Implications of Conservatism for Capital Structure and Debt Pricing - Book Report/Review Example

Implications of conservatism for Capital Structure and Debt Pricing Credit rating agencies are firms that rate a debtors creditworthiness. This refers to a person or a companys ability to pay back a loan timely or their likelihood of default payment. These agencies can also be involved in the rating of the creditworthiness of loaners of liability obligations as well as servicing of the underlying debts. The various debt instruments that are dealt with by these firms include government bonds, corporate bonds, municipal bonds as well as mortgage-backed securities. This paper, however, aims at analyzing the fact that rating agencies have become more conservative over the years. This is notably in the assignment of corporate credit rating between the years 1985 and 2009. This conservatism has seen the average debt ratings drop by three notches over this period. However, these changes in credit rating have not produced the anticipated implications for many firms. The affected had adopted a policy of holding more cash and issuing less debt. The events that led to the financial crisis in 2008 were linked by observers to have been partly caused by rating agencies due to their failure in rating the creditworthiness of individuals as well as institutions. These observers accused the rating agencies of having been too generous with endorsing institutions to borrow high valued securities despite the associated high default risk. Following the financial crisis, these companies have been subjected to increased scrutiny to avoid such a scenario from repeating itself. As such, several changes have been made in the standards applied by rating agencies that have had a significant impact of companies debt pricing policies. These changes have been as a result of the direct blame to rating agencies for the 2008 economic crisis. The conservatisms of rating agencies, first documented by Blume and MacKinlay, has shown that the latter increased conservatisms. For instance, a firm rated AAA in terms of credit worthiness back in the year 1985 could only be rated AA in the year 2009 when the standards of rating agencies were reviewed. Astonishingly, firms with BBB rating by 1985 have been seen to lose their creditworthiness by recent times. The implications of this increased conservatism can be viewed in two dimensions. First, if the increased stringency applied by these agencies occurred when the latter was warranted given the changes in the macroeconomic environment and their effects on general default risk, then there would be no observable change in default risk as seen between the years 1985 and 2009. On the contrary, if the increased conservatism were unwarranted and did not provide a representation of increased default risk, then the observation would be a decline in defaults (Mclean and Joseph 45). This conservatism has also had a significant impact on corporate behavior regarding the capital structure adopted, decision-making concerning accessing public bond markets by companies as well as cash holding and growth. If the changes in the rating system were considered to be unwarranted by firms, then the implication for the companies that suffered most from the conservatism are most likely to use less debt financing over time. This conclusion was arrived at using the rating model employed between 1958 and 1996 to predict the rates used in the years 1997-2009. Turing to the implication of increased conservatisms on firms decision to access public bonds, it is paramount to note that companies have refrained from using municipal bonds as a method of financing. However, there is an observable direct relationship between the companies which suffered most from the increased stringency of the rating agencies and their decision to reduce the use of public bonds. On the same note, conservatisms have been observed to have a negative effect on the affected firms ‘growth. This is because these companies have been forced to hold more cash meaning lessened investment activities. The implication here is that these companies have been experiencing little or no growth over the years. Shifting the focus on the implications of the changes in credit rating standards for firms debt pricing was necessary in the event. It has been observed that if the conservatisms were deemed unwarranted, the expectation would be debt spreads. Holding the actual rating constant, it was found that firms that were most affected by conservatism experienced lower debt spreads. This is unlike the case of the corporation that were less affected that enjoyed increased debt yields as bond rating worsened over time. The overall view from this discussion shows that the increased conservatisms of rating agencies is not fully warranted as shown in its implication on firms default rates, capital structure decision-making as well as debt pricing. With growing inflation in various economies and the work of rating agencies conservatisms, the expected implication is a further problem in the way credit ratings are assigned to companies and consequently the need to have even more stringent standards on the part of rating agencies. From this discussion, my opinion is similar to that of the observers who accused rating agencies of having been too generous to back up the issuance of highly valued securities with high default risk. I feel that there was slack management in the rating agencies. Additionally, there could have been corrupt motives among the officials who assigned high credit rating to companies that ended up defaulting in payments. Their operation did not consider the effect that any misdoing would have on the clients. Lack of scrutiny of these agencies before the onset of the financial crisis, from my opinion, was also a cause of the major economic implication that followed. There should have been an established body or government agency whose sole duty would have to scrutinize companies credit ratings issued by the various rating agencies at the time. Thus, the agencies would have ensured that the assigned ratings reflected the true creditworthiness of these companies and hence avoid the rampant default in payment of security based loans that led to the financial crisis. If these measures had been put in place in time, the adverse effects of companies, especially the companies most affected by the stringent standards now employed by rating agencies, would not have impacted on the latter as it have been seen above. These firms would most likely have enjoyed more growth over the years on the contrary. There is a need to scrutinize financial institutions, especially rating agencies if future financial crises are to be avoided. I feel that a country should not be experiencing a financial downturn from avoidable problems. Accountability of the rating agencies is extremely important in the current world. Conclusively, my opinion is that it is right to blame the financial crisis on the loose methods that rating agencies used from 1985 onwards ultimately leading to the world economic crisis. They were reluctant to perform their duties effectively considering the intensity of the situation and consequences of failure. The stringent standards that were later on forced on rating agencies can be said to have affected most companies negatively. Companies began experiencing financial troubles due to cumulative effects of bad performance by rating agencies. Works Cited Baghai, Ramin P., Henry Servaes, and Anne Tamayo. "Have Rating Agencies Become More Conservative? Implications for Capital Structure and Debt Pricing. “Journal of Finance LXIX.5 Oct. (2014). Print. Read More