AreCreditRatingAgenciesDiscredited? PriceEﬀects ... · Outline 1 Introduction 2 LiteratureReview 3 DataandMethodology 4 EmpiricalResults 5 Conclusion Presented by Evan Weicheng

Are Credit Rating Agencies Discredited? Price Effectsfrom 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 CentralBank of Turkey.


Outline

1 Introduction

2 Literature Review

3 Data and Methodology

4 Empirical Results

5 Conclusion


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 andthe 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 ratingchanges 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 verylikely, but not certain to be downgraded within the next 90 days.


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; thelikelihood of defaultCredit ratings in S&P, Moody’s, and Fitch are generally comparable.

2 5 main factors in sovereign ratingsinstitutional effectiveness and political risks;economic structure and growth prospects;external liquidity and international investment position;fiscal performance and flexibility, as well as debt burden; monetaryflexibility


Literature on CRA Announcements on Financial Asset Price

1 CRA (mostly) on corporate and sovereign bonds and CDS spreads; (afew) on other assets, such as equity prices, foreign exchange rates

2 Asymmetries in literature:Outlook and Watch more important than credit rating changesNegative events more important than positive events; some literaturefinds the oppositeDiverse studies


Cantor and Packer (1996)

1 They consider announcements by Moody’s and S&P’s, 1987-19942 Daily sovereign bond prices for 18 countries, 79 announcements, 39 of

which are actual rating changes3 Results:

Relative spread

{rose by 0.9% for negative announcements.fell by 1.3%, for positive announcements;

statistically significant.


Ismailescu and Kazemi (2010)

1 The effect of sovereign credit rating change announcements by S&Pon 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):

Relative spread

{upgrade rating lower the spreads by 11bps.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


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>a2

Neg Watch

Neg Outlook

Stable/Developing

Pos Outlook

Pos Watch

Likely to upgradeLikely to downgrade


Research Questions: CRA Effects on Sovereign CDS Markets

Do Credit Rating Agency Announcements on Sovereign Bonds AffectMarket 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/watchstate 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)?


Signal Interpretation

1 Upgrade (Downgrade): always positive (negative) event2 Transition between Outlook/Watch/Stable

Neg Watch Neg Outlook Stable/Developing Pos Outlook Pos Watch

Positive eventsNegative events


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.

Positive eventsNegative eventsSpread ↓Spread ↑

UpgradeDowngradeOutlook/Watch transitionOutlook/Watch transition


Hypotheses 2-3: Effects of Credit Rating Changes onDifferent Outlook/Watch Status; Surprise or not

1 H2: CRA announcements of credit rating downgrades (upgrades) havelarger impact, in absolute value, when on prior stable/developingassignment status than when on prior negative (positive) outlook orwatch status.

2 H3: CRA announcements of credit rating downgrades (upgrades) havelarger impact, in absolute value, when on prior negative (positive)outlook status than when on prior negative (positive) watch status.

Neg Watch Neg Outlook Stable/Dev Pos Outlook Pos WatchUpgrade effect:High Upgrade effect:Low

Dowgrade effect:HighDowngrade effect:Low


Hypothesis 4-5: Effects (Direction) of Transition betweenOutlook/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/developingstatus, and lower (raise) CDS spreads when bonds are on priornegative (positive) watch status.Neg Watch Neg Outlook Stable/Dev Pos Outlook Pos Watch

Spread ↓Spread ↑


Hypotheses 6: Effects (Magnitude) of Transition betweenOutlook/Watch/Stable designation

1 H6: CRA announcements of negative (positive) watch status have alarger impact for bonds on prior stable/developing status than thoseon prior negative (positive) outlook status.

Neg Watch Neg Outlook Stable/Dev Pos Outlook Pos Watch

Larger effectLarger effect

Smaller effectSmaller effect


Hypotheses 7: Effects before and after Global FinancialCrisis

1 H7: CDS spreads responds less in absolute value to CRAannouncements in the post-GFC period compared to the pre-GFCperiod.This hypothesis suggests that that CRA have been discredited sincethe GFC, with markets discounting their information value as to thedefault risk of a sovereign bond.


Credit Default Swap (CDS) – our market-based measure ofdefault risk

1 A credit default swap (CDS) is a financial contract that the seller ofthe CDS will compensate the buyer in the event of a loan default (bythe debtor) or other credit event.

2 The seller of the CDS insures the buyer against some reference loandefaulting. The buyer of the CDS makes a series of payments (theCDS "fee" or "spread") to the seller and, in exchange, receives apayoff 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.


What happened in case of a credit event, e.g., a downgrade?

1 Example: Brazil bonds, CDS widen after Fitch downgrade2 New York, Dec 16,2015 (Reuters)- Brazil’s sovereign bonds and credit

default swaps widened by around 30bp Wednesday after Fitch strippedthe sovereign of its investment-grade rating and lowered the credit toBB+.

3 On a priori ground, downgrade (or a negative credit ratingannouncement) ⇒ CDS spread ↑.

4 Empirical question: Is the impact of CRA announcement on themarket statistically significant?


Greek CDS spread ↑ when downgraded


Data

1 55 countries, January 1, 2005 - December 31st, 2012; daily data2 CDS 5-year tenor on sovereigns3 CRAs: S&P, Moody’s, Fitch (Big 3)


Research Question

1 How much are the effects of CR announcements on market price ofCDS spreads? Are they statistically significant?


"Abnormal" returns: disentangle the country-specific effectfrom the market-wide movement.

1 Apple’s Stock Dips After Death of Steve Jobs (CBS News, Oct 6,2011)

2 How much of the stock price drop is attributable to the death of SteveJobs?

3 Stock price change = overall market effect + stock-specific effect4 Need to look at S&P 500 or NASDAQ (market portfolio) and

disentangle the (Apple) stock-specific effect (abnormal return) fromthe market-wide movement.

5 Our application:Need to look at CDS for other countries, and disentangle thecountry-specific effect (abnormal return) from the market-widemovement.


Event Study Methodology I

1 Event: CRA announcements2 Response: CDS “abnormal” returns3 Define Day 0: event day; +1: next weekday day; −5: one week prior

to the event day4 Event windows:

Two-day window: [0,+1]Pre-event windows: [-40, -15] (8 to 3 week prior to the event) and[-14, -1] (3 week to 1 day prior to the event)Post-event windows [+2, +14]


Event Study Methodology II

1 Excluding overlapping events: Exclude any event that is preceded byanother event within 3 weeks (If one event occurs shortly after anearlier event, then the latter event may be less informative)

2 If 2 events of opposite nature on same day, exclude both events3 If 2 events of same type (e.g. downgrades by 2 agencies for same

country), then counted as one event


Event Study Methodology III

1 Following CAPM:CDS return for country i , date t: RC

i ,t =Si,t

Si,t−1− 1

CDS Market Spread Sk,t =1N

∑Ni=1 Si ,t

Return on CDS Market Portfolio RCk,t =

Sk,tSk,t−1

− 1Abnormal return for country i , date t ARC

i ,t = RCi ,t − αC

i − βCi RCk,t

Cumulative abnormal return CARCi ,[w1,w2]

=∑w2

t=w1ARC

i ,t

2 Find the average effect of a class of credit rating events (e.g., alldowngrades on negative watch) by averaging the SCAR (CARstandardized by its standard deviation) in the same class.


Event Study Methodology IV

1 Alternative: signs of spread changes in event window2 A priori expected change (pos or neg)3 Test whether proportion of Pos/Neg spread change significantly

greater than 1/2.4 Chi-square test


Results 1

1 What are the effects of conditional CRAannouncements?

2 Do they conform to our priors?Ans: Yes for both


Full sample Up/Downgrade effects

1 Most highly significant: t-stats (7/8) and spread changes (6/8)2 All significant, expected signs; all spread changes direction expected3 Downgrades larger than upgrades4 Biggest downgrade effects: from neg. outlook and stable5 Biggest upgrade effects: from stable6 Smallest effects: from positive watch (insignificant) and neg watch7 Unconditional = “all” . . . more information from conditional events


Full sample Outlook/Watch Announcements

1 All neg. watch significant and generally expected signs2 Big rise in CDS from neg. outlook to watch3 Neg. outlook sig. and large effects from stable4 Most pos. watch / outlook NOT significant, exception is positive

outlook from stable (as expected)


Results 2

Are events anticipated?Ans: Only negative watches are partlyanticipated.


Full sample Credit Rating Changes, pre-event window[−40,−15] and [−14,−1]

1 No evidence of "anticipation" of CR changes in pre-event windows (nosignificant SCARs)


Full sample Outlook/Watch events, pre-event window[−40,−15]

1 Negative watch announcements anticipated: Significant positiveSCARs, 3-8 weeks prior to negative watch announcements (from negoutlook and stable)

2 Negative news already incorporated into CDS (rising CDS)3 Contrast: In corporate CDS, some evidence that positive news

"leaked" and therefore CRA credit rating changes not significant newsPresented by Evan Weicheng Miao Binici, Hutchison and Miao 2017 August 10th, 2017 32 / 42

Full sample Outlook/Watch events, pre-event window[−14,−1]

1 No evidence of anticipation of outlook/watch announcement in the3-week pre-event window.


Results 3

How has the relative effects of CRAannouncements changed since the GlobalFinancial Crisis?Ans: CRAs are not discredited, at least in termsof credit rating changes.


Credit Rating Changes, Pre-crisis

1 Some significant effects (3/8) during "normal" period2 Little response on upgrades, except from stable (similar to full sample,

as expected)3 No impact from neg watch to downgrade, biggest effect from neg

outlook to downgrade (expected & same as full sample)


Credit Rating Changes, Post-crisis

1 CRA NOT discredited in terms of credit rating changes; 5/8significant after the crisis, compared with 3/8 during the normal crisis.

2 All downgrade categories significant, SCAR & spread directional change, andexpected signs– more significant results than pre-crisis

3 Biggest "negative" event is from Stable (by CAR mean/median), asexpected; overall magnitudes often smaller than pre-crisis

4 Only pos outlook to upgrade significant. Low power of tests? Comparison:Pre-crisis stable to upgrade significant (only)


Outlook/Watch Changes, Pre-crisis

1 All Negative events significant w/ correct signs, large effects2 Note: All to Neg Watch significant despite few events3 Larger effects than full sample (CDS rise) Only one positive signal

significant: stable to pos outlook; same as full sample


Outlook/Watch Changes, Post-crisis

1 Only 1/7 outlook/watch announcements significant, compared to 4/6in pre-crisis period

2 Only neg outlook significant– from stable to negative outlook


Results 4

Do CRA announcement effects depend on priorlevel of rating grade?Ans: Yes, but one caveat applies.


CRA announcement effects and the prior level of ratinggrade

1 High ratings very sensitive to downgrades2 Low rating sensitive to upgrades and downgrades (from outlook)3 Caveat: Sample size for classes other than high rating are low, which

may result in a lower testing power


Comparison with other studies

1 Diverse studies in the literature(1) Norden and Weber (2004), Hull et al. (2004) and Norden (2008) find

that only negative CR announcements significant in corporate CDS(2) Ismailescu and Kazemi (2010) find only positive events matter(3) IMF (2010) and Alsakka and ap Gwilym (2013) claim watch/outlook

most important2 We find upgrades and downgrades important and negative watch lead

to significant effects3 Our results, which condition upon the prior outlook/watch status, may

reconcile part of the contradictory results in literature


Conclusion

1 CRAs not “discredited” after GFC; negative announcements and esp.downgrades have larger effects

2 Conditioning of CR announcements on prior outlook/watch statecritical to precise measurement of effects, as expected

3 Effects largest for upgrades/downgrades if NOT on watch; largesteffects if on stable or outlook status prior.

4 CR changes not anticipated5 Negative watch partly anticipated6 High-rated bonds sensitive to downgrades, and low-rated bonds

sensitive to downgrades and upgrades


Documents

AreCreditRatingAgenciesDiscredited? PriceEﬀects ... · Outline 1 Introduction 2 LiteratureReview 3 DataandMethodology 4 EmpiricalResults 5 Conclusion Presented by Evan Weicheng