Pulling the Trigger: Activating Rating Triggers Under COVID-19

Abstract

Rating Trigger is a contractual mechanism that penalizes a party whose credit rating falls below a stipulated grade. When activated, this mechanism imposes onerous collateralization duties and requires that outstanding debt be repaid immediately. These repercussions often have a devastating effect on debt-issuers by undercutting their solvency and harm third parties as well. According to the accepted wisdom, nonetheless, rating triggers are socially beneficial. Arguably, they enhance economic efficiency by reducing the agency and supervision costs for creditors and investors.<br><br>The coronavirus-induced economic crisis and the ensuing volatility and instability challenge this accepted wisdom. Under the abnormal market conditions brought about by COVID-19, credit rating agencies prefer to err on the side of caution: they skew their evaluations toward “downward mistakes” thereby downgrading debt-issuers’ ratings without sufficient cause. This business strategy is a mirror image of the “upward mistake” strategy that rating agencies followed prior to the financial crisis of 2008-2009 and became accused of systematically inflating ratings. To shield themselves against such accusations and to entrench their position in the financial market, rating agencies have now shifted from over-optimism to over-caution by issuing projections that give creditors and investors excessive protection for the times of crisis. Tightened regulation and the drive to reduce operational costs have further strengthened the agencies’ incentive to pursue the “downward mistake” strategy, as did the difference between the agencies’ costs of making upward and downward mistakes. Both upward and downward mistakes are non-observable ex ante, when the agency delivers the rating. During a crisis, however, upward mistakes can be detected ex post as the true situation emerges, while downward mistakes remain largely undetectable.<br> <br>Downward mistakes come at a high social cost. They induce economic breakdowns when rating triggers are activated by investors. Such breakdowns have devastating effects on the economy and on society at large. They therefore need to be prevented. To this end, I recommend that a special tribunal be set up to oversee creditors’ activations of rating triggers and to enjoin unjustified activations. This tribunal would uncover the rating agencies’ downward mistakes, provide debt-issuers the protection they need, and incentivize the agencies to deliver more accurate credit ratings and protect the integrity and efficiency of financial markets.<br>