Effects of Credit Rating Agencies - Research Paper Example

Effects of Credit Rating Agencies In this globalization era, investment opportunities are available in various parts of the world as well as in various business sectors. Although the global recession was a dampener to these investments, now with the global economy showing good signs of recovery, investment opportunities have increased again. However, the issue is, with investment opportunities that are available becoming more global and diverse in nature, both in the territories sense as well as business sectors sense, it has become difficult to decide not only which companies but also which countries are good investment opportunities. (Heakal, n. d). As each company or country will have both advantages as well as risks regarding many aspects of its functioning, it is very important for the investors to have insight about those investment opportunities. As it will not be practically feasible for the investors to analyze and understand each and every aspect of the companies or countries and their advantages and risks, they will elicit the help of external agencies. Also, even if they do analysis on their own, they will consult or refer external agencies to give them some guidelines or ideas about the investment opportunities. This is where the role of credit rating companies or agencies comes into the picture. “Measuring the ability and willingness of an entity - which could be a person, a corporation, a security or a country - to keep its financial commitments or its debt, credit ratings are essential tools for helping you make some investment decisions.” (Heakal, n. d). Background and Objectives Do changes in credit ratings affect equity valuation? If so how? And to what extent? This is an important topic that has interested many professionals in the field of economics and business, although it is often overlooked. As pointed out in the introduction, credit rating companies play an extremely vital role in any economy, local or foreign. The information provided by these agencies is used by all kind of parties starting from business organizations, independent investors, financial institutions, even countries’ governments, charity organizations, etc. “Only because of the availability of clear, internationally accepted indicators of the risk of default were investors willing to invest in international securities—whether corporate or government bonds—whose credit quality they would have been virtually unable to assess on their own.” (Utzig, 2010). The objectives of this research paper are: firstly, to show how credit rating companies’ ratings or changes have an important part in various decisions of the organizations. The paper will also discuss how changes in ratings, provided or appointed by these agencies, will affect asset prices. Lastly, the paper will discuss how different variables play a role in the asset price change. As part of fulfilling these objectives, the paper would show the effects of credit rating changes by looking at various real life case studies as possible, analyzing them thoroughly, and coming up with the right conclusions. To analyze topics like this, real life examples are the key and so to fulfil those necessities, number of cases will be incorporated and discussed. Methodology Methodology plays an important role in any research paper. It is the “bridge” through which the aims and objectives of the paper can be achieved. For this research paper with the topic and objective on the role of credit ratings changes on asset prices, the paper will first define the variables. That is, various variables which will aid in finding the role of credit agencies will be analyzed. Briefly these variables include: whether or not the information is “contaminated”, whether the change in ratings is within the same class or across classes, whether or not the effects of credit changes have the same effects in emerging and developed countries, the amount of information that is available about the company and how that affects asset prices, and the size of the firm with the rating change. All these variables have to fall in place for effective analysis. Information is said to be “contaminated” if the story or information about the credit rating change of the company contains information from a source other than the rating agency, or if other information concerning the firm is published in the time frame of four days surrounding the date of the press release by the rating agency. When a change in ratings is within the same class of letters, like a downgrade from AAA to AA, it is considered within the same class; whereas a change from A to BBB is considered across classes. It makes a difference in the degree of price change in equity if the ratings change is within the same class or across classes. Lastly, the size of the firm with the rating change affects the degree to which price changes. After focusing and analyzing each of these variables, how each of these variables affects the model as a whole has to be examined. Methodology Process or Data Collection To do good and in-depth study about these variables and how it impacts the credit rating changes, good research has been or has to be done using various creditable sources. Good amount of relevant information about this topic has been retrieved from useful books, journal articles, and the web. The variety of sources from different timelines has provided good depth to the research. Books have been used to study the concepts and practices of credit rating agencies. The same role was fulfilled by the journals as well, along with providing information about the current scenario. However, maximum information has been gathered from the web. Articles from the internet have been useful in studying the past case studies, particularly how credit rating changes impacted real life companies. Thus, to achieve the objective, the various variables of the methodology are studied using various and relevant sources. Description Credit rating companies had its originations in the United States in the 19th century. That is, the predecessors of CRAs can be identified as Mercantile credit agencies, which measure a merchants ability to pay his financial obligations. The modern credit rating industry started off with the establishment of Moodys investor service in 1909 by John Moody. (Geisst, 2006). From that time, the functioning and the role of the rating agencies have evolved and now they play a significant role in the financial markets of many countries. They process and release important information that can make or break companies of all sizes. The main objective of a credit rating agency is to assign a credit rating to issuers of debt. As discussed above, this credit rating is used by various forms of investors as well as issuers, broker-dealers, and governments. This rating is used to measure the credit worthiness of the issuing company and also credit status of various countries. “Credit rating agencies provide an assessment of the credit worthiness of a corporation or security, based on the issuers quality of assets, existing liabilities, borrowing history, and overall business performance.” (Lagace, 2009). It is mainly used to measure the probability that the money invested will be returned. “Investors depend on the ratings to predict the likelihood of default on financial obligations and the expected repayment in the event of default.” (Lagace, 2009). Standards Followed by Well Known Credit Rating Agencies There are three major companies that are well known for credit ratings in the U.S. and globally. They are Standard and Poor’s Corporation, Moody’s Investors Service and Fitch Investors Service. Standard and Poor’s unlike the others added a new service that lists probable future bond rating changes. They called it the Credit Watch List, and it also has an effect on equity prices. These companies have similar ways of rating bonds. Moody’s rates bonds use letters from Aaa down to C, while Standard and Poor’s and Fitch rate bonds from AAA down to D. It is important to know that bond ratings measure default risk only and not interest rate risk. An important point in bond ratings is whether or not bonds are investment grade. Investment grade is a rating of BBB or greater under Standard and Poor’s and Fitch or Bbb or greater under Moody’s. If a bond is rated below investment grade, it is said to be speculative, and the bond is termed as a junk bond. Junk bonds are very risky but provide high returns although the risk is entirely related to credit quality. Thus, a body of thought developed among the institutional investors and among academics that junk bonds would continue to provide very high returns, when compared to higher quality bonds. (Thau, 2001). Analysis Kaminsky and Schmukler (2002) show that the ratings or changes of the credit rating agencies indeed affect financial asset prices, but they are not able to fully assess the extent to which the information featured or embedded in rating changes is already incorporated into bond prices. According to Hand, Holthausen and Leftwich (1992), by closely looking at the change in stock returns during the 2-day announcement period, they found a significant price decrease for across-class rating downgrades. The average abnormal return on day 0 and day + 1 is -2.66% and is significant at the 1% level. Moreover, for within-class rating downgrades, they found a small -0.2% abnormal return. They found no significant price response for firms that experienced within-class upgrades. For across-class upgrades, they found an insignificant 0.08% abnormal return for rating upgrade announcements. The results were loud and clear. An announcement by a credit rating company of a downgrade in the rating of a bond results in substantial negative returns of the matching stock. An announcement of an upgrade in the rating of a bond results in small increase, or no change, in the returns of the corresponding stock. The above results are for contaminated announcements. The results for the non-contaminated are similar to the preceding, but less conservative. Downgrades result in negative abnormal returns, although the magnitude is not as large, whereas upgrades result in no change at all. “Previous papers in the literature focus on the abnormal equity returns following credit rating changes, and show that abnormal returns are negative following downgrades”( Vassalou and Xing, 2005). Indicated downgrades and upgrades in the Credit Watch sample have a significant effect on stock prices, even if contaminated observations are excluded. Reliably nonzero average excess bond returns are observed for additions to Standard and Poors Credit Watch List when an expectation model is used to classify additions as either expected or unexpected. When the change in credit rating is across classes as compared to within the same class, it results in a bigger, more noticeable change in the returns of the corresponding equity. The reason for that is that a change across classes looks more significant and is more alarming to investors. My research has shown that these changes that were mentioned above are greater and much for significant in small, low credit quality firms as compared to larger corporations. This adds to the fact that the less the information available about a company the bigger the change in returns of the equity. Ethical and Corrective Aspects Apart from being statistically and numerically accurate, these ratings have to be ethically viable and unbiased. Enron is the perfect example of ethical misses as it was given good investment rating by many credit agencies, only to see it going bankrupt immediately after. “Credit rating agencies have faced criticism for failing to identify impending crises at corporations such as Enron and many in the telecommunications industry.” (Teather, 2003). This Enron scandal has damaged the credibility of these agencies, and effective steps are regularly taken to avert such a scenario. “The credit rating industry is facing sweeping regulatory changes in the wake of the scandals that have beset Wall Street during the past year.” (Teather, 2003). In addition, there are criticisms that inappropriate ratings and results given by the credit rating agencies also played a part in the global financial crisis, which has affected and is still affecting the global economy. That is, for the past two years, the view is the changes that have been witnessed in the ratings of structured credit are very inconsistent and volatile, when compared to the historical record. This inconsistent and unstable rating as form of cyclical effects negatively impacted the global economy. That is, in the post-recession period, credit rating agencies provided high marks to certain risky financial vehicles like the collateralized debt obligations, which is not clearly understandable to the investors. So, “it has been argued that these ratings misled investors as to the safety of those investments, and that this contributed to the financial turmoil that followed.” (Lagace, 2009). Thus, this underperformance of the credit rating agencies is viewed in many circles as one of the reasons, which contributed or even accentuated the global financial crisis. Conclusion From the above analysis, it is clear that the information provided to various investors as well as other stakeholders by credit rating companies is very important and can be used in various optimal ways. The price of equity securities does depend on changes in the credit rating of bonds of the related company. There are many variables that affect the degree of change of the equity associated with the change in the bond rating. These include whether or not the information is contaminated, if the change is across or within the class, the size of the company in question and how much information is available about the company. Therefore, with many stakeholders depending on their results, credit rating agencies are expected to function optimally, with clear ethics. References Geisst, C. R. (2006). Encyclopaedia of American Business History. Volume 2. Infobase Publishing. Heakal, R. (n. d). What Is A Corporate Credit Rating? Retrieved on December 7, 2010 from http://www.investopedia.com/articles/03/102203.asp Hand, J, Holthausen, R W & Leftwich, R W. (1992). The effect of bond rating agency announcements on bond and stock prices. Journal of Finance, 57, p.733–752. Kaminsky, G. and S. Schmukler (2002). Emerging Market Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns? The World Bank Economic Review, 16 (2): 171-195 Lagace, M. (2009). Why Competition May Not Improve Credit Rating Agencies. Retrieved on December 7, 2010 from http://hbswk.hbs.edu/item/6260.html Teather, D. (2003). SEC seeks rating sector clean-up. Retrieved on December 7, 2010 from http://www.guardian.co.uk/business/2003/jan/28/usnews.internationalnews Thau, A. (2001). The bond book: everything investors need to know about treasuries, municipals, GNMAs, corporates, zeros, bond funds, money market funds, and more. McGraw-Hill Professional. Utzig, S. (2010). The Role Played by Credit Rating Agencies in the Financial Crisis. Retrieved on December 7, 2010 from http://www.adbi.org/working-paper/2010/01/26/ 3446.credit.rating.agencies.european.banking/the.role.played.by.credit.rating.agencies.in.the.financial.crisis/ Vassalou, M and Xing, Y. (2005). Abnormal Equity Returns Following Downgrades. Retrieved on December 7, 2010 from http://www.maria-vassalou.com/pdf/changeDLI5.pdf. Read More