Learn how the Dodd-Frank Act impacted credit rating agencies with CFA Institute. Understand if Dodd-Frank had a positive or negative impact on quality of credit ratings.
The Dodd–Frank Act has not led to credit rating agencies providing more accurate and informative credit ratings as anticipated. Instead, rating agencies are issuing lower ratings and giving more false warnings as well as issuing downgrades that are less informative. This result is especially prevalent in industries in which Fitch Ratings has low market share and Moody’s and Standard & Poor’s have strong incentives to protect their reputations.
What’s Inside?
The Dodd–Frank Wall Street Reform and Consumer Protection Act (2010) outlined a series of reforms for credit rating agencies (CRAs) after the mass defaults of highly rated structured finance products in 2007 and 2008 led to a renewed focus on the quality of ratings. The authors research whether the Dodd–Frank Act achieves the goal of improving the quality of credit ratings. They also study whether the increase in legal and regulatory penalties under the Dodd–Frank Act has an adverse effect on the quality of credit ratings, with CRAs potentially issuing lower credit ratings than necessary, more false warnings (false warnings are defined as speculative-grade-rated issues that do not default within one year), and downgrades that are less informative.
How Is This Research Useful to Practitioners?
The authors find that rating downgrades are less informative in the period after the passage of the Dodd–Frank Act, defined as July 2010–May 2012. The reason is that the market seems to see the actions of CRAs as a means of protecting their reputations, which outweighs the intended disciplining effect. CRAs have responded to the increased regulatory pressure under the Dodd–Frank Act by issuing lower corporate bond ratings that are also less informative because CRAs are penalized for optimistically biased ratings but not for pessimistically biased ratings.
The passage of the Dodd–Frank Act increased the odds of a corporate bond being rated as noninvestment grade by 1.19 times, increased the odds of a false warning by 1.84 times, reduced the reaction of bond prices to rating downgrades by 0.369%, and reduced the reaction of stock prices to rating downgrades by 1.213%. Studying how these results vary with exogenous variations in reputation, the authors also find that CRAs invest more in reputation when they face less intense competition.
Following the passage of the Dodd–Frank Act, the ratings of Moody’s and Standard & Poor’s are lower and less accurate/informative in industries in which Fitch Ratings has a lower market share. In industries that are in the bottom quartile of the Fitch Ratings market share, the passage of the Dodd–Frank Act increased the odds of a corporate bond being rated as noninvestment grade by 2.27 times, increased the odds of a false warning by 8.21 times, reduced the reaction of bond prices to rating downgrades by 1.083%, and reduced the reaction of stock prices to rating downgrades by 2.976%.
How Did the Authors Conduct This Research?
Credit rating announcements during January 2006–May 2012 are obtained from Mergent’s Fixed Investment Securities Database. The sample includes US domestic corporate bonds rated above D (default) by Moody’s, Standard & Poor’s, or Fitch Ratings. The resulting sample includes 26,625 credit rating upgrades, credit rating downgrades, initial ratings, and ratings that are reaffirmed. Bond prices are obtained from the Financial Industry Regulatory Authority (FINRA) Trade Reporting and Compliance Engine (TRACE) database, and stock prices are obtained from CRSP.
Examining how credit rating levels changed after the passage of the Dodd–Frank Act, the authors estimate an ordered logit model of credit rating levels as a function of firm characteristics and equity values. The numerical bond ratings from before and after the Dodd–Frank Act are then compared. The results are then examined with regard to how they vary with ex ante reputational costs by comparing rating announcements in industries in the lowest (25th) percentile of Fitch Ratings market share and rating announcements in industries in the highest (75th) percentile of Fitch Ratings market share.
The authors analyze whether lower credit ratings following the passage of the Dodd–Frank Act are warranted by subsequent outcomes and look at the incidence of false warnings (if a BB+ or lower-rated issue does not default within one year).
The effect of the Dodd–Frank Act on the informativeness of credit ratings is examined by comparing the reaction of the bond market and the stock market to rating changes before and after the passage of the Dodd–Frank Act.
Abstractor’s Viewpoint
As rating announcements by CRAs become potentially less informative, in-house research capabilities by investors need to be built and refined as a way to rely less on CRA announcements. These capabilities will lead to greater reliance on the resultant in-house research, which should give a better idea on where various company bond ratings are relative to each other in various industries and thus give a better idea of relative pricing.