Major credit rating agencies have a conflict of interest, market observers long have charged, because they get paid by the issuers they rate. The conflict, of course, reflects the incentive the services have to hand out higher scores to please customers.
But a recently released working paper by Han Xia of the University of Texas School of Management and Gunter Strobl of the University of North Carolina's Kenan-Flagler Business School goes a long way toward vindicating this common wisdom.
For one thing, it shows that the naming of a new CFO -- even more than a new CEO -- tends to be accompanied by a Standard & Poor's ratings boost.
Xia and Strobl looked at 23,233 S&P ratings actions on 2,033 issuers from July 1999 to July 2009, comparing them with the corresponding actions taken by Egan-Jones Rating Co. Egan-Jones, which has had nationally recognized statistical organization status since 2007, charges investors instead of issuers for its services. The company also uses the same AAA-to-D scale in its ratings as S&P.
Analyzing the difference between the scores produced by the two raters, the researchers found that it was most pronounced "when S&P's conflict of interest is particularly severe." Write the authors, "There is a significant boost in rating inflation in the year when a new CFO is appointed and in the following year," and they note that this appointment is accompanied by a 0.29 notch higher S&P than Egan-Jones rating for those two years.
While there was a similar effect from new CEOs, "CFOs seem to have a bigger impact than CEOs in affecting the rating agencies' strategies."
Other situations found to cause ratings inflation, although not to the same extent as when a new CFO is chosen: when firms have more short-term debt, or a lower percentage of past bond issues rated by S&P. Companies in these situations all find themselves "significantly more likely to receive a rating from S&P that exceeds their rating from EJR."
They go on, "Newly appointed corporate leaders are more inclined to change the firm's operational strategy and may therefore also be more likely to switch rating agencies. S&P may thus have a particularly strong desire to please its customers by issuing favorable ratings for firms that recently appointed a new CEO or CFO."
It's apparently a win-win situation for these new CFOs, there being "no evidence" that the ratings inflation after their arrival affects corporate bond yield spreads.
"Investors may be unaware of S&P's incentive," they add.
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