ESSAYS ON FORCES UNDERLYING 2008 FINANCIAL CRISIS: CREDIT RATING AGENCIES AND INVESTOR SENTIMENT
Prabhala, Nagpurnanand R.
Kyle, Albert S.
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The roots of the 2008 financial crisis are often traced back to the collapse of the housing bubble. The factors that precipitated the crisis, and propagated its effects on firms and consumers to produce an economic contraction, are still the subject of ongoing debate among academics, policy makers, and practitioners. Macroeconomic factors, flawed government policies, and perverse incentives at financial institutions that lead to excessive risk taking are often cited as contributing forces to the crisis. In this dissertation, I investigate two forces that drove the 2008 financial crisis. One force is the credit rating agencies, whose excessively generous ratings lie at the root of the 2008 financial crisis. The popular claim is that the rating agencies have become too loose at their rating assignments, which led to overestimation of the creditworthiness of the companies by the public. In this dissertation, I examine the assertion that the rating companies have progressively relaxed their standards in recent decades for corporate credit ratings. Such relaxation seems to have lulled investors into a false sense of security about the safety of credit instruments whose values collapsed abruptly. Next I examine the contagion effects of rating downgrades. I ask whether rating downgrade news have spill over effects on the rest of the industry. I then investigate a different force that has received less attention in the crisis; investor confidence. The third essay focuses explicitly on the period when the financial crisis was at its peak. In Essay 1 titled, "Structural Shifts in Credit Rating Standards", I examine the time series variation in corporate credit rating standards for the period 1985-2007. I report two main findings: (i) There is a divergent pattern between investment grade and speculative grade rating standards during 1985-2002. Investment grade ratings tighten between 1985 and 2002. In contrast, the speculative grade rating standards loosen during the same period. Consistent with an agency explanation, rating companies assign more issuer friendly ratings to speculative grade credits, where there is substantial growth by the first-time entrants. The loose standards in speculative grade ratings are consistent with widespread criticism of the rating agencies during the Dot-Com crash. However, while the media focused on failure of rating agencies in high profile corporate debacles, the more serious problem was in the speculative grade rating assignments. (ii) There is a sharp structural break in both investment grade and speculative grade standards towards more stringent ratings around 2002. The change in rating levels due to the structural break is both economically and statistically significant. Holding firm characteristics constant, firms experience a drop of 1.5 notches in ratings due to tightening standards between 2002 and 2007. It appears that widespread criticism and threat of regulation led rating agencies to move towards more conservative ratings after the Dot-Com crash, Enron debacle and passage of Sarbanes-Oxley Act. In Essay 2 titled "Contagion Effects of Rating Downgrade Announcements", we examine the intra-industry spill over effects of rating downgrade announcements based on abnormal returns for stock and CDS spreads of competitor industry portfolios. We find minor contagion effects for the equity prices of the industry portfolios for the entire sample. For the competitors of investment grade firms, we find significant contagion effects in the magnitude of -15 basis points for the window (0,1). For the speculative grade sample, we do not observe contagion or competition effects although this result can be due to cancellation of contagion and competition effects for the low rated firms. These results suggest that the net effect is dependent on the event firm's original rating. We find statistically significant CDS reaction of industry portfolios to downgrade news although in moderate magnitudes. The cross sectional tests show that the industry portfolio equity response and event firm equity response are positively correlated. This finding presents further evidence of contagion effects for rating downgrades. Essay 3 discusses a different force that has received less attention in the financial crisis, investor sentiment, and focuses on data drawn from the crisis period. In Essay 3, titled "Confidence and the 2008 Financial Crisis", we examine the role of confidence in the 2007-2008 financial crisis using new high frequency data on daily closed-end fund discounts and novel measures of consumer sentiment from non-financial sources extracted at daily frequency. Empirically, there is some movement in sentiment through much of the crisis period but it is relatively moderate. However, tests detect a sharp structural break around the Lehman bankruptcy, after which there are breaks in both pricing across multiple asset classes and co-movement, especially in hard-to-arbitrage fund classes. Fund discounts also exhibit significantly increased co-movement with non-financial Gallup sentiment measures after the Lehman bankruptcy, and closed-end fund discount betas with respect to the market increase significantly during this period. While fund discounts may reflect liquidity issues in normal conditions, they seem to better reflect sentiment in stressed environments, so funds have undesirable conditional betas. The results are consistent with the view that the Lehman bankruptcy induced a negative shock to the supply of arbitrage capital, and as predicted by behavioral finance models of costly arbitrage, sentiment then matters more and is closely tied to returns. The results are also consistent with theories of financial crisis in which sentiment or confidence is an extra force that amplifies and transmits economic shocks that add to the usual credit and collateral mechanisms studied in the literature.