Do credit ratings affect spread and return? A study of structured finance products

• Date: 01 April 2018
• Published date: 01 April 2018
• DOI: http://doi.org/10.1002/ijfe.1612

RESEARCH ARTICLE

Do credit ratings affect spread and return? A study of

structured finance products

Fernando Moreira | Sheng Zhao

University of Edinburgh Business School,

Edinburgh, UK

Correspondence

Fernando Moreira, University of

Edinburgh Business School, Edinburgh,

UK.

Email: fernando.moreira@ed.ac.uk

Abstract

Although the previous studies investigating the relationship between credit rat-

ings and spread or return in the financial market are normally restricted to non-

causal measures, this paper uses structural equation modelling to test the

possibility of causal links from ratings to spread and return in the context of

structured finance products. Our analyses are split into 2 stages: First, we

search for causality between ratings and spread at the issuance stage (primary

market) based on a sample comprising all tranches of asset‐backed securities

issued in the United States by American and foreign institutions from Decem-

ber 1999 to December 2015. Then, we consider all ABS rating changes from

February 2001 to December 2015 to check whether the assumption of causal

connection between ratings and return at the trading stage (secondary market)

is reasonable. After testing all pertinent combinations among the variables in

our database, we find evidence of causality at the issuance stage but very little

support to causality at the trading stage. This study contributes to the debate on

the regulation of credit rating agencies as our findings suggest that ratings may

have an effective influence on decisions made by investors at the time structure

finance products are issued. As this effect is very weak when those assets are

traded in the secondary market, in principle, regulators should focus their

attention on the credit rating agencies'activities regarding the issuance of

new structured products.

KEYWORDS

causality, creditratings, return, spread, structured finance products

1|INTRODUCTION

Credit ratings play a vital role in the structured finance

market not only due to regulatory requirements but also

because the instruments issued are more complex than

conventional securities, which makes most of the inves-

tors unable to evaluate the risks involved in the

transactions.

Especially after the events observed in the U.S.

Subprime Mortgage Crisis in 2007 and the global financial

crisis in 2008, credit rating agencies (CRAs) have been

highly criticized for assigning inaccurate and biased rat-

ings to structured finance products (Griffin & Tang,

2011; He, Qian, & Strahan, 2011; Kraft, 2015). Invest-

ments on mortgage‐backed securities (MBS) and other

types of asset‐backed securities (ABS) that became worth-

less during the financial crisis were presumably based on

credit ratings provided by CRAs (Friedman & Posner,

2011). This has stimulated a debate on the regulation of

CRAs as they are believed to have the potential for

Received: 26 September 2017 Accepted: 12 December 2017

DOI: 10.1002/ijfe.1612

Int J Fin Econ. 2018;23:205–217. Copyright © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 205