How Credible are Credit-rating Agencies?
Institutional incentives shape the different roles of contracting (certified) and valuation (non-certified) bond-rating agencies, which in turn, affect various properties of their ratings.
ANN ARBOR, Mich. The scandals and failures of major companies, such as WorldCom and Enron, have prompted many in the investment community to blame bond-rating agencies for missing impending meltdowns and not providing investors with timely, useful information.
Although some of this criticism may be deserved, recent calls from the financial press and Congress to push approved credit-rating agencies, such as Moody's Investor Services, to be more responsive to investors may be misguided, according to Catherine Shakespeare of the Stephen M. Ross School of Business at the University of Michigan.
"Our results show the incentives of certified bond-rating agencies, or NRSROs (Nationally Recognized Statistical Rating Organizations), differ from those of non-certified agencies," says Shakespeare, assistant professor of accounting at the Ross School of Business. "NRSROs play a quasi-regulatory role in the capital markets, where new bond issues are required to be rated by a certified agency. Therefore, their bond ratings have a contracting/monitoring role and tend to be more conservative.
"In contrast, non-certified agencies do not have this regulatory function and their bond ratings are used for valuation rather than contracting. As a result, those ratings tend to be more responsive and closely associated with investors, consistent with the investment-advisor role of non-certified firms."
Credit-rating agencies were given a quasi-governmental role by a series of governmental regulations, beginning in 1973. The Securities and Exchange Commission introduced Rule 15c3-1, which requires broker-dealer firms to calculate net capital requirements using the credit rating assigned by an approved group of credit-rating agencies. The four remaining NRSROsMoody's, Standard & Poor's, Fitch Ratings and Dominion Rating Servicesare paid by the companies they rate and, thus, serve a different clientele than non-certified agencies, which are paid by investors in the firms being rated.
In a new study, Shakespeare and colleagues William Beaver and Mark Soliman of Stanford University investigate the impact that different roles (contracting vs. valuation) have on financial intermediation.
They compare the properties of bond-rating changes involving 782 firms between 1997 and 2002 that were made by Moody's, a representative contracting (certified) agency, and Egan Jones Ratings Company (EJR), a representative valuation (non-certified) agency. These properties include the timeliness of rating changes, association of rating changes with equity prices over both short and long windows, association with bond yields on the day of a bond issue and the ability to predict default.
The study shows that the differing roles of these two types of agencies have different impacts on the properties of their bond ratings. Valuation-focused ratings must change when new relevant information emerges about a firm that impacts its bond. However, contracting-focused ratings should be more stable to minimize any unnecessary consequences, particularly losses resulting from overvaluing assets.
Shakespeare and colleagues find that EJR bond ratings correspond more closely to both stock and bond market returns and appear to be more timely. The EJR ratings lead those of Moody's, which is consistent with the non-certified firm's role of providing current information to investors.
By comparison, the researchers say that Moody's ratings do a better job of reflecting negative news rather than positive news related to stock returns, and are more effective at explaining non-investment-grade bond yields and predicting bond defaults.
These findings suggest that the conservative ratings of Moody's are more consistent with its regulatory responsibilities and that changing its role to make it more responsive to investors is not advisable, the researchers say.
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