0:16

It shows the importance of credit ratings.

Â It's a fundamental variable for credit markets, and what we see in this

Â picture is that every country in the world actually has a credit rating.

Â Countries borrow in debt markets, and what happens is that rating agencies have to

Â determine what is the likelihood that a country will default on its debts?

Â So, you can see that most countries, actually, not everywhere.

Â There are some places in Africa that don't have a credit rating, and Asia.

Â But by and large, you can see that every country has a credit rating.

Â So, this is just an interesting way to think about the world, right?

Â These are the credit ratings that we're talking about.

Â It goes from AAA, which is the highest rating.

Â If you're looking at S&P, there are other companies that do credit ratings as well.

Â So, ratings go from AAA, all the way down to default.

Â So, if a company's rated D, down here, it means that you defaulted.

Â If you have a high rating,

Â it means that you have a low probability of default, okay?

Â And rating agencies like to separate these ratings into two categories.

Â 2:27

It probably would not be a great business model to have a mathematical

Â model that use a very precise answer, right?

Â And then what people could do is just replicate that model,

Â and it would send the rating agencies out of business.

Â So, the bottom line is that it's a measure of the chance that they issue a default,

Â but it's not the purely objective measure.

Â 3:07

So, rating agencies are a combination of objective data and subjective calls.

Â What we can do is we can try to look at the objective side.

Â Which variables matter most for ratings?

Â Let's bring our researcher here.

Â People have done research on this, right?

Â It's fairly straightforward.

Â We have the ratings from standard imports, right?

Â And then we have the data on the companies.

Â We can try to relate them and see which variables are related to ratings.

Â So, I'm going to show you two tables.

Â This table actually comes from a paper that I wrote recently about

Â credit ratings.

Â It's a regression, if you learned about regression,

Â maybe in your statistics course,

Â it's a regression of credit rating on different firm characteristics.

Â The variables that I have here in this regression,

Â we actually talked about already in this course.

Â So, ROA is a measure of profitability, is the company's profit divided by assets.

Â Size, is obvious, and then leverage, right,

Â which is what we were talking about in module one.

Â What you'll see in this regression table is that

Â profits are positively correlated with ratings.

Â So, profitable companies have higher ratings.

Â Larger companies have higher ratings, and companies that have higher leverage.

Â If you have a lot of debt, you're going to end up with a lower credit rating.

Â The regression also has square terms, but

Â it really doesn't really change the degradation that much.

Â And here's an interesting observation.

Â The R square of a regression, again, if you cover this in your statistics course,

Â which It's a very important tool for finance.

Â The R square shows that it's a 0.6 R square, 0.587, approximating to 0.6.

Â This shows that these variables, profit size and leverage explain

Â a lot of the variation in credit ratings, but they don't explain 100%.

Â So, there's 40% of the variation in credit ratings that perhaps

Â are capturing the subjective judgment that

Â the rating agencies exercise when they give out credit ratings.

Â 5:22

Another way to look at credit ratings is to look at leverage ratios per rating.

Â So here, we have the highest rating, AAA, when we look at the leverage ration that I

Â wrote down explicitly here as total debt divided by the market value of assets,

Â you see that it will only be 3.7% for AAA rated companies.

Â And the leverage ratio keeps increasing as the ratings go down, right?

Â So, there is a one-to-one relationship between ratings and leverage ratio.

Â We can also look at EBIT interest coverage,

Â which is another financial ratio we talk about in corporate finance one.

Â It's the ratio of EBIT operating income to interest payments.

Â It's essentially telling us how large are the company's profits

Â relative to the interest payment.

Â And again, you see that there's this one to one relationship between how much

Â the company borrow, and the credit rating that is given by the rating agency.

Â 6:21

To summarize, essentially what we've seen is

Â that highly levered companies are going to have lower credit ratings, right?

Â Particularly so if they are small and less profitable.

Â There is this one-to-one relationship between rating and

Â leverage, which makes sense, but this raises an interesting question.

Â Why should we care about ratings then?

Â Maybe then off to just think about leverage, right?

Â In Module 1 of corporate finance two, will already talked about how to determine and

Â optimal leverage ration, which consideration is going through that?

Â Why do we care about ratings?

Â 6:54

Let's bring back our researcher.

Â There's been a lot of research about credit ratings and

Â corporate finance recently, including a paper that I wrote I'm going to show you.

Â But, here is the answer.

Â Here's why companies should care about a credit rating.

Â The idea is that a rating downgrade

Â can have a very significant impact on the cost of capital for a company.

Â This is what Kisgen showed in his research.

Â There are several papers that Darren Kisgen wrote about this issue.

Â And some of the reasons why a rating downgrade matters, because

Â rating downgrade affects variables, like access to commercial paper mark.

Â We're going to talk about commercial paper later on in this module.

Â Companies with low rating cannot tax as credit rating.

Â 8:02

Bank capital requirements are also tied to ratings.

Â If banks make a loan that has a low rating, the bank has to hold

Â more capital against that loan, increasing the cost of the loan for the bank.

Â And finally, ratings can trigger violations of financial covenant,

Â which is that it's another issue that we're going to talk about in this module.

Â If you don't know what a financial covenant is, you're going to learn soon.

Â So, here's the summary that I was talking about.

Â So, access to commercial paper, insurance companies can be restricted

Â from investing in junk bonds, so on and so forth.

Â The bottom line is that there are lots of frictions in financial

Â markets that are related to credit ratings.

Â 8:44

A rating downgrade can really matter for a company.

Â Recently, I've followed up on this idea with my

Â to think about sovereign downgrade.

Â What happens in a sovereign downgrade is that some companies tend to be downgraded

Â together with the country.

Â For example, we have this example of EDP Energias, which is a Portuguese company.

Â It got downgraded from A to BBB- together with Portugal in March, 2011.

Â So, Portugal got downgraded from A to BBB-,

Â EDP Energias got downgraded together with Portugal, that happens because

Â the rating agencies use something that is called the ceiling room.

Â They don't like rating a Portuguese company higher than the country, so

Â what tends to happen in the data we've shown is that companies like EDP Energias,

Â they tend to get downgrade together with the sovereign.

Â Okay, and what we show in our paper is that the sovereign downgrades cause

Â a significant increase in the cost of capital for companies like EDP Energias.

Â This is a study that look at many countries, many years.

Â And it's summarized here in this picture, essentially,

Â this blue line shows what happens to companies that get downgraded.

Â You can see that the y-axis is measuring the spread.

Â So, these companies usually have a lower spread than the other companies in

Â the economy, because they are the companies with high ratings, right?

Â EDP Energies had the same rating as Portugal.

Â Those tend to be the highly rated companies in the country.

Â But following the downgrade, the sovereign downgrade is marked here by this line,

Â the cost of capital increased a lot for companies like EDP Energies.

Â 10:32

Bond spreads increased significantly.

Â We'll show in our paper that this has severe consequences for

Â what happens with these companies.

Â Okay, what this means is that, there is a very important idea in corporate finest.

Â Managers should care about credit rating.

Â Capital structure is not just about determining

Â an optimal amount of leverage you have, a company should also be thinking about

Â how the rating agency going to react to my financial decision, okay?

Â This is a very nice quote that I took from GE's annual reporting in 2006.

Â It shows exactly this idea.

Â It's one of the strategic objectives of GE when they think about financial policy

Â to maintain their credit rating.

Â At that time, was AAA, right?

Â The reason is that it lowers cost of funds, facilitate access to a variety of

Â lenders, and etc, which is exactly what we've been talking about.

Â So, credit ratings do matter and companies should target credit ratings.

Â Actually has this very nice idea that I'm showing you here.

Â It actually changes the way you think about the trade off model.

Â Remember that we had that picture that related value to a leverage, right?

Â So, when leverage goes up, value goes up, and then it goes down, right?

Â That allows you to think about the optimal capital structure.

Â 11:56

Credit ratings make this picture jagged, like what I have here, right?

Â So for example, there are these points when,

Â if you increase leverage beyond that point, you might get a downgrade.

Â If a company gets downgraded, there's going to be

Â a significant change in form value, because of increasing the cost of capital.

Â So, your value you can see in that picture,

Â the value is dropping by a discrete amount.

Â When you change, your leverage by a little bit, so

Â this picture becomes jagged is one way to think about how ratings really matter when

Â a financial manager determines optimal [INAUDIBLE].

Â