Wednesday, February 13, 2013

13/2/2013: Rating Agencies Role & Effectiveness: 2 recent studies

In light of all the cases being filed against the rating agencies and in light of the general controversy surrounding them, here are two recent papers dealing with the topic of rating agencies performance and the links between their ratings and investors' decisions.

One interesting paper was published in the Journal of Banking & Finance )vol 36, number 5, May 2012, pages 1478-1491) by Thomas Mahlmann titled "Did Investors Outsource Their Risk Analysis to Rating Agencies? Evidence from ABS-CDOs".

The paper looks at the floating-rate tranches from collateralised debt obligations (CDO) backed by asset-backed securities to test whether yield spreads at the point of issuance (origination) act as good predictors of future performance. The paper found that, once we control for rating at issuance and other deal-specific data, yield spreads do indeed indicate future performance. However, this result is primarily due to tranches that were initially rated below AAA.

The study concludes that at the issuance / origination, investors did not rely only on ratings, when pricing the CDOs studied. The study econometric evidence also indicates that ratings were inadequate for CDOs because these instruments are much riskier than corporate bonds.

Another paper, published in the International Journal of Finance and Economics (March 2012) by Eduardo Cavallo, Andrew Powell and Roberto Rigobon, titled "Do Credit Rating Agencies Add Value? Evidence from the Sovereign Rating Business" look at the credit downgrades made during and after the financial crises asking whether rating agencies opinions provide any incremental information to the market.

The answer to the question is yes. Rating agencies opinions on sovereign risks do explain a portion of variation in three macroeconomic variables, relevant to the market: exchange rates, stock market indices and future sovereign bond spreads, once the authors control for observed bond spreads.

The study also found that rating agencies upgrades (downgrades) are correlated with:

  1. decreases (increases) in the spreads one day forward;
  2. increases (decreases) in the stock market;
  3. nominal exchange rate appreciation (depreciation) relative to the USD.
Top level conclusion: the ratings do contain information about specific credit and the rating's informational content is in addition to other publicly available market data, such as credit spreads.
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