The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe, and argue that two key features of the structured finance machinery fueled its spectacular growth. First, we show that most securities could only have received high credit ratings if the rating agencies were extraordinarily confident about their ability to estimate the underlying securities’ default risks, and how likely defaults were to be correlated. Using the prototypical structured finance security—the collateralized debt obligation (CDO)—as an example, we illustrate that issuing a capital structure amplifies errors in evaluating the risk of the underlying securities.

/pdf/the-economics-of-structured-finance-g4s0jtjqs5.pdf

The Economics of Structured Finance

http://www.audytax.mx/wp-content/uploads/2015/07/Kothari-Ramanna-y-Skinner-2010.pdf

Implications for GAAP from an analysis of positive research in accounting

Mandatory IFRS Reporting around the World: Early Evidence on the Economic Consequences

This paper develops a theoretical framework to shed light on variation in credit rating standards over time and across asset classes. Ratings issued by credit rating agencies serve a dual role: they provide information to investors and are used to regulate institutional investors. We show that introducing rating-contingent regulation that favors highly rated securities may increase or decrease rating informativeness, but unambiguously increases the volume of highly rated securities. If the regulatory advantage of highly rated securities is sufficiently large, delegated information acquisition is unsustainable, since the rating agency prefers to facilitate regulatory arbitrage by inflating ratings. Our model relates rating informativeness to the quality distribution of issuers, the complexity of assets, and issuers' outside options. We reconcile our results with the existing empirical literature and highlight new, testable implications, such as repercussions of the Dodd-Frank Act.

/pdf/rating-agencies-in-the-face-of-regulation-58t3igzq98.pdf

Rating Agencies in the Face of Regulation

Analyzing 916 CDOs, we find that a top credit rating agency frequently made positive adjustments beyond its main model that amounted to 12.1% larger AAA tranche sizes. These adjustments are difficult to explain by likely determinants, but exhibit a clear pattern: CDOs with smaller model-implied AAA sizes receive larger adjustments. CDOs with larger adjustments experience more severe subsequent downgrading. Additionally, prior to April 2007, 91.2% of AAA rated CDOs only comply with the credit rating agency’s own AA default rate standard. Accounting for adjustments and the criterion deviation indicates that AAA tranches were on average structured to BBB support levels.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2009625_code33531.pdf?abstractid=1364933&rulid=180026&mirid=2

Did Subjectivity Play a Role in CDO Credit Ratings

Prior research shows that firms’ financial statement comparability improves the accuracy of market participants’ valuation judgments and thus may reduce firms’ costs of capital. Distinct from prior research focusing on the equity market, we develop measures of comparability relevant to debt market participants based on the within-industry variability of Moody’s adjustments to reported accounting numbers for the purposes of credit rating. We examine two sets of adjustments: (1) to the interest coverage ratio and (2) to non-recurring income items. We validate these comparability measures by providing evidence that greater comparability is associated with lower frequency and magnitude of split ratings by credit rating agencies. We predict and find that greater comparability is associated with (1) lower estimated bid-ask spreads for traded bonds, (2) lower credit spreads for both bonds and five-year credit default swaps, and (3) a steeper one- to five-year credit default swap term structure. Our results are consistent with financial statement comparability reducing debt market participants’ uncertainty about and pricing of firms’ credit risk.

/pdf/financial-statement-comparability-and-credit-risk-253nk8ye1q.pdf

Financial statement comparability and credit risk

Using a dataset of financial statements that are adjusted by Moody's for its credit analysis, I document extensive and large differences between firms' reported U.S. GAAP numbers and firms' adjusted numbers. Off-balance sheet financing accounts for the largest difference. The adjusted leverage ratio exceeds the reported leverage ratio by 20% (70%) for the median (average) firm. Adjusted profitability ratios and cash flow to debt ratios differ from their U.S. GAAP equivalents primarily because of greater adjusted interest expense and greater adjusted debt numbers. This implies that essentially all firms in the sample understate their leverage. In addition to adjusting reported accounting numbers, credit analysts adjust ratings down by an average of 0.38 notches due to credit risk from qualitative factors. I predict and find that rating agency adjustments are associated with greater credit spreads and a flatter credit spread term structure. This implies that credit ratings are a function of quantitative adjustments to U.S. GAAP numbers and the rating agency's qualitative assessment of credit risk arising from soft factors. The results suggest that rating agency's quantitative and soft adjustments capture true default risk and rating agencies efficiently process accounting and soft information. Thus ratings can serve as a contracting device to incorporate off-balance-sheet debt adjustments and credit-risk increasing soft factors.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1876672_code1104503.pdf?abstractid=1266381&rulid=159302&mirid=2

Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Credit Spreads

I examine whether rating agencies cater to borrowers with rating-based performance-priced loan contracts (PPrating firms). I use data from Moody's Financial Metrics on its quantitative adjustments for off-balance-sheet debt and qualitative adjustments for soft factors. In the cross-section and for borrowers experiencing adverse economic shocks, I find that these adjustments are more favorable for PPrating firms than for other firms, consistent with rating agencies catering to the PPrating borrowers. I find that this catering is muted in two circumstances when rating agencies' reputational costs are higher than usual: (1) near the investment grade and prime short-term rating thresholds and (2) when Fitch Ratings also provides a rating.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1881940_code1104503.pdf?abstractid=1726943&rulid=223079&mirid=5

Do Rating Agencies Cater? Evidence from Rating-Based Contracts

I examine a dataset of both quantitative (hard) adjustments to firms' reported U.S. GAAP financial statement numbers and qualitative (soft) adjustments to firms' credit ratings that Moody's develops and uses in its credit rating process. I first document differences between firms' reported and Moody's adjusted numbers that are both large and frequent across firms. For example, primarily because of upward adjustments to interest expense and debt attributable to firms' off-balance sheet debt, on average, adjusted coverage (cash flow-to-debt) ratios are 27 percent (8 percent) lower and adjusted leverage ratios are 70 percent higher than the corresponding U.S. GAAP ratios. I then find that Moody's hard and soft rating adjustments are associated with significantly higher credit spreads and flatter credit spread term structures. Overall, the results indicate that Moody's quantitative adjustments to financial statement numbers and qualitative adjustments to credit ratings enable it to better capture de...

/pdf/rating-agency-adjustments-to-gaap-financial-statements-and-3u1ofpfdp1.pdf

Prior research shows that firms' financial statement comparability improves the accuracy of market participants' valuation judgments and thus may reduce firms' costs of capital. Distinct from prior research focusing on the equity market, we develop measures of comparability relevant to debt market participants based on the within-industry variability of Moody's adjustments to reported accounting numbers for the purposes of credit rating. We examine two sets of adjustments: (1) to the interest coverage ratio and (2) for non-recurring income items. We validate these comparability measures by providing evidence that greater comparability is associated with lower frequency and magnitude of split ratings by credit rating agencies. We predict and find that greater comparability is associated with: (1) lower estimated bid-ask spreads for traded bonds, (2) lower credit spreads for both bonds and five-year credit default swaps, and (3) a steeper one- to five-year credit default swap term structure. Our results are consistent with financial statement comparability reducing debt market participants' uncertainty about and pricing of firms' credit risk.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2199684_code1104503.pdf?abstractid=2094637&mirid=1&type=2

Pepa Kraft

Papers

Financial statement comparability and credit risk

Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Credit Spreads

Do Rating Agencies Cater? Evidence from Rating-Based Contracts

Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Credit Spreads

Financial Statement Comparability and Credit Risk