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

Abstract

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.

Keywords: Credit Ratings, Performance-Sensitive Debt, Pricing Grid, Rating Catering

JEL Classification: G14, G24, G28, G32