Structural Shifts in Credit Rating Standards
46 Pages Posted: 18 Mar 2010
Date Written: March 16, 2010
I examine the time series variation in corporate credit rating standards for the period 1985-2007. I report two main findings: (i) There is a divergent pattern between investment grade and speculative grade rating standards during 1985-2002. Investment grade ratings tighten between 1985-2002. In contrast, the speculative grade rating standards loosen during the same period. Consistent with an agency explanation, rating companies assign more issuer friendly ratings to speculative grade credits, where there is substantial growth by the first-time entrants. The loose standards in speculative grade ratings are consistent with widespread criticism of the rating agencies during the Dot-Com crash. However, while the media focused on failure of rating agencies in high profile corporate debacles, the more serious problem was in the speculative grade rating assignments. (ii) There is a sharp structural break in both investment grade and speculative grade standards towards more stringent ratings around 2002. The change in rating levels due to the structural break is both economically and statistically significant. Holding firm characteristics constant, firms experience a drop of 1.5 notches in ratings due to tightening standards between 2002 and 2007. It appears that widespread criticism and threat of regulation led rating agencies to move towards more conservative ratings after the Enron debacle and passage of Sarbanes-Oxley Act.
Keywords: credit ratings, credit rating standards, Dot-Com crash, Sarbanes-Oxley
JEL Classification: G3, G10, G20, L5
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