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Does the Bond Market Want Informative Credit Ratings?

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Does the Bond Market Want Informative Credit Ratings? Does the bond market want informative credit ratings? Jess Cornaggia and Kimberly J. Cornaggia* May 2, 2011 Abstract We examine the information content of Moody’s traditional credit ratings compared to those produced by an independent subscriber-paid firm. We find that the independent ratings provide more timely information and we quantify the wealth effects of relying on Moody’s ratings to assess credit quality. Prevailing wisdom suggests that traditional credit ratings are slow to downgrade because Moody’s receives compensation from issuers. Our results suggest that regulated investors dominating fixed income markets also benefit from Moody’s sluggish downgrades. Regulatory reliance on relatively uninformative credit ratings allows banks, insurance companies, and pension funds to hold riskier bonds and therefore earn higher returns. We discuss several important differences between the traditional credit rating and its independent alternative in the context of the changing regulatory environment following Dodd-Frank. JEL classification: G14, G28, G32 Keywords: Corporate Debt, Credit Ratings, NRSROs, Information Intermediary, Capital Markets Regulation *Jess Cornaggia ([email protected]) is at the Kelley School of Business at Indiana University and Kimberly J. Cornaggia ([email protected]) is at the Kogod School of Business at American University. The authors are grateful to Rapid Ratings for proprietary ratings data and to Bo Becker, Shane Corwin, Dan Gallagher, John Griffin, Katherine Guthrie, Larry Harris, Steve Heston, John Hund, Spencer Martin, Todd Milbourn, Tim Simin, Jonathan Sokobin, Jan Sokolowsky, and Larry White for helpful discussion, as well as audience members at the 2010 State of Indiana Finance Symposium, College of William & Mary, University of Illinois at Urbana-Champaign, U.S. Securities and Exchange Commission, and 2010 Conference on Financial Economics and Accounting at the University of Maryland. The authors thank Sumit Behl, Celal Evirgen, Catalina Gutierrez de Pineres, Riddhimaan Nandgaonkar, and Xiaoxiao Yin for research assistance. Jess Cornaggia is grateful for financial support from the Kelley School of Business Research Database Committee. Any errors belong to the authors. A previous draft of this paper circulated under the title “Why are credit ratings useful?”. The prevailing explanation for the ‘failure’ of the Big 3 credit rating agencies (Moody’s Investors Service, Standard & Poor’s, and Fitch) is the conflict of interest in the issuer-pays compensation structure.1 Consistent with this belief, we document that Moody’s credit ratings contain less information than ratings produced by Rapid Ratings, an emerging, independent credit rating agency compensated by investors and other subscribers. However, we offer an additional explanation for the less informative Moody’s ratings. We provide evidence that regulated institutional investors actually benefit from regulatory reliance on uninformative ratings. Specifically, Moody’s sluggish downgrades allow regulated investors to hold risky bonds and thus earn higher returns. We conclude that Moody’s ratings contain less information not merely due to conflicts of interest in the issuer-pays model, but also because the largest users of ratings are a party to this equilibrium.2 We define ‘regulatory arbitrage’ as financial institutions and other regulated investors taking advantage of credit ratings that do not fully reflect financial risk in order to earn higher yields while still complying with regulatory restrictions. Even without systematic rating inflation, our results suggest that regulated investors can exploit noisy ratings to conduct regulatory arbitrage, cognizant of the difference between actual credit risk (which investors can price appropriately using more timely credit analysis) and the risk implied by imperfect credit ratings. In a private memo, Moody’s president Raymond McDaniel recently confided that investors dislike informative credit ratings: 1 For commentary on credit ratings ‘failure’, see U.S. Senate (2002), comments by Chairman Waxman (U.S. Congress, 2008) and comments by Securities and Exchange Commission (SEC) Commissioner Casey (2009). Rules issued by the SEC recognize it is a conflict of interest for an Nationally Recognized Statistical Rating Organization (NRSRO) to be paid by an issuer or underwriter (Exchange Act Rule 17g-5(b)(1)) and NRSROs must maintain procedures reasonably designed to manage this conflict (Section 15E9(h) of the Exchange Act). Several recent articles explicate the effects of this conflict of interest on ratings quality. Skreta and Veldkamp (2009), and Sangiorgi, Sokobin, and Spatt (2009) discuss ratings shopping, Griffin and Tang (2010), discuss subjectivity, and Coval, Jurek, and Stafford (2009) discuss the role of inflated credit ratings in the collapse of the structured finance market. 2 Large, regulated entities (including insurance companies, banks, pension funds, and dealers) hold approximately 40% of corporate bonds and asset-backed securities. By comparison, atomistic domestic households and foreign investors account for 11% and 29%, respectively. In European Union bond markets, retail investors (households) represent closer to 3% (SIFMA (2007)). 1 It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don't want rating downgrades; short-sighted bankers labor short-sightedly to game the rating agencies for a few extra basis points on execution. 3 (emphasis added) We find evidence to support our definition of regulatory arbitrage as a rational, market- based explanation for the sluggish updating by Moody’s. In particular, we document higher returns to portfolios that buy bonds and hold them until maturity, default, or Moody’s downgrades to speculative grade, compared to other portfolios that buy and hold the same bonds until maturity, default, or Rapid Ratings downgrades to speculative grade. The Moody’s portfolios generate annual returns that are as much as 3.1% higher than the Rapid Ratings portfolios. These higher returns are a reward for bearing more risk. In fixed income markets, taxpayer dollars insure the dominant institutional investors engaging in such risks. Thus the incentive for regulatory arbitrage is complete. To the best of our knowledge, our paper is the first to examine this explanation for sluggish credit ratings produced by the Big 3. In addition to this contribution, we make detailed comparisons between the credit ratings produced by Moody’s and Rapid Ratings. Credit ratings and the firms that produce them take shape according to several key dichotomies. For each of the following dichotomies, Moody’s is characterized by the former trait and Rapid Ratings by the latter trait: issuer-pays or subscriber-pays compensation structure, whether the credit ratings are stable or timely, whether the credit ratings are ordinal (relative) or cardinal (absolute), whether the credit ratings are based on qualitative analysis or quantitative models, and whether or not the rater is a Nationally Recognized Statistical Rating Organization (NRSRO). We discuss how these dichotomies contribute to differences in the firms’ ratings. Each rater appears to focus on mitigating the error type most important to its paying clients. Moody’s receives compensation from issuers, whereas Rapid Ratings receives compensation from investors and other subscriber. We find Moody’s is less likely to misclassify 3 Quote taken from a 2007 internal Moody’s memo presented as evidence to the Congressional hearing on credit rating agencies and the financial crisis on October 22, 2008. 2 healthy issuers’ debts as distressed (Type 2 error) and more likely to misclassify distressed issuer’s debts as healthy (Type 1 error) compared to Rapid Ratings. Rapid Ratings updates its ratings more frequently than Moody’s and in doing so provides more timely information about credit quality. For example, among bonds that ultimately default, Rapid Ratings downgrades its ratings to speculative grade earlier than Moody’s—a portfolio manager would avoid an average loss of principal equal to 11.7 percent of face value by selling the bonds when Rapid Ratings downgrades to speculative grade, rather than waiting for Moody’s to downgrade. Similarly, we document a higher default frequency among issues with investment grade ratings according to Moody’s than according to Rapid Ratings.4 Moody’s stable ratings (i.e., ratings that are slow to update) are not without merit, however. Stable ratings may prevent pro-cyclicality, or the effect of downgrades exacerbating recessions (Altman and Rijken (2005)). Stable ratings also avoid prematurely forcing investors to sell assets to comply with regulations and unnecessarily triggering covenants in debt contracts (Cantor and Mann (2006)). However, if the purpose of ratings-based regulations and ratings- based debt covenants is to control the risk exposure of taxpayer-backed institutions and corporate counterparties, then credit ratings should map to absolute levels of credit risk over time. Although neither Moody’s nor Rapid Ratings produce ratings that convey identical information with respect to default prediction year after year, we find the information content of Moody’s ratings exhibits more variation. The standard deviation of default frequency among investment grade ratings according to Moody’s is over three times larger than that of Rapid Ratings. Among speculative grade ratings, the disparity is even greater: the standard deviation of default
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