When Credit Rating Agencies Avoid Downgrading: The Effects of Performance-Sensitive Debt

Credit rating inflation in securitized products was a major contributor to the Financial Crisis. The major credit rating agencies (CRAs) subsequently settled with the U.S. government for yielding to conflicts of interest, and they renewed their commitment to credit rating quality. We study the $900 billion performance-sensitive debt market, in which interest rates are a dynamic function of credit ratings. Using detailed data on loan pricing schedules, we show that credit rating inflation is prevalent in this market, and credit rating inflation remained unchanged after the settlements. In the presence of competing CRAs, rating inflation is stronger for a CRA when its rating is decisive in determining interest rates. Our results are not driven by firms hiding negative information from CRAs, and they are not driven by CRAs catering to investors at the border of the investment grade classification. Moreover, the potential for credit inflation is priced at origination, indicating that borrowers and lenders are aware of the CRAs’ conflicts of interest. JEL classification: G14, G24, G28, G32 keywords : Credit ratings, performance-sensitive debt, pricing grid, rating catering Electronic copy available at: https://ssrn.com/abstract=3579030 Credit rating agencies (CRAs) play a key role in financial markets by assessing the credit risk of debt issuers and financial securities. However, many observers have questioned CRAs’ ability to provide reliable credit risk assessments. They argue that the issuer fee– based business model, in which clients pay for their own ratings, distorts the incentives of CRAs to the extent that the fear of a loss of reputation or the fear of regulatory penalties are ineffective deterrents. Consistent with this concern, the two major CRAs, Standard and Poor’s (S&P) and Moody’s, recently settled with the U.S. government for contributing to the Financial Crisis by inflating the credit ratings of residential mortgage-backed securities (RMBSs) and collateralized debt obligations (CDOs). In these settlements, CRAs renewed their commitment to credit rating quality. In this paper, we study whether the conflicts of interest of CRAs prevail in the performance-sensitive debt (PSD) market, a much less complex market than that of securitized products. Importantly, unlike the market for RMBSs and CDOs, the PSD market did not disappear after 2007. This allows us to study whether CRAs effectively changed their behavior after the settlements. Moreover, the availability of pricing data allows us to study whether market participants internalize these conflicts. In performance-sensitive debt contracts, interest payments depend directly on a measure of the borrower’s financial health, such as credit ratings or financial ratios. Normally, if the borrower’s financial health deteriorates, the interest rate associated with the PSD loan increases. In this paper, we focus on the $900 billion subset of the PSD market which has interest payments that depend exclusively on credit ratings. In the context of these loans, a CRA experiences a conflict of interest when a credit rating downgrade causes an increase in the interest rate paid by the borrower (i.e., the client that pays the CRA for the credit rating). Thus, we consider the interest rate increase that would result from a credit rating downgrade as a measure of the conflicts of interest for CRAs for each loan. We then study whether this measure affects a CRA’s rating behavior, such as the probability of issuing a Graham and Harvey (2001) survey 392 CFOs, and they find that 57% of CFOs consider credit ratings as important, making credit ratings the second most important debt policy factor after financial flexibility. Cornaggia, Cornaggia, and Israelsen (2018) show that investors continue to rely on CRAs for assessing credit risk post-Crisis.