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Can Market Discipline Work in the Case of Rating Agencies? Some Lessons from Moody’s Stock Price

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Abstract

This paper examines whether the stock price of the rating agency Moody’s reacts negatively to rating actions that could indicate low rating quality. The reaction to rating reversals, which Moody’s describes as particularly damaging to investors, is economically significant. It suggests that market discipline has the potential to influence agency behavior. On the other hand, defaults of highly rated issuers do not consistently impact Moody’s stock price. The focus on reversals and the neglect of default events are consistent with either collusion or with misconceptions of how rating quality should be evaluated. Both interpretations question whether market discipline can be sufficient to ensure a socially optimal rating policy within the current environment.

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Notes

  1. News release “Moody’s Confirms External Review of European CPDO Rating Process”, available on http://ir.moodys.com/RELEASEDETAIL.cfm?releaseid=311726

  2. cf. Erturk (2009). In the mature corporate bond rating sector, by contrast, the 2008 investment-grade default rate of 0.41% compares to a 1981–2006 average of 0.10%, and does not exceed the previous maximum default rate in 2002 (cf. Vazza 2009).

  3. Moody’s and S&P have an estimated market share of 80% measured by revenue, cf. US Senate Report 109–326, 2006.

  4. For information on investment restrictions and rating triggers, see Cantor and Packer (1997) and Stumpp and Coppola (2002), respectively.

  5. According to Moody’s, a rating is meant to provide “a signal that looks through cycles and immaterial events and focuses on long-term creditworthiness” (Mahoney 2002, p.3).

  6. S&P, which itself pursues non-rating related activities, is part of McGraw-Hill; and Fitch is part of the France-based company Fimalac, which now focuses on risk management but was an industrial conglomerate before 2005. In 2004, halfway through the sample period, Fitch contributed 36% to Fimalacs’ revenue while the financial services segment, which comprises the S&P rating business, contributed 39% to McGraw-Hill’s revenue.

  7. Source: Moody’s annual reports. Other business sectors are structured finance ratings, research, and Moody’s KMV. From 1998 to 2010, the average revenue share of structured finance was 32.2%. The structured finance share exceeded the traditional rating business in the years 2005 to 2007.

  8. I am indebted to Ken French for making this data available on http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

  9. I examine estimated senior ratings as described in Gupta and Parwani (2009). Some changes in issuer ratings are due to changes in the methodology used to derive issuer ratings from individual bond ratings. I use a flag contained in the database as well as the detailed rating information provided on www.moodys.com to identify actual rating actions as opposed to changes due to methodology, and use only actual rating actions in my analysis.

  10. Cf. “Moody’s lowers bank ratings following refinement of methodology”, Global Credit Research, 4/10/2007. The 2006 change in methodology is described in “Moody’s publishes final Methodology and related research for Loss-Given-Default Assessments and Probability-Of-Default Ratings”, Global Credit Research, 8/23/2006. Both reports are available on www.moodys.com.

  11. Binder (1985) discusses the use of multivariate regressions for event studies. For recent applications see Cornett et al. (1998) or Bittlingmayer and Hazlett (2000).

  12. To further check robustness, partly motivated by the fact that reversal and default events appear to be clustered (cf. Fig. 1), I estimate standard errors with the Newey-West estimator and a lag length of 21 (= 1 month). Results do not change conspicuously. For example, the t-statistics of the reversal dummy change from −2.34 to −2.28 (no winsorization) and from −2.65 to −2.64 (winsorization).

  13. Fortune 500 lists are available on http://money.cnn.com/magazines/fortune/fortune500_archive. One could also use the volume of outstanding bonds to classify issuers, but this information is not contained in the database available to me.

  14. Defaults of subsidiaries are not taken into account when determining the number of defaults on a given day.

  15. One could argue that one should ignore the estimated impact of non-eminent reversals because it is not statistically significant. Ignoring insignificant coefficients is ad hoc, though. On the other hand, it does not have a great effect. Ignoring the −0.00129 leads to a estimated cumulative loss of −25.2% (=(1−0.01110)26−1), which is still economically significant.

  16. Classifications are available on www.moodys.com.

  17. Within a multivariate regression, overlapping event windows also reduce the precision of the estimation. However, by construction, regression coefficients are estimates of partial effects, which means that they can easily be interpreted in a standard way.

  18. See: http://www.sec.gov/news/extra/credrate/credrate-sched.htm and https://house.resource.org/110/org.c-span.281924-1.pdf

  19. Currently, there are ten agencies that enjoy the “Nationally Recognized Statistical Rating Organization” status awarded by the SEC (cf. http://www.sec.gov/answers/nrsro.htm)—an important prerequisite for widespread investor use of an agency’s ratings.

  20. λ = 14,400 is a common choice for monthly data. Pedersen (2001) recommends λ > 100,000.

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Authors and Affiliations

  1. Institute of Finance, University of Ulm, Helmholtzstrasse 18, 89069, Ulm, Germany

    Gunter Löffler

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Correspondence to Gunter Löffler.

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I am very grateful to an anonymous reviewer and the editor for many helpful comments, as well as to Moody’s Investors Service for providing the data.

Appendix

Appendix

Table 6 Robustness checks related to large rating changes. All returns are excess returns over the risk-free rate. MARKET is the value-weighted CRSP market index. BUS_SERV is the return on the Fama-French “Business Services” industry portfolio minus MARKET; BANKS is defined similarly with the Fama-French “Banking” portfolio; HML is the value factor. REVERSAL is one on days with a rating reversal, DRIFT is one on days where a rating change follows a previous one in the same direction; LARGE is one on days with a rating change equal or larger to the number of notches stated in the column header. NEG is one on days with a negative rating change, INV is one on days with a rating change that spans the investment grade boundary
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Löffler, G. Can Market Discipline Work in the Case of Rating Agencies? Some Lessons from Moody’s Stock Price. J Financ Serv Res 43, 149–174 (2013). https://doi.org/10.1007/s10693-011-0128-5

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