
  probabilities. (Delianedis and Geske 1999)

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Why is this surprising?

• have access to insider information such as
  minutes of the board meetings, new
  product plans, expansion plans etc.
• Exempt from Reg FD
• Goal to come up with a model explaining delay
  by rating agencies in downgrade.

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Possible Explanations

• Infrequent monitoring Ederington and Yawitz
  (1987)
• Ratings management Loffler (2003)
• Oligopolistic nature of industry too little
  monitoring done. (law circles)
• Private and public uses of ratings exogenous
  investment restrictions, rating triggers etc.

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Basic Idea

• Rating agencies have to take into account the
  feedback effect of their decision to downgrade
• Downgrades can increase borrowing costs
  exacerbate financial distress. Can create
  incentives to engage in asset substitution
• Care about ex-post accuracy between rating given
  and final outcome observed.
• Effects are greatest when downgrading across the
  investment grade boundary
• gt Rating agencies are cautious/conservative
  when downgrading across investment grade boundary

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Model

• 3 dates, 2 periods.
• Players
• Rating Agency, Firm, and Institutional Investor.

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Empirical Predictions

• Downgrades across investment grade boundary tend
  to be lumpy
• More financially constrained the firm, greater
  the documented delay by the agency.
• Proxy for delay Market Anticipation on downgrad
• (p(t-1)
  p(t-n))/(p(t) p(t-n))
• Where P(t) is the price of the bond after the
  downgrade

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Data

• Mergent FISD database
• Bond transactions by insurance companies between
  1995-2005
• Historical bond ratings for issues
• Exclude Yankee bonds, foreign denominated bonds.

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Future Research Ideas

• Examine changes in liquidity at the investment
  grade boundary
• Examine transaction costs incurred by
  institutional investors at the BBB- boundary
• Will the entry of more rating organizations
  improve informativeness?