Rating Alignment, Rating Shopping and Reputation of Credit Rating Agencies: Evidence from the Subprime Crisis

28 Pages Posted: 21 Apr 2011

See all articles by Annalisa Croce

Annalisa Croce

Polytechnic University of Milan - Dipartimento di Economia e Produzione

Stefano Lugo

Utrecht University - School of Economics

Robert W. Faff

University of Queensland

Date Written: April 21, 2011

Abstract

This paper compares conflict of interest incentives and reputational concerns of credit rating agencies (CRAs) in the context of the subprime crisis. We argue that, during up-market periods, ratings levels are affected by both a strong tendency for alignment across CRAs and ratings “shopping” by issuers, while, during periods of economic slowdown, these distortions disappear since CRAs are then more concerned about their long-run reputation. We test our hypotheses by analyzing the gap between Moodys and S&Ps ratings on US residential, subprime mortgage-backed securities before and after the 2007 crisis. Overall, our results show a clear reduction in ratings alignment. Moreover, we find strong evidence that harsher downgrades came from S&P, which had higher ratings before the crisis, and that the gap reduction is strongly correlated with the rating gap before the crisis. We interpret this as evidence that CRAs try to “reverse the gap”, to reduce the impact on their (relative) reputation. Finally, we find that harsher downgrades tend to occur for securities not jointly rated and that the relation between downgrades and initial rating is significantly different across the two agencies, this being consistent with the rating shopping hypothesis.

Keywords: credit rating agencies, subprime, conflicts of interest, rating alignment, rating shopping

JEL Classification: G01, G14, G24, G38

Suggested Citation

Croce, Annalisa and Lugo, Stefano and Faff, Robert W., Rating Alignment, Rating Shopping and Reputation of Credit Rating Agencies: Evidence from the Subprime Crisis (April 21, 2011). Available at SSRN: https://ssrn.com/abstract=1817092 or http://dx.doi.org/10.2139/ssrn.1817092

Annalisa Croce

Polytechnic University of Milan - Dipartimento di Economia e Produzione ( email )

Piazza Leonardo da Vinci, 32
Milan, 20133
Italy

Stefano Lugo

Utrecht University - School of Economics ( email )

Kriekenpitplein 21-22
Adam Smith Building
Utrecht, +31 30 253 7373 3584 EC
Netherlands

Robert W. Faff (Contact Author)

University of Queensland ( email )

St Lucia
Brisbane, Queensland 4072
Australia

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