The Bond Market Effects of Reputational Shocks to Credit Rating Agencies

Credit rating agencies (CRAs) play a unique role in capital markets, subject to neither the discipline of a competitive market nor the incentives of an unregulated market. As a result, the expected effects of a reputational shock to CRAs’ credibility are difficult to predict. We examine whether investors decrease their reliance on credit ratings after two reputational shocks, the Enron and WorldCom bankruptcies in 2001-2 and the 2008 financial crisis. For new bond issues, we find that the association between ratings and the bond spread decreases after each reputational shock. For bond rating changes, we find statistically lower bond market reactions to downgrades and upgrades after each reputational shock compared to before the shock. Overall, our findings suggest that investors place less reliance on ratings after a CRA has been hit by a reputational shock.