DOCSLIB.ORG

Three Essays on Credit Ratings

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Three Essays on Credit Ratings Three Essays on Credit Ratings Leo Tang A dissertation submitted to the Graduate School - Newark Rutgers, the State University of New Jersey in partial fulfillment of the requirements for the degree of Doctor of Philosophy Graduate Program in Management Written under the direction of Professor Bikki Jaggi and approved by ______________________ Dr. Bikki Jaggi ______________________ Dr. Valentin Dimitrov ______________________ Dr. Dan Palmon ______________________ Dr. Gary Kleinman Newark, New Jersey May 2016 Abstract In this dissertation, I examine several forces which impact credit ratings. One driver of credit ratings is recent legislation from the Dodd-Frank Wall Street Reform and Consumer Protection Act. This sweeping regulatory reform moderated the incentives of credit rating agencies (CRAs) to issue upwardly biased ratings by significantly increasing CRAs‟ exposure to litigation and regulatory risk. The first essay examines how the impact of this legislation affected rating properties. Another driver behind credit rating is access to soft information. Utilizing proximity between rating agencies headquarters and firm headquarters, the second essay analyzes how access to soft information impacts the accuracy of ratings. The third essay examines market participant‟s degree of reliance on credit ratings. The 2010 recalibration of municipal bonds provides an opportunity to test investors‟ reactions to rating changes which incorporate no new information and which were done irrespective of changes in credit quality. Reaction to the implementation of recalibration may imply that market participants over-rely on ratings and “fixate” on them. ii Acknowledgements I would like to gratefully acknowledge the contributions and guidance of the members of my dissertation committee, Bikki Jaggi, Valentin Dimitrov, Dan Palmon and Gary Kleinman. I would like to specially thank Dr. Jaggi and Dr. Dimitrov for their mentorship during my time at Rutgers University. I would like to specially thank my family for their support and encouragement. iii TABLE OF CONTENTS Abstract ...................................................................................................................................... i Acknowledgements .................................................................................................................. ii Table of Contents .................................................................................................................... iii List of Tables ............................................................................................................................ v List of Figures ......................................................................................................................... vii Chapter 1: Introduction ............................................................................................................. 1 Chapter 2: Literature Review ................................................................................................... 5 2.1. Credit Ratings and Informativeness .............................................................................. 5 2.2. Credit Ratings and Conflicts of Interest........................................................................ 6 2.3. Credit Ratings and Competition .................................................................................... 8 2.4. Regulatory Reform and Credit Ratings ........................................................................ 9 Chapter 3: The Impact of Dodd-Frank on Credit Ratings ..................................................... 10 3.1. Introduction .................................................................................................................. 10 3.2. Legislative Background ............................................................................................... 15 3.3. Sample ......................................................................................................................... 20 3.4. Findings ....................................................................................................................... 23 Chapter 4: Geographic Location of the Firm and Credit Rating Accuracy .......................... 36 4.1. Introduction .................................................................................................................. 36 4.2. Hypothesis ................................................................................................................... 43 4.3. Sample ......................................................................................................................... 48 iv 4.4. Findings ....................................................................................................................... 53 Chapter 5: Do Investors Fixate on Credit Ratings ................................................................. 64 4.1. Introduction .................................................................................................................. 64 4.2. Recalibration Background ........................................................................................... 70 4.3. Sample ......................................................................................................................... 72 4.4. Findings ....................................................................................................................... 76 Chapter 6: Conclusions ........................................................................................................... 83 References ............................................................................................................................... 85 Appendix A: Tables and Figures ............................................................................................ 94 v List of Tables Essay 1 I.1: Table 1: Variable measurement ....................................................................................... 95 I.2: Table 2: Summary statistics ............................................................................................. 97 I.3: Table 3: Rating levels before and after Dodd-Frank ....................................................... 98 I.4: Table 4: False warnings before and after Dodd-Frank ................................................... 99 I.5: Table 5: Bond price response to rating downgrades and upgrades .............................. 100 I.6: Table 6: Stock price response to rating downgrades and upgrades .............................. 102 I.7: Table 7: Rating levels and false warnings for alternative start dates ............................ 104 Essay 2 II.1: Table 1: Variable measurement .................................................................................... 105 II.2: Table 2: Summary statistics .......................................................................................... 107 II.3: Table 3: Logistic Regression Results on the Association Between Geographic Distance and Type 1 Error Rate ........................................................................................... 108 II.4: Table 4: Logistic Regression Results on the Association Between Geographic Distance and Type 2 Error Rate ........................................................................................... 109 II.5: Table 5: OLS Regression Results on the Association Between Geographic Distance and Timeliness of Downgrades ............................................................................................ 110 II.6: Table 6: Logistic Regression Results for the Interaction Effect between Complexity and Distance to NYC ............................................................................................................ 111 II.7: Table 7: Logistic Regression Results for the Interaction Effect between Analyst Following and Distance to NYC .......................................................................................... 113 II.8: Table 8: Logistic Regression Results on the Association Between Rating Levels and Geographic Distance ............................................................................................................. 115 vi Essay 3 III.1: Table 1: Moody‟s Rating Recalibration for U.S. States and territories ..................... 116 III.2: Table 2: Bond Price Response to Moody‟s Implementation ..................................... 118 III.3: Table 3: Bond Price Response to Moody‟s Announcement ...................................... 119 III.4: Table 4: Regression Analysis for Investor Reactions Surrounding the Announcement and Implementation of Recalibration ................................................................................... 120 III.5: Table 5: Bond Price Response to Uncertainty surrounding Moody‟s Recalibration 121 Appendix A: Summary of Dodd-Frank provisions ............................................................. 122 Appendix B: Numerical transformation of alphanumerical rating codes ........................... 125 Appendix C: Essay 2-Data selection process....................................................................... 126 vii List of Figures Figure 1: Moody‟s 2010 default study ................................................................................. 127 Figure 2: Bond yields May 17th, 2010 ................................................................................. 128 Figure 3: Indicated recalibrations on the announcement date ............................................. 129 viii 1 Chapter 1: Introduction
Load more

Recommended publications
  • Understanding Credit Ratings
    Select Portfolio Management, Inc. www.selectportfolio.com Toll Free: 800.445.9822 Telephone: 949.975.7900 Fax: 949.900.8181 Securities offered through Securities Equity Group Member FINRA, SIPC, MSRB Understanding Credit Ratings What are credit ratings? In determining the creditworthiness of an issuer, Moody's, S&P and Fitch focus on the Credit ratings are the most common benchmark issuer’s overall financial condition, as well as used to assess the ability of a bond issuer to that of the industry or sector in which the issuer make timely payments of interest and principal. operates. A rating represents the opinions of As credit ratings are subject to change without the rating agency at a particular point in time. notice it is important to review a bond's credit Ratings on individual issues are continuously rating, and the effect a rating change could revised to reflect any industry, sector, company have on the bond, before you invest. In or municipal developments, and these ratings measuring credit quality, U.S. Treasury changes can have a distinct effect on a bond’s securities, which are backed by the ‘full faith market price. The rating agencies classify bond and credit’ of the U.S. Government, are issues as either ‘investment grade’ or ‘below accepted within the investment community as investment grade.’ the benchmark, against which the credit quality of all other fixed income securities are Investment Grade Bonds measured. Here, we take an informative look at the bond credit rating system. These bonds are generally more appropriate for conservative clients. They typically provide the An Overview of Rating Agencies highest degree of principal and interest payment protection, and are generally the least When considering a potential investment, likely to default.
    [Show full text]
  • Rating Agency Reform in the Wake of the 2007 Financial Crisis
    Fordham Journal of Corporate & Financial Law Volume 16 Issue 1 Book 1 Article 4 2011 The Collapse Of An Empire? Rating Agency Reform In The Wake Of The 2007 Financial Crisis Elizabeth Devine Follow this and additional works at: https://ir.lawnet.fordham.edu/jcfl Part of the Business Organizations Law Commons, and the Securities Law Commons Recommended Citation Elizabeth Devine, The Collapse Of An Empire? Rating Agency Reform In The Wake Of The 2007 Financial Crisis, 16 Fordham J. Corp. & Fin. L. 177 (2011). Available at: https://ir.lawnet.fordham.edu/jcfl/vol16/iss1/4 This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Journal of Corporate & Financial Law by an authorized editor of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact [email protected]. THE COLLAPSE OF AN EMPIRE? RATING AGENCY REFORM IN THE WAKE OF THE 2007 FINANCIAL CRISIS Elizabeth Devine* “There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s bond rating service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.” —Thomas Friedman1 INTRODUCTION In 1996, Thomas Friedman’s remarks echoed the sentiments of many. The rating agency business was booming, and it seemed like the agencies themselves could do no wrong. Because nearly every financial business was limited in some way by credit ratings,2 a rating agency became the most powerful player in many business transactions.
    [Show full text]
  • Credit Rating
    CREDIT RATING AN ANALYSIS OF THE CREDIT RATING AGENCIES ANSHUMAN DUTTA, 1YR DoMS, NITT ROLL NO-215111070 CONTENTS INTRODUCTION--------------------------------------------------------------------------2 ROLE OF CREDIT RATING ON COUNTRIES------------------------------------3 ECONOMIC RESILIENCY--------------------------------------------------------------3 FINANCIAL ROBUSTNESS-------------------------------------------------------------3 STANDARD & POOR---------------------------------------------------------------------5 MOODY’S CORPORATION------------------------------------------------------------7 FITCH-----------------------------------------------------------------------------------------8 USES OF RATING-------------------------------------------------------------------------8 METHODS OF RATING-----------------------------------------------------------------9 RATING USED IN STRUCTURED FINANCE------------------------------------10 CRITICISM------------------------------------------------------------------------------- 10 KEY FACTS ON RATING-------------------------------------------------------------15 CONCLUSION----------------------------------------------------------------------------16 REFERENCE------------------------------------------------------------------------------18 1 INTRODUCTION Credit rating agencies (CRA) are companies that assign credit ratings for issuers of certain types of debt obligations as well as the debt and in certain cases the services of the underlying debt are also provided ratings. The impact of credit
    [Show full text]
  • Ending the Credit Rating Agencies' Special Status and Access to Confidential Information
    Valparaiso University Law Review Volume 46 Number 4 Summer 2012 pp.1091-1137 Summer 2012 What Makes You So Special?: Ending the Credit Rating Agencies' Special Status and Access to Confidential Information Cheryl Evans Follow this and additional works at: https://scholar.valpo.edu/vulr Part of the Law Commons Recommended Citation Cheryl Evans, What Makes You So Special?: Ending the Credit Rating Agencies' Special Status and Access to Confidential Information, 46 Val. U. L. Rev. 1091 (2012). Available at: https://scholar.valpo.edu/vulr/vol46/iss4/5 This Notes is brought to you for free and open access by the Valparaiso University Law School at ValpoScholar. It has been accepted for inclusion in Valparaiso University Law Review by an authorized administrator of ValpoScholar. For more information, please contact a ValpoScholar staff member at [email protected]. Evans: What Makes You So Special?: Ending the Credit Rating Agencies' S Notes WHAT MAKES YOU SO SPECIAL?: ENDING THE CREDIT RATING AGENCIES’ SPECIAL STATUS AND ACCESS TO CONFIDENTIAL INFORMATION I. INTRODUCTION “The story of the credit rating agencies is a story of a colossal failure. The result is that our entire financial system is now at risk . .”1 In the words of a famous presidential advisor, “Never waste a good crisis.”2 The financial markets crisis that began in the second half of 2007 and surged into a full-blown maelstrom in 2008 is certainly one not to be wasted.3 This crisis can be traced to the 2006 bursting of the housing bubble, which triggered the collapse of the subprime mortgage market.4 1 Credit Rating Agencies and the Financial Crisis: Hearing Before the H.
    [Show full text]
  • Commercial Mortgage Backed Securities (CMBS)
    ChapterChapter 20:20: CommercialCommercial MortgageMortgage BackedBacked SecuritiesSecurities (CMBS)(CMBS) 1 20.1.20.1. WhatWhat areare CMBS?...CMBS?... • CMBS are mortgage-backed securities based on commercial mortgages. • Provide claims to components of the CF of the underlying mortgages. • Issued in relatively small, homogeneous units, so as to facilitate trading by a large potential population of investors, • Including those who do not wish (or are unable) to invest large sums of money in any given security. • Many CMBS are traded in relatively liquid public exchanges (part of the bond market). • Market for a given individual security is likely to be rather thin, but the similarity within classes of securities is great enough to allow relatively efficient price discovery and resulting high levels of liquidity in the market. • Other CMBS are privately placed initially, only traded privately (if at all). 2 20.1.20.1. WhatWhat areare CMBS?...CMBS?... Commercial mortgage loans that are: – Originated – Pooled – Rated by a rating agency – Sold as a security 3 Servicer Trustee (Master Svcr, Oversees Pool Sub-Svcrs) Collects CF Special Servicer Deals with defaults, workouts 4 CMBSCMBS -- ServicersServicers andand LingoLingo …… • Real Estate Mortgage Investment Conduit (REMIC)(REMIC) • Pooling and Servicing Agreement (PSA)(PSA) • Servicers: Master, Sub, and Special •Trustee • B-Piece Buyers • Rating Agencies 5 20.1.1 A brief history: The birth of an industry... • Resolution Trust Corporation (RTC), Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA): • RTC (Federal Govt Corp) set up to liquidate the loan portfolios of thrifts and banks that had failed in the commercial property crash of the late 1980s.
    [Show full text]
  • How to Issue Green Bonds, Social Bonds and Sustainability Bonds
    How to Issue Green Bonds, Social Bonds and Sustainability Bonds Prepared by Climate Bonds Initiative Commissioned by State Securities Supported by International Finance Corporation and Commission of Vietnam Swiss State Secretariat for Economic Affairs (SECO) Contents 1. State Securities Commission of Vietnam’s Foreword 3 8. Labelled bond issuance process 19 2. Introduction and Context 4 Pre-issuance steps 20 Issuance - launch of the bond into the market 22 3. Background on green, social and sustainability bonds 5 Post-issuance steps 23 What is a green bond? 5 9. Distinctive Characteristics of Sovereign, municipal What is a social bond? 5 and corporate issuances 24 What is a sustainability bond? 5 Similarities and differences between green, social 10. Financial institutions 27 and sustainability bonds 7 Financial institutions as underwriters 27 4. Benefits of labelling for issuers and investors 9 Financial institutions as issuers 27 5. International & local principles 10 11. Key service providers in the ASEAN market 28 The principles (ICMA) 10 Credit rating agency 28 International Climate Bonds Standards 10 Second party opinion provider (SPO provider) 28 ASEAN standards 11 Verifier under the Climate Bonds Standards 28 Principles and standards in Vietnam 11 12. Case studies from other countries 29 6. Taxonomies of green definitions 12 Malaysia: Telekosang Hydro One Sdn Bhd 29 Climate Bonds Taxonomy 12 Thailand: B.GRIMM Power Public Company Limited 29 EU Taxonomy 13 Philippines: Bank of the Philippine Islands 30 Vietnam’s local context 14
    [Show full text]
  • The Credit Rating Game: Evidence from a Strategic Game Model
    The Credit Rating Game: Evidence from a Strategic Game Model Ruoyan Huang, Hongtao Li∗ Preliminary draft, please do not cite or circulate. Abstract This paper empirically analyzes the effect of competition on rating quality under the "issuer- pay" compensation scheme. Using hand-collected data of collateralized debt obligations (CDOs), we specify the competition among credit rating agencies with a discrete game framework and test its influence on the rating quality. We find that competition raised the probability of choos- ing lenient rating by 31% for Moody’s and 27% for S&P in the sample period of 2007-2008. We further demonstrate that the propensity for selecting lenient rating increases with the bar- gaining power of the underwriters and the complexity of the CDOs. Overall, we find evidence suggests that competition among CRAs reduces their rating quality under the "issuer-pay" scheme. ∗Huang is with the University of Hong Kong and Li is with Tulane University E-mail: [email protected], [email protected]. We are indebted to seminar participants at the University of Rochester. All remaining errors are the sole responsibility of the author. “Oh God, are you kidding? All the time. I mean, that’s routine. I mean, they would threaten you all of the time. ... It’s like, ‘Well, next time, we’re just going to go with Fitch and S&P. ’ ” — Gary Witt, a former Moody’s team managing director told the Financial Crisis Inquiry Commission when asked if the investment banks frequently threatened to withdraw their business if they did not get their desired rating1.
    [Show full text]
  • How Does Tranching Create Economic Value?
    How does tranching create economic value? Adam B. Ashcraft* Banking Studies Federal Reserve Bank of New York [email protected] 212‐720‐1617 15 January 2005 Abstract Tranching a portfolio into multiple securities with a market value greater than the original portfolio is possible when there differences in the non‐credit components of spreads between segmented markets. This paper documents that the ability of a tranching to generate cash flows that fund structuring fees is driven simply by an arbitrage between high non‐credit components of spread for fixed‐income securities and low non‐credit components of spread for equity securities. *Preliminary and incomplete. Please do not cite without permission. The views expressed here are those of the author only and do not reflect those of the Federal Reserve Bank of New York or the Federal Reserve System. 1. Introduction Consider an arbitrageur that buys new cars, takes them apart, and sells the parts in a market where they are viewed as perfect substitutes for those produced by a parts manufacturer. If the total value of parts is larger than the cost of purchasing the car and breaking it up into parts, this process generates economic profit. Alternatively consider an arbitrageur that purchases a portfolio of corporate bonds from the secondary market, re‐packages this portfolio into a senior debt tranche and a subordinated equity tranche of a collateralized bond obligation (CBO), and sells these securities to investors at a price higher than the cost of acquiring the portfolio. In the first transaction, the arbitrageur is taking advantage of market power by an auto parts manufacturer which has the ability to price discriminate between consumers in two segmented markets.
    [Show full text]
  • Weekly Market Outlook Contributors: Credit Markets Review and Outlook by John Lonski Market Implied Ratings Differ on the Likely Direction of Baa3 Ratings
    CAPITAL MARKETS RESEARCH JULY 11, 2019 Market Implied Ratings Differ on the Likely WEEKLY Direction of Baa3 Ratings MARKET OUTLOOK Moody’s Analytics Research Weekly Market Outlook Contributors: Credit Markets Review and Outlook by John Lonski Market Implied Ratings Differ on the Likely Direction of Baa3 Ratings Moody's Analytics/New York: » FULL STORY PAGE 2 John Lonski Chief Economist The Week Ahead 1.212.553.7144 We preview economic reports and forecasts from the US, UK/Europe, and Asia/Pacific regions. [email protected] » FULL STORY PAGE 5 Yukyung Choi Investment Grade: We see year-end 2019’s average Quantitative Research Credit investment grade bond spread above its recent 119 basis The Long View Spreads points. High Yield: Compared with a recent 421 bp, the high- yield spread may approximate 475 bp by year-end 2019. Defaults US HY default rate: Moody's Investors Service’s Default Moody's Analytics/Asia-Pacific: Full updated stories and Report has the U.S.' trailing 12-month high-yield default rate Katrina Ell key credit market metrics: dipping from June 2019’s actual 3.0% to a baseline estimate Economist Second-quarter 2019’s of 2.9% for June 2020. bond issuance by U.S. Issuance For 2018’s US$-denominated corporate bonds, IG bond companies revealed yearly issuance sank by 15.4% to $1.276 trillion, while high-yield Moody's Analytics/Europe: bond issuance plummeted by 38.8% to $277 billion for high- gains of 5.0% for yield bond issuance’s worst calendar year since 2011’s $274 Barbara Teixeira Araujo investment-grade and billion.
    [Show full text]
  • Instructions and Guide for Credit Rating
    Instructions and Guide for Credit Rating c 2015 Huiming Zhang 1 Introduction 1.1 Overview In the lab, you will use Bloomberg to explore the topic of credit rating. In previous labs, you should have learned the idea of default risk, the risk investors are bearing in lending money to the financial institutions and for which those investors are com- pensated in a form of higher interest rate. Credit rating measures a bond/issuer's default risk by classifying these bonds/issuers into classes of groups based on the credit rating agencies' view of they defaulting on their borrowings to creditors. Thus investors are able to evaluate the investing opportunities and to compare among bonds of different yields and prices in the market. In the World Bonds and Yields lab, we discuss and compare the borrowing costs of German bund, US Treasury bond and Spanish government bond. We might expect the Spanish government bond to have the highest interest rate among these three categories of government bonds, because Spain has the greatest opportunities to fail to make its promised interest rate payments and default in its borrowings. You will take this point to this Credit Rating lab - a worse credit rated issuer would have higher coupon rates to compensate its investors for the default risk. Default risk could be measured in various ways. You could look at the inter- est coverage ratio (EBIT/interest expense), market capitalization (market value of the company's outstanding shares), and so on, to evaluate the company's default probability. For instance, the higher the interest coverage ratio, the more earnings (before interest and taxes) the company holds which could be used to pay back the company's borrowings.
    [Show full text]
  • Guide to Credit Rating Essentials What Are Credit Ratings and How Do They Work? Guide to Credit Rating Essentials
    Guide to Credit Rating Essentials What are credit ratings and how do they work? Guide To Credit Rating Essentials Contents About this guide 3 What are credit ratings 4 Why credit ratings are useful 6 Who uses credit ratings 8 Credit rating agencies 10 The ABCs of rating scales 13 Rating issuers and issues 15 Surveillance 18 Why credit ratings change 19 How we communicate credit ratings 21 About this guide This guide is designed to provide an understanding of what credit ratings are and how they work. This guide: If you would like to learn more 1. Helps explain what credit ratings are and are not, about credit ratings, additional who uses them and how they may be useful to the information is available at capital markets. spglobal.com/UnderstandingRatings 2. Provides an overview of different business models and methodologies used by different ratings agencies. 3. Describes generally how S&P Global Ratings form ratings opinions about issuers and individual debt issues, monitors and adjusts its ratings and studies ratings changes over time. Credit ratings are a tool, among others, that investors can use when making decisions about purchasing bonds and other fixed income investments. Ratings help foster the development and smooth functioning of capital markets; capital allows people to start and grow businesses, cities and states to build highways and hospitals, and manufacturers to build factories and create jobs. Ratings express independent opinions on creditworthiness, using a common terminology that may help investors make more informed investment decisions. S&P Global Ratings is a leading provider of independent credit ratings and analysis, offering a combination of global perspective with local insight.
    [Show full text]
  • Bond Insurers: Issues for the 110Th Congress
    Bond Insurers: Issues for the 110th Congress Updated March 10, 2008 Congressional Research Service https://crsreports.congress.gov RL34364 Bond Insurers: Issues for the 110th Congress Summary Beginning in 2007, higher than expected defaults and delinquencies in “subprime” mortgages led to a significant slowdown of the housing market. Most of these mortgages were financed by capital markets through asset- or mortgage-backed securities, rather than by traditional banks. Thus, rather than being confined to the institutions that made the now-questionable loans, losses caused by unexpected mortgage defaults have been felt throughout the financial system by any entity who bought mortgage-backed securities. In addition, financial guaranty insurance companies, often known as “monoline” insurers, have also been affected because they insured the prompt payment of interest and return of principal for various securities that may now not be able to pay the promised amounts. With most possible insurance payouts still in the future, these insurers have yet to experience large real losses. Possible massive future losses, however, have caused financial turmoil for insurers, downgrades from rating agencies, and fears about further harm to other institutions, individuals, and municipalities. While the federal government does not currently oversee any insurers, various proposals for broad federal oversight have been introduced, including S. 40/H.R. 3200 in the 110th Congress. The House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing entitled “The State of the Bond Insurance Industry” on February 14, 2008, and the full Financial Services Committee is scheduled to examine “Municipal Bond Turmoil: Impact on Cities, Towns, and States,” on March 12, 2008.
    [Show full text]