Are Credit Rating Agencies Discredited? Price Effects from Agency Sovereign Debt Announcements Mahir Binici (Central Bank of Turkey), Michael Hutchison (UC Santa Cruz, California, U.S.A.), Evan Weicheng Miao (UC Santa Cruz, California, U.S.A.) Presented by Evan Weicheng Miao August 10th, 2017 Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 1 / 42
The view does not represent the Central Bank of ROC, Taiwan or Central Bank of Turkey. Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 2 / 42
Outline Introduction 1 Literature Review 2 Data and Methodology 3 Empirical Results 4 Conclusion 5 Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 3 / 42
Credit Rating Agencies and Announcements 1 Credit rating agencies (CRA), assigns credit ratings (e.g., AAA, BB), which rate a debtor’s (firm or country) ability to pay back debt and the likelihood of default. 2 "Three Big" credit rating agencies: S&P, Moody’s, Fitch. 3 They also assign "watch" (negative or positive), "outlook" (negative or positive), "stable" and "developing" designation, not credit rating changes but signals that there may be (or not) credit rating changes. 4 Developing : a review is ongoing; outlook : longer term; watch : short-term. 5 For example, if a country is on negative watch, the country is very likely, but not certain to be downgraded within the next 90 days. Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 4 / 42
Credit Ratings (S&P) 1 25 rating categories (From highest AAA to lowest D) Judgment about ability and willingness of debtor to repay the debt; the likelihood of default Credit ratings in S&P, Moody’s, and Fitch are generally comparable. 2 5 main factors in sovereign ratings institutional effectiveness and political risks; economic structure and growth prospects; external liquidity and international investment position; fiscal performance and flexibility, as well as debt burden; monetary flexibility Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 5 / 42
Literature on CRA Announcements on Financial Asset Price 1 CRA (mostly) on corporate and sovereign bonds and CDS spreads; (a few) on other assets, such as equity prices, foreign exchange rates 2 Asymmetries in literature: Outlook and Watch more important than credit rating changes Negative events more important than positive events; some literature finds the opposite Diverse studies Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 6 / 42
Cantor and Packer (1996) 1 They consider announcements by Moody’s and S&P’s, 1987-1994 2 Daily sovereign bond prices for 18 countries, 79 announcements, 39 of which are actual rating changes 3 Results : � rose by 0.9% for negative announcements . Relative spread fell by 1.3% , for positive announcements; statistically significant. Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 7 / 42
Ismailescu and Kazemi (2010) 1 The effect of sovereign credit rating change announcements by S&P on the CDS spreads for 22 emerging markets. 2 Method/Data: event study methodology / daily data over 2001-2008. 3 Results 1 (Mean Changes; NOT statistically significant) : � upgrade rating lower the spreads by 11bps . Relative spread downgrade rating , raise spreads by 67 bps but NOT statistically significant; means are affected by outliers. 4 Look at (1)median changes (2) proportion of negative/positive CDS spread changes over the event window. 5 Results 2 (Median Changes and Proportion of Neg/Pos Changes; partly Statistically Significant) : Median changes are significant for both negative/positive events. Positive rating events reduce the CDS spreads, statistically significant; not so for Negative events Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 8 / 42
What’s missing? Evaluating Conditional Announcements 1 Consider the following two downgrade scenarios: (a) Negative Watch → Downgrade: The downgrade is to some extent anticipated; less of a surprise (b) Stable → Downgrade: The downgrade is more of a surprise The effects should be different: b>a 2 Stable/Developing Neg Watch Pos Watch Neg Outlook Pos Outlook Likely to downgrade Likely to upgrade Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 9 / 42
Research Questions: CRA Effects on Sovereign CDS Markets Do Credit Rating Agency Announcements on Sovereign Bonds Affect Market Expectations of Default Probability? 1 How do different types of announcements affect expectations? (a) Credit rating changes (b) Watch changes (c) Outlook changes 2 Are the effects of rating changes conditional upon prior outlook/watch state and prior grade level of bond? 3 Are there asymmetric effects between downgrades and upgrades? 4 Are CRA announcements anticipated? 5 Has the market effect of CRA announcements changed since the global financial crisis (when CRA credibility damaged)? Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 10 / 42
Signal Interpretation Upgrade (Downgrade): always positive (negative) event 1 Transition between Outlook/Watch/Stable 2 Neg Outlook Stable/Developing Pos Outlook Neg Watch Pos Watch Negative events Positive events Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 11 / 42
Hypotheses 1: Effects of Positive/Negative Announcements 1 H1: CRA announcements of positive (negative) credit rating changes, watch/review designations or outlook designations conditionally lower (raise) CDS spreads. Spread ↑ Spread ↓ Negative events Positive events Downgrade Upgrade Outlook/Watch transition Outlook/Watch transition Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 12 / 42
Hypotheses 2-3: Effects of Credit Rating Changes on Different Outlook/Watch Status; Surprise or not 1 H2: CRA announcements of credit rating downgrades (upgrades) have larger impact, in absolute value, when on prior stable/developing assignment status than when on prior negative (positive) outlook or watch status. 2 H3: CRA announcements of credit rating downgrades (upgrades) have larger impact, in absolute value, when on prior negative (positive) outlook status than when on prior negative (positive) watch status. Upgrade effect:High Upgrade effect:Low Neg Watch Neg Outlook Stable/Dev Pos Outlook Pos Watch Downgrade effect:Low Dowgrade effect:High Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 13 / 42
Hypothesis 4-5: Effects (Direction) of Transition between Outlook/Watch/Stable Status 1 H4: CRA announcements of stable/developing status lower (raise) CDS spreads from negative watch or outlook status, and raise (lower) CDS spreads from positive watch or outlook status. 2 H5: CRA announcements of negative (positive) outlook status raise (lower) CDS spreads when bonds are on prior stable/developing status, and lower (raise) CDS spreads when bonds are on prior negative (positive) watch status. Stable/Dev Neg Watch Neg Outlook Pos Outlook Pos Watch Spread ↑ Spread ↓ Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 14 / 42
Hypotheses 6: Effects (Magnitude) of Transition between Outlook/Watch/Stable designation 1 H6: CRA announcements of negative (positive) watch status have a larger impact for bonds on prior stable/developing status than those on prior negative (positive) outlook status. Stable/Dev Neg Watch Neg Outlook Pos Outlook Pos Watch Larger effect Larger effect Smaller effect Smaller effect Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 15 / 42
Hypotheses 7: Effects before and after Global Financial Crisis 1 H7: CDS spreads responds less in absolute value to CRA announcements in the post-GFC period compared to the pre-GFC period. This hypothesis suggests that that CRA have been discredited since the GFC, with markets discounting their information value as to the default risk of a sovereign bond. Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 16 / 42
Credit Default Swap (CDS) – our market-based measure of default risk 1 A credit default swap (CDS) is a financial contract that the seller of the CDS will compensate the buyer in the event of a loan default (by the debtor) or other credit event. 2 The seller of the CDS insures the buyer against some reference loan defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. 3 CDS spread = insurance premium rate, which depends on how "risky" the debtor is. High likelihood of default = Higher CDS spreads. Presented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 17 / 42
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