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Federal Reserve & Academic Studies

Compensation Incentives of Credit Rating Agencies and Predictability of Changes in Bond Ratings and Financial Strength Ratings.


The timeliness of changes in corporate bond ratings and financial strength ratings that correspond to the sample of publicly traded insurance firms (1997-2007) is examined in this paper. Results suggest that Egan Jones Ratings (EJR) leads both Standard & Poor's and Fitch. Focusing on industry-adjusted returns before and after downgrades, there is evidence that investors may benefit by unconditionally following downgrades by EJR, since their downgrades are followed by a thirty-day period of economically significant negative returns. This negative, post-announcement drift is not present in the sample of downgrades by Fitch and Standard & Poor’s.

Andreas Milidonis, the University of Cyprus,
September 2012.

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The Issuer-Pays Rating Model and Ratings Inflation: Evidence from Corporate Credit Ratings

Direct excerpts and conclusions:

This paper provides evidence that the conflict of interest caused by the issuer-pays rating model leads to inflated corporate credit ratings. Comparing the ratings issued by Standard & Poor’s Ratings Services (S&P) which follows this business model to those issued by the Egan-Jones Rating Company (EJR) which adopts the investor-pays model, we demonstrate that the difference between the two is more pronounced when S&P’s conflict of interest is particularly severe: firms with more short-term debt, a newly appointed CEO or CFO, and a lower percentage of past bond issues rated by S&P are significantly more likely to receive a rating from S&P that exceeds their rating from EJR. However, we find no evidence that these variables are related to corporate bond yield spreads, which suggests that investors may be unaware of S&P’s incentive to issue inflated credit ratings.

Günter Strobl†, the University of Texas,
Han Xia‡, the University of North Carolina,
November 2011.

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The Information Content of Credit Ratings: Compensation Structure Does Matter

Direct excerpts and conclusions:

We exploit an investor-paid credit rating agency’s designation as an NRSRO in 2007 to disentangle competing explanations for the information content of credit ratings. We find the investor-paid agency produces ratings that are more timely and symmetric compared to those produced by a traditional, issuer-paid agency. These differences are significant before and after the investor-paid agency received the NRSRO designation, suggesting they are a result of the raters’ different compensation structures rather than the government certification. Our results indicate that although the recent Dodd-Frank legislation mitigates the importance of the NRSRO designation, the designation itself is less important than the source of rater compensation. More broadly, our results provide unique insights into the relevance of government certification.

Valentina Bruno and Kimberly J. Cornaggia, the Kogod School of Business at American University,
Jess Cornaggia, the Kelley School of Business at Indiana University,
November 2011.
J. Cornaggia is the corresponding author.

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Differential Properties in the Ratings of Certified vs. Non-Certified Bond Rating Agencies

Stanford University and University of Michigan studies

Direct excerpts and conclusions:

Credit ratings from Egan-Jones more accurately reflect information in the marketplace and are frequently up to 237 days ahead of actions taken by Moody’s and S&P.

The powerful market incentives resulting from the investor supported, independent business model of Egan-Jones Ratings Company produces more timely and accurate ratings with predictive value.

William H Beaver, Graduate School of Business, Stanford University, Stanford, CA 94305,
Catherine Shakespere, Mark T. Soliman, University of Michigan, Ann Arbor, MI 48109,
First version 2003, Second version, June 2006.

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An Examination of Rating Agencies’ Actions Around The Investment-Grade Boundary

Direct excerpts and conclusions:

Overall, it is robustly the case that S&P’s re-grades moved in the direction of EJR’s earlier ratings. It appears more likely that this result reflects systematic differences between the two firms rating policies than a small number of lucky guesses by EJR.

A comparison between S&P’s and EJR’s ratings shows that, conditional on S&P’s upgrading or downgrading a firm,its new grade was correlated with the grade EJR had awarded at least ten weeks earlier. This suggests that S&P defines its ratings more widely in terms of default probabilities than EJR.

It also suggests that S&P’s large downgrades do not occur immediately after negative surprises to firms, but rather after a steady accumulation of bad news which EJR’s ratings previously reflected.

S&P ratings converge toward Egan-Jones Ratings.

Richard Johnson, Research Division, Federal Reserve Bank of Kansas City,
February 2003, RWP030.

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