Are Some Credit Rating Analysts Guilty of ‘Informed Trading’?

Earlier this month, research was published which spectacularly suggests that some analysts of the Big Three rating agencies are guilty of ‘informed trading’, which in this context means leaking information to institutional investors ahead of the publication of rating actions by their respective credit rating agencies. In this post, we will look at this researched claims and assess the potential impact such findings may have upon the industry, if any.

 

Dr Omri Even-Tov of Berkeley Haas Business School and Dr Naim Bugra Ozel, Visiting Associate Professor at Wharton Business School have co-authored an article that can be read here. The article, entitled What moves stock prices around credit rating changes? seeks to extend the studies that have found that credit rating changes lead to significant stock price reactions by examining whether informed trading may affect the stock price before the rating announcement. One of the key elements that the researchers look for is whether the ratings developed by those analysts that have gone on to work for institutional investors caused a significant stock price fluctuation before the rating announcement.

 

As the authors state, and as was contextualised by Newswise, ‘we set out to study whether there is informed trading between the private notification and the public announcement, which is typically no more than 48 hours’. Previous research has suggested that stock movements immediately after credit rating announcements were generally modest, but this research suggests that this is only because stock price changes before the rating announcement were so significant but not factored in. In analysing potential reasons for stock price fluctuation before the rating announcement, the researchers identified a number of potential scenarios. First, rating announcements often come after other important news events, which could affect stock prices. However, when such instances were accounted for, there was still plenty of fluctuation before the rating announcement. The, they considered whether the market could have anticipated such rating movements, and found that whilst the market may predict upgrades, the availability of publicly-available information could not explain the movement for downgrades. This led the researchers to examine the final scenario, which is that prior to rating announcements there was some form of informed trading.

 

Informed trading can relate to actions that utilise public information but just act much quicker than usual, up to acting upon confidential information. This article by Professors Fox, Glosten, and Rauterberg describes the intricate legal framework that governs informed trading, and the accompanying complaints well. However, what the Even-Tov and Ozel article does is link this to the incentives for rating analysts, which arguably changes the parameters drastically. The scholars assessed the rating actions and, crucially, the analysts involved with those ratings and ciphered their data to examine which ratings had caused stock price fluctuations in relation to the future career choices of those same analysts. They found that, in relation to rating downgrades, there was a significant fluctuation in stock prices for those rated entities. This ties in with other research that the authors indicate (Corniggia et al; Jiang et al; Kempf) which illustrates how rating analysts inflate the grades of securities for the entities that they then go on to join not long after (of course, not all do this). Whereas there are a number of instances of ‘insider trading’ involving credit rating analysts (plenty are documented in the article), the scholars find that instances on informed trading have a direct consequence for the actions of institutional investors for whom the rating analyst(s) identified then went on to join. In simple terms, institutional investors for whom the rating analysts identified went on to join sold more in a given entity than they invested during the pre-announcement period of 48 hours for a downgrade, consistently. They find that this is more prevalent within Moody’s than S&P, but both are categorised as being statistically significant. Even-Tov is cited as saying ‘our paper shows yet another example of the revolving door on Wall Street, which should draw the attention of the SEC and credit rating agencies’, but there are issues with this.

 

Even-Tov is absolutely correct of course, but the realities are something different. The simple question is whether there is enough regulatory/legislative appetite to enforce a ban on analysts joining firms/entities they have rated until after a given period upon leaving the agency, and also whether this is even practicable. Analysts often specialise in sectors and, upon leaving the agency, will have rated a large number of firms in their specialised sphere – what is the analyst to do? Remain in the rating agency forever, or sift out those entities that they have not rated? The Big Three rate the largest of firms, so the chances of an analyst rating market-leading entities in their fields are high – should they be precluded for a number of years from joining said market leaders? One wonders whether it is even possible to prevent this conflict from taking hold, because it is almost impossible to prevent conceptually. It relies on the professional integrity of the analyst, but whilst most analysts have this integrity, there is more than enough evidence to suggest that, for some, the temptation to advance one’s career nefariously is too great. The SEC will not take action on this, but the understanding that it takes place is important. It is interesting to note that the analyst is beset by potential conflicts on all sides – from the issuer in terms of inflating their ratings for their future prospects, from the agency in terms of inflating ratings to garner business, and from the investors in terms of leaking information to protect potential future employers from the effects of a downgrade. Whilst there is no real solution, it is indeed further confirmation of the remarkable issues that continue to plague the rating industry. What is perpetually interesting, is that there continues to be no consequence.

Keywords – credit rating agencies, informed trading, law, @finregmatters