| Recent events have brought renewed attention to the conflicts of interests of rating agencies. In the first chapter, I document that a major rating agency (Moody's) extensively modifies reported financial statements, using a new dataset of US GAAP and adjusted financial statements. Overall, the rating agency's hard and soft adjustments are conservative and tend to lower ratings. The major quantitative adjustment incorporates off-balance sheet financing activity (operating leases and securitizations), causing the adjusted leverage ratio (interest coverage ratio) for the median firm to increase (decrease) by 16%. Adjustments for off-balance sheet debt and soft adjustments are associated with higher bond yields. Thus ratings can serve as a contracting device to incorporate off-balance sheet debt adjustments and credit-risk increasing soft factors. The evidence is consistent with the view that rating agencies are, for the most part, efficient processors of accounting information for credit risk assessments of corporate issuers.;In the second chapter, I study the use of credit ratings in debt contracts. When debt contracts use credit ratings rather than accounting ratios to enforce restrictions on borrowers, rating changes directly impact borrowers' cash flows, there is likely to be increased pressure on rating agencies to cater to borrower incentives. I investigate whether the explicit use of ratings in contracts affects rating agencies' incentives to issue more favorable credit risk assessments than justified by the underlying economics. I focus on performance pricing (PP) agreements which are now widespread in lending agreements and which use either ratings or accounting ratios to calibrate pricing grids. I examine whether, ceteris paribus, rating agencies are more likely to cater to borrowers when PP agreements use ratings rather than accounting ratios. I use data from Moody's to investigate this prediction and report evidence from a number of tests that is consistent with the catering hypothesis. In the cross-section and for firms experiencing adverse economic shocks, the rating agency adjustments are more favorable for PPrating firms. Rating agency adjustments are more unfavorable however for PPrating firms if their ratings are close to the investment grade cutoff or allow access to the commercial paper market. |
