Revolving Rating Analysts and Ratings of Mortgage-Backed and Asset-Backed Securities: Evidence from LinkedIn

Abstract

This study examines whether revolving rating analysts who transition from major rating agencies to issuers are associated with any rating inflation in the issuers’ mortgage-backed securities (MBS) or asset-backed securities (ABS). Using professional profiles posted on LinkedIn to identify revolving rating analysts with structured finance rating experience, we find that the more the issuers employ such analysts, the more likely that ratings of issuers’ MBS and ABS new issuances are inflated compared with otherwise similarly rated securities. Additional analyses show that the impact of revolving rating analysts is more pronounced in complex deals and when the revolving analysts are more senior, indicating that rating expertise in structured finance may play a role in MBS and ABS rating inflation. Finally, we find that at least for AAA-rated MBS and ABS, investors fail to see through the rating inflation associated with revolving rating analysts. The online appendix is available at https://doi.org/10.1287/mnsc.2017.2921 . This paper was accepted by Shivaram Rajgopal, accounting.

The PCAOB Revolving Door and Audit Quality.

“…As many of the PCAOB hires appear to be hired into national roles supporting firm-wide audit quality, we conjecture that they participate in these communications of firm policy. 9 Further, in 8 In a setting where the transfer of technical expertise is less relevant, Jiang et al (2018) find that bond ratings tend to be inflated for issuers that have hired more individuals from large ratings agencies, suggesting that the revolving door has a negative outcome in this setting. Some studies focus on the outcomes at the regulator before the regulator leaves to join a regulated firm (e.g., deHaan et al 2015).…”

“…In documenting these results, we add to a growing stream of literature on the real effects of revolving resources between the organizations responsible for monitoring the finance and accounting industry (e.g., regulators, credit ratings agencies, etc.) and the firms they monitor (e.g., deHaan, Kedia, Koh, and Rajgopal 2015;Cornaggia, Cornaggia, and Xia 2016;Jiang, Wang, and Wang 2018;Kempf 2020). Lastly, while numerous studies have documented audit quality improvements spurred by PCAOB inspection findings (e.g., Lamoreaux 2016;DeFond and Lennox 2017;Fung, Raman, and Zhu 2017;Krishnan, Krishnan, and Song 2017;Gipper, Leuz, and Maffett 2019), the mechanisms employed by firms to drive these improvements have received little attention.…”

Asset-Level Transparency and the (E)Valuation of Asset-Backed Securities

“…Higher deal complexity increases the difficulty for market participants to assess the risk of ABS tranches (Furfine, 2014;Efing and Hau, 2015;Ghent et al, 2017). The number of tranches in a deal is a measure of deal complexity commonly used in prior research on structured finance products (e.g., Furfine, 2014;Efing and Hau 2015;He et al, 2012;He et al, 2016;Jiang et al, 2018). Increasing the number of tranches with distinct seniority yields more complex tranching of the credit risk of the underlying assets, i.e., the payoffs to individual tranches become more nonlinear and hence more sensitive to assumptions about the subsequent performance of the underlying assets (Furfine, 2014).…”

“…In contrast, although over-optimistic credit ratings of ABS have been identified as a key cause of the financial crisis (Jones et al, 2008;Duyn and Chung, 2008;Ashcraft et al, 2010;Jiang et al, 2018), and various provisions of the Dodd-Frank Act are intended to require or induce credit rating agencies to refine their rating methodologies and resolve incentive problems (e.g., Altman et al, 2010), Reg AB II's asset-level disclosure requirements do not appear to have affected the information the agencies use to determine ratings. None of the big three rating agencies substantially changed their rating methodologies around the effective date of the asset-level disclosure requirements.…”

What moves stock prices around credit rating changes?

“…However, data on credit analysts’ trades is not available, so, for our analysis, we turn to career-related incentives that may motivate analysts to leak information. Research indicates that these incentives exert a measurable effect on the accuracy of rating decisions concerning analysts’ future employers (e.g., Cornaggia et al 2016 ; Jiang et al 2018 ; Kempf 2020 ). In the same vein, an analyst may disclose information to investors in the asset or portfolio management industry to secure a job in that sector.…”