Ebook Multiple Ratings and Credit Spreads
Rating agencies produce information about the risk of fixed income securities, however, the various ways the information is used by financial, legal and regulatory entities may potentially influence the nature of this information production. Bond ratings are not only used to assess risk, they are also used for certification, e.g. to classify securities into investment grade and high yield (i.e., junk) status.
These classifications in turn influence institutional demand and serve as bright-line triggers in corporate credit arrangements and regulatory oversight. For example, regulations may mandate banks and insurance companies to keep much higher reserve capital for high yield issues than for investment grade, where the level of reserve capital required goes up in large discrete increments depending on which side of the investment grade boundary an issue lies. The institutional importance of credit ratings to issuers and investors has raised questions about whether the current system provides the proper incentives to optimally produce value relevant information about risk.
This was illustrated in the sub-prime crisis of 2007-2008 when rating agencies were publicly accused of being too optimistic in rating complex structured products like CDOs and RMBSs. The rating of those structured products was a major source of profits (fees for rating tranches were about 13-16 bps for Moody’s and S&P and somewhat lower for Fitch) for the CRAs and allegedly, rather than competing on fees, competition manifested itself by allowing larger sizes for the AAA and smaller sizes for the junior and equity tranches. Thus, regulatory boundaries and the hold-up power of CRAs became important elements of competition among rating agencies.
This process is often labeled “a race to the bottom”. However, since these products are complex, heterogeneous and data is hard to come by, these allegations are hard to quantify using statistical analysis. This debate, however, does raise the question of whether this problem is specific to complex structured products or more broadly present in the CRA industry. The most natural way to investigate this is by analyzing CRA and investment behavior in the corporate bond market. Because of the simpler structure, larger data availability and more homogeneity of the products, statistical analysis is much easier. Results from this analysis can be a starting point for the discussion on structured products.
Almost all large, liquid bond issues are rated by both S&P and Moody’s but not by Fitch. Fitch thus plays the role of a “third opinion” for large bond issues. The most prevalent institutional rule used for classifying rated bonds is that, if an issue has two ratings, only the worse rating can be used, and if an issue has three ratings, the middle rating should be used (see for example the Basel II accord or NAIC guidelines). Therefore, if S&P and Moody’s ratings are on opposite sides of the investment grade boundary, the Fitch rating (assuming it is the marginal rating) will decide into which class the issue falls.
A natural question in light of this practice is to ask is whether Fitch might play the role of “tie-breaker” for large bond issues, and if so, what the nature is of the “tie” being broken, informational or regulatory/rules-based. We thus address the question of whether the third rating agency primarily plays a certification role or an informational role in the marketplace for bond ratings. If the certification role dominates, only the weaker issuers would need a third rating. Therefore, we also investigate whether the option of a third rating leads to adverse selection effects in pricing.
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